Yesterday the Securities and Exchange Commission published a notice of intent to issue an order that would increase the performance fee threshold, i.e., the definition of “qualified client” under Adviser’s Act Rule 205-3, to $2.0 Million from $1.5 Million (under the client net worth test), and to $1.5 Million from $750,000 (under the client asset under management test). The SEC also notified that it intended to adopt a rule requiring inflation adjustment reevaluation of these thresholds every five years.
The order proposal is a result of a study required by Section 418 of the Dodd-Frank Act. The proposed inflation-adjustment amendment would require the use of the Personal Consumption Expenditures Chain-Type Price Index (“PCE Index”), published by the Department of Commerce. The PCE Index is often used as an indicator of inflation in the personal sector of the U.S. economy.
The proposed amendment to Rule 205-3 would also specify that the value of a prospective client’s personal residence and any debt associated therewith should be excluded in determining net worth for purposes of determining whether he or she is a “qualified client” to whom performance fees may be charged.
Performance based fees have historically been charged by advisers to hedge funds and other private funds, although any adviser can charge them as long as they comply with the Investment Advisers Act, the SEC rules and any applicable state rules. Most states do, in fact, have rules that govern this situation, so advisers should not overlook them.
Historically, large categories of advisers have opposed performance-based fees in principle, believing them to be unseemly at best or breaches of their fiduciary duty at worst. Mostly these are dyed-in-the-wool fee only or financial planning types, but there are exceptions. The industry is trending toward fee based business slowly, according to recent studies, and performance fee arrangements are increasing at a similar pace.
Of the types of performance based fees, so-called fulcrum fees that provide for a fee enhancement when a portfolio meets a certain benchmark, are becoming more prevalent. Many firms that have introduced such fees have done so at the request or, in many cases, insistence, of their clients. Advisers that historically have touted their ability to surpass benchmarks have had to back up their claims by agreeing, essentially, to forgo part of their fees if the benchmarks aren’t met. The SEC and some states have special rules for implementing fulcrum fee arrangements.
If the order and proposed rule amendments are adopted or issued, they will provide, as a matter of transition, that any contract in existence for payment of a performance fee that was valid when made based on prior thresholds for determining qualified client status will remain valid, assuming no additional client is added to the contract. Also as a matter of transition, a contract entered into by an investment adviser exempt from registration and therefore not subject to Rule 205-3 at the time the contract was entered into can remain in effect, even if the adviser is no longer exempt from registration.
Due to detailed requirements of SEC and state rules, care should be taken in implementing any such performance fee arrangement.
Comments to the SEC’s proposed order modifying the performance-fee threshold, and the related rule, should be submitted by July 11, 2011.