Nathan J. Greene and Caitlyn B. Gale

On May 10, 2011, the US Securities and Exchange Commission (SEC) proposed to adjust the financial thresholds used to define a “qualified client” for purposes of the performance compensation rules under the US Investment Advisers Act of 1940 (Advisers Act), generally raising the so-called net worth qualification test from US$1.5 million to US$2 million and the so-called assets under management qualification test from US$750,000 to US$1 million. In general, only a “qualified client” may be charged performance-based fees by SEC-registered investment advisers, and the Dodd-Frank Act had directed the SEC to revisit these thresholds. Notably, the new thresholds would not apply retroactively, so that performance fee arrangements entered into under the earlier rules will not be affected. The SEC also confirms that newly registered investment advisers need not retroactively apply any qualified-client thresholds to performance fee arrangements entered into prior to a firm’s registration with the SEC.

Going forward, the Dodd-Frank Act sets a five-year cycle for further revision to the thresholds, with the first update now set for May 2016 and adjustments based on an inflation measure.

The performance fee rules do not limit their application to direct adviser-client relationships. The rules also generally require that the investors in an investment fund be “qualified clients” when the fund is charged a performance fee by the fund’s investment adviser (assuming the investment adviser is registered with the SEC and subject to the Advisers Act rules).

Again, the proposed transition rules operate so that restrictions on the charging of performance fees apply to new contractual arrangements and do not apply retroactively to existing contractual arrangements. Grandfathering applies both to a direct adviser-client relationship and to the investment funds context. It also is proposed that follow-on investments by grandfathered investors will be permitted and those follow-on investments would likewise be grandfathered. But new investors investing for the first time after the new rules come into effect would be subject to the new rules in full.

In addition, the proposed rules would amend the net worth test in the definition of “qualified client” to exclude the value of a person’s primary residence and debt secured by the property. The SEC notes that this change was not required by the Dodd-Frank Act, but is similar to the Dodd-Frank Act’s requirement that the SEC exclude the value of a person’s primary residence in the definition of “accredited investor” under the US Securities Act of 1933.

For a more detailed summary of these matters, please see our client publication entitled, SEC Proposes to Update Investment Adviser Performance Fee Rules, available at http://www.shearman.com/sec-proposes-to-update-investment-adviser-performance-fee-rules-05-18-2011/