SEC Adopts Inflation-Based Adjustment to "Qualified Client" Thresholds

The U.S. Securities and Exchange Commission issued a final order (Order) on June 14, 2016, to adjust for inflation the “qualified client” thresholds applicable when a registered investment adviser charges a performance fee in reliance on Rule 205-3 (Rule) under the Investment Advisers Act of 1940 (Advisers Act).¹ The new thresholds take effect on August 15, 2016. 

Highlights of the Order include: 

• Increase in thresholds for “qualified client” determination: The Commission performed an inflation calculation using the Personal Consumption Expenditures Chain-Type Price Index (PCE Index). Based on inflation, the Commission raised the qualified client net worth requirement from $2 million to $2.1 million. Because the effect of inflation on the assets under management (AUM) threshold was less than the applicable rounding threshold, the AUM threshold remains at $1 million. 
• No retroactive application for contracts/investments already in place: The Rule does not retroactively apply to contracts/fund investments in existence prior to the effective date. However, if a natural person or company that was not a party to the contract becomes a party on or subsequent to August 15, 2016, the increased thresholds will apply to the new party. 
• No changes to Section 3(c)(7) or non-U.S.-resident exemptions: Section 205(b) of the Advisers Act exempts certain investment advisory contacts and clients from the general ban on performance fees, including those with Section 3(c)(7) funds and non-U.S. residents. The Order does not alter these exemptions. 

Background 

Performance fees tie an investment adviser’s compensation to a client’s capital gains or capital appreciation. Section 205 prohibits investment advisers from charging performance fees because of Congress’ belief that such fees might encourage advisers to take undue risks with client funds.² However, Section 205(e) authorizes the Commission to create exemptions from the general performance fee prohibition where the Commission determines that an investor or particular class of investors does not require protection. 

In 1985, pursuant to Section 205(e), the Commission adopted the Rule, which permits an adviser to charge performance fees, provided the advisory contract is with a “qualified client.”³ A “qualified client” under the Rule is a client that meets one of two financial thresholds – based on the client’s AUM with the adviser (immediately after entering into the advisory contract) or the client’s overall net worth.⁴ The qualified client thresholds are designed to allow performance fee arrangements with clients or investors that the Commission believes have sufficient financial expertise and stability to bear the risk of performance fees.⁵

The Dodd-Frank Act amended Section 205 to require that the Commission regularly adjust the qualified client thresholds to account for inflation. Under amended Section 205, every five years (beginning in 2011), the Commission must adjust the qualified client thresholds for inflation, rounding to the nearest $100,000.⁶ Pursuant to the first round of adjustments, in July 2011, the AUM threshold was increased from $750,000 to $1,000,000, and the net worth threshold was increased from $1,500,000 to $2,000,000.⁷ 

In February of 2012, the SEC amended Rule 205-3 to: (i) reflect the adjusted thresholds; (ii) establish the PCE Index as the index to be used in calculating future inflation adjustments; and (iii) exclude the value of a natural person’s primary residence and debt secured by that property (unless the fair value of the debt exceeds the fair value of the residence) for purposes of the net worth threshold.⁸ 

2016 Adjustment to Qualified Client Thresholds and Transition Provisions 

In the Order, the Commission calculated AUM and net worth inflation adjustments using the PCE Index. Based on these calculations, the AUM threshold will remain at $1,000,000, because the calculated inflation adjustment was not large enough to round up to the next multiple of $100,000. However, the net worth inflation calculation was significant enough to require an adjustment and will, accordingly, be increased from $2,000,000 to $2,100,000.⁹ 

The increased net worth threshold applies only to new investment advisory arrangements entered into on or after the August 15, 2016, effective date – not to “new investments by clients who met the definition of qualified client when they entered into the advisory contract, even if they subsequently do not meet the dollar amount thresholds of the [R]ule.” This section of the Order refers to two transitional provisions under sections (c)(1) and (c)(2) of the Rule. 

First, pursuant to Rule 205-3(c)(1), the Order’s adjustments to the thresholds do not apply to current advisory contracts that, when entered into, were in compliance with the thresholds that were then in effect under existing orders from the Commission – which includes existing investments in 3(c)(1) funds – even if additional assets are added to the investment or account. This exception extends to transfers of an equity ownership in a private investment company by gift or bequest or pursuant to an agreement related to a legal separation or divorce. The Commission does not consider these transfers a separate investment decision but rather the receipt of the benefit of a pre-existing contractual relationship. If, however, “a natural person or company who was not a party to the contract becomes a party,” the new party to the contract will need to meet the increased qualified client thresholds. 

Second, pursuant to Rule 205-3(c)(2), the Order’s adjustments to the thresholds do not apply to registered investment advisers that were previously not registered (and not previously required to be registered) with respect to advisory contracts with clients entered into prior to registration. As explained by the Commission, “if any investment adviser to a private investment company ... was exempt from registration ... but then subsequently registered ... Section 205(a)(1) will not apply to the contractual arrangements the adviser entered into before [registration].” The exception applies to any investors the investment adviser had in the private investment company and any additional investments those investors might make. Nevertheless, Section 205(a)(1) will apply, “after the adviser registers with the Commission,” (i) to new investors in the existing fund and (ii) with respect to a new fund, to existing investors in a prior fund who subsequently invest in the new fund.¹⁰ 

Advisers relying on Rule 205-3 should update client onboarding documentation for new contractual relationships, and private fund subscription documents for Section 3(c)(1) funds, to reflect the increased net worth threshold. 

Footnotes 

_{1) Order Approving Adjustment for Inflation of the Dollar Amount Tests in Rule 205-3 under the Investment Advisers Act of 1940, Release No. IA-4421 (June 14, 2016).
2) Investment Adviser Performance Compensation, Release No. IA-3372 (Feb. 15, 2012).
3) Exemption to Allow Registered Investment Advisers to Charge Fees Based Upon a Share of Capital Gains Upon or Capital Appreciation of a Client’s Account, Release No. IA-996 (Nov. 14, 1985) (1985 Adopting Release).
4) Net worth excludes a natural person’s primary residence and any liability on such residence, unless the outstanding liability exceeds the estimated fair value of the residence.
5) 1985 Adopting Release supra note 11.
6) The Dodd-Frank Act, in relevant part, requires that the Commission “shall, by order, not later than 1 year after the date of enactment of the Private Fund Investment Advisers Registration Act of 2010 and every 5 years thereafter, adjust for the effects of inflation ....” Adjustments are subject to rounding to the nearest $100,000 and no adjustment takes place if the adjustment would be below the rounding threshold.
7) Order Approving Adjustment for Inflation of the Dollar Amount Tests in Rule 205-3 under the Investment Advisers Act of 1940, Release No. IA-3236 (July 12, 2011). The Rule was codified to amend these thresholds in February 2012.
8) Investment Adviser Performance Compensation, Release No. IA-3372 (Feb. 15, 2012) (2012 Release).The Commission indicated that the PCE Index “is an indicator of inflation in the personal sector of the U.S. Economy and is used in other provisions of the federal securities law.” See also PCE Inflation Dispersion, Federal Reseerve Bank of San Francisco (June 7, 2016), available here. (“The personal consumption expenditure price index ... measures the percentage change in prices of goods and services purchased by consumers throughout the economy. Of all the measures of consumer price inflation, the [PCE index] covers the broadest set of goods and services.”)
9) Order supra note 3.
10) 2012 release supra note 19.}