Final Rule on Advisers Charging Performance Fees

The Securities and Exchange Commission (SEC) released Final Rule No. IA – 3372 which changes the qualifications for advisers who charge performance fees. We discussed the proposed amendment to the rule in a previous blog post, Performance Based Fee Threshold Increase Sought by SEC in Proposed Order. These amendments are required by the Dodd-Frank Wall Street Reform and Consumer Protection Act, and will take effect 90 days after publication in the Federal Register, which is anticipated shortly. Until then advisers can rely on the grandfather provisions.

While advisers are generally unable to accept performance fees, there are exceptions. For example under certain circumstances, a client may become a “qualified client,” under Rule 205-3, meaning he or she is deemed to be capable of bearing the risks associated with performance fee arrangements. Under the new rule, an adviser may charge performance fees to “qualified clients” who have at least $1 million of assets under management for that definition to apply. Under the previous rule, $750,000 in assets were required to be under management. Also, the net worth of an investor may also be a qualification for an exception. The amended rule raises the minimum net worth standard for qualified clients from $1 million to $2 million. (The other “qualified client” basis includes clients who immediately before entering the advisory contract are either executive officers, directors, trustees, general partners of the adviser or employees of the adviser and who have participated in the adviser’s investment activities for at least twelve months. This definition has not changed with the amendment.)

The new rule also contains a provision requiring an inflation adjustment to the net worth “qualified client” test every five years. It specifies the price index, the Personal Consumption Expenditures Chain-Type Price Index, on which future inflation adjustments are to be made.

The revised rule also excludes a client’s primary residence and certain property-related debts in the net worth calculation. This change was not a requirement of the Dodd-Frank Act; however, the SEC is trying to remain consistent with other rules previously enacted, such as the new definition of an “accredited investor,” which also excludes the value of the primary residence. We have previously discussed the new definition of an accredited investor in a previous blog, Financial Advisers Should Note More Restricted Accredited Investor Definition.

The grandfathering provision included in the rule allows registered investment advisers who were previously charging performance fees to clients were considered “qualified clients” under the previous rule to continue to do so. This provision is intended to minimize the disruption of existing contractual relationships. Also, newly-registered investment adviser who previously was not required to register with the SEC because of an exemption may continue to receive already agreed upon performance fees from clients.

Parker MacIntyre provides legal and compliance services to investment advisers, broker-dealers, registered representatives, hedge funds and issuers of securities, among others. Our regulatory practice group assists financial service providers with the complex issues that arise in the course of their businesses, including compliance with federal and state laws and rules.