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SEC Amends Performance Compensation Rule and Provides Transition Relief for Pre-existing Advisory Relationships

Securities Alert | February 20, 2012
by: Neil P. Casey

Registered investment advisers are prohibited from entering into any advisory contract with a client that provides for performance fees or performance compensation unless the client is a “qualified client” within the meaning of Rule 205-3 under the Investment Advisers Act of 1940 (the Advisers Act).[1] In the case of any private fund that relies on Section 3(c)(1) of the Investment Company Act of 1940 to remain exempt from registration as an investment company (a Section 3(c)(1) fund), each equity owner of the fund (except for the adviser and any equity owner not charged a performance fee) must be a qualified client under the Rule.

The term “qualified client” includes any natural person or company (i) that has at least $1 million of assets under management with the adviser immediately after entering into the advisory contract (the AUM test) or (ii) whom the adviser reasonably believes has a specified net worth, or joint net worth with a spouse, of more than $2 million (the net worth test).[2]

On February 15, 2012, the Securities and Exchange Commission (SEC) amended Rule 205-3 to:

  • incorporate into the Rule the current $1 million and $2 million thresholds for the AUM test and net worth test, respectively[3];
  • provide that the SEC will adjust these thresholds for inflation every five years, based on a specified price index, commencing on or about May 1, 2016;
  • require a natural person’s primary residence and certain debt secured by the property to be excluded from the calculation of net worth (consistent with the recently amended “accredited investor” definition applicable to certain unregistered securities offerings)[4];
  • allow for transfers of interests in a Section 3(c)(1) fund by gift or bequest, or pursuant to legal separation or divorce, from a qualified client to a person that is not a qualified client at the time of transfer; and
  • grant transition relief for certain pre-existing advisory relationships.

The amendments will take effect 90 days after publication in the Federal Register (i.e. May 2012), but advisers are allowed to rely on the transition provisions of the amended Rule before the effective date.

The transition provisions generally provide that an adviser may maintain existing performance fee arrangements if the arrangements were permitted at the time the advisory contract was entered into, even if they would be impermissible if entered into at a later date. Thus, the Advisers Act prohibition on performance fees will not apply to any contractual arrangement entered into by an investment adviser at a time when the adviser was not required to be registered with the SEC (and was not so registered). However, once the adviser does register with the SEC, any new advisory contracts, as well as the accounts of any new investors in any Section 3(c)(1) funds advised by the adviser (whether such funds were established before or after registration) will be subject to the requirements of the Rule. For example, an adviser that previously relied on the “private adviser” exemption of Section 203(b)(3) of the Advisers Act to remain exempt from SEC registration, but who is now required to register due to the repeal of that exemption, will be permitted to maintain the performance fee arrangements in any advisory contract entered into with a Section 3(c)(1) fund prior to the adviser’s SEC registration, even for the account of investors in that fund who are not qualified clients, so long as those investors were invested in that fund prior to the date on which the adviser registers with the SEC. Any such “grandfathered” investors will also be permitted to invest additional assets in that same fund even after the adviser has registered with the SEC, despite the fact that they are not qualified clients. On the other hand, the qualified client requirements of Rule 205-3 will apply to the account of (i) any investor who first invests in that preexisting fund after the adviser registers with the SEC and (ii) any investor in a Section 3(c)(1) fund formed after the adviser registers with the SEC, whether or not the investor was otherwise “grandfathered” with respect to its investment in a preexisting fund.

In the case of advisers already registered with the SEC, the advisory contract must comply with the conditions of Rule 205-3 as in effect on the date on which the client enters into the contractual relationship with the adviser, or in the case of an investor in a Section 3(c)(1) fund, the date on which he or she first becomes an investor in the fund (i.e. becomes a party to the advisory contract for purposes of the Rule). Consequently, an investor who satisfies the requirements of the Rule on the date he or she first invests in a Section 3(c)(1) fund can invest additional assets in that fund even if the dollar thresholds under the Rule are subsequently increased by the SEC and he or she does not meet the new thresholds.

The SEC’s Final Rule Release and the full text of the amendments to Rule 205-3 can be found at

Please note that the foregoing summary addresses the performance compensation rules under federal securities laws only. Advisers that are subject to state regulation should be mindful that applicable state laws may incorporate the provisions of Rule 205-3 and/or set forth additional or different requirements with respect to performance fee arrangements.[5]

For more information regarding this alert, please contact Neil Casey (212.631.4414; or Lori Smith in our New York office (212.714.3075;, or Merritt Cole in our Philadelphia office (215.864.7018;

[1] Section 205(a)(1) of the Advisers Act prohibits registered investment advisers from directly or indirectly entering into, extending, or renewing any investment advisory contract that provides for compensation to the investment adviser on the basis of a share of capital gains upon or capital appreciation of the funds or any portion of the funds of the client. Congress imposed restrictions on these types of compensation arrangements to protect advisory clients from arrangements it believed might encourage advisers to take undue risks with client funds. However, Congress also authorized the SEC in Section 205(e) of the Advisers Act to adopt rules which would exempt advisory contracts with clients whom the SEC determined did not need the protections of the restrictions. The SEC adopted Rule 205-3 in 1985 pursuant to that authority.

[2] “Qualified client” also includes any natural person or company who is (i) a “qualified purchaser” as defined in the Investment Company Act of 1940 (the Investment Company Act), (ii) an executive officer, director, trustee, general partner or person serving in a similar capacity, of the investment adviser, or (iii) a non-clerical employee of the adviser who regularly participates in the investment activities of the adviser and has performed such functions, or substantially similar functions for another company, for at least 12 months. See Advisers Act Rule 205-3(d). Section 2(a)(51) of the Investment Company Act defines a “qualified purchaser” as (i) any natural person who owns at least $5 million of specified investments (either alone or together with a qualified purchaser spouse), (ii) any company that owns not less than $5 million in investments and that is owned directly or indirectly by or for two or more family members or related estates, foundations, charitable organizations or trusts, (iii) certain types of trusts not formed for the specific purpose of acquiring the securities offered, as to which the trustee or other person authorized to make decisions with respect to the trust, and each settlor or other person who has contributed assets to the trust, is a qualified purchaser and (iv) any other person who owns and invests on a discretionary basis at least $25 million of investments.

[3] These current thresholds actually took effect on September 19, 2011. See Order Approving Adjustment for Inflation of the Dollar Amount Tests in Rule 205-3 under the Investment Advisers Act of 1940, Investment Advisers Act Release No. 3236 (July 12, 2011). Before that date, the thresholds for the AUM test and the net worth test had been $750,000 and $1.5 million, respectively, since 1998.

[4] See “SEC Amends Net Worth Standard for Accredited Investors and Provides Limited Transition Relief”, White and Williams LLP Securities Alert, December 29, 2011 (available at

[5] See, e.g., New Jersey Bureau of Securities Rules, 13:47A-2.10; Code of Massachusetts Regulations, Ch. 950, Sec. 12.205(2)(c). 

This correspondence should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult a lawyer concerning your own situation and legal questions.
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