[Federal Register Volume 77, Number 35 (Wednesday, February 22, 2012)]
[Rules and Regulations]
[Pages 10358-10368]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2012-4046]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 275
[Release No. IA-3372; File No. S7-17-11]
RIN 3235-AK71
Investment Adviser Performance Compensation
AGENCY: Securities and Exchange Commission.
ACTION: Final rule.
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SUMMARY: The Securities and Exchange Commission (``Commission'' or
``SEC'') is adopting amendments to the rule under the Investment
Advisers Act of 1940 that permits investment advisers to charge
performance based compensation to ``qualified clients.'' The amendments
[[Page 10359]]
revise the dollar amount thresholds of the rule's tests that are used
to determine whether an individual or company is a qualified client.
These rule amendments codify revisions that the Commission recently
issued by order that adjust the dollar amount thresholds to account for
the effects of inflation. In addition, the rule amendments: provide
that the Commission will issue an order every five years in the future
adjusting the dollar amount thresholds for inflation; exclude the value
of a person's primary residence and certain associated debt from the
test of whether a person has sufficient net worth to be considered a
qualified client; and add certain transition provisions to the rule.
DATES: Effective Date: The amendments are effective on May 22, 2012.
FOR FURTHER INFORMATION CONTACT: Daniel K. Chang, Senior Counsel, or C.
Hunter Jones, Assistant Director, at 202-551-6792, Office of Regulatory
Policy, Division of Investment Management, Securities and Exchange
Commission, 100 F Street NE., Washington, DC 20549-8549.
SUPPLEMENTARY INFORMATION: The Commission is adopting amendments to
rule 205-3 [17 CFR 275.205-3] under the Investment Advisers Act of 1940
(``Advisers Act'' or ``Act'').\1\
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\1\ 15 U.S.C. 80b. Unless otherwise noted, all references to
statutory sections are to the Investment Advisers Act, and all
references to rules under the Advisers Act, including rule 205-3,
are to Title 17, Part 275 of the Code of Federal Regulations [17 CFR
part 275].
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Table of Contents
I. Introduction
II. Discussion
A. Inflation Adjustment of Dollar Amount Thresholds
B. Exclusion of the Value of Primary Residence From Net Worth
Determination
C. Transition Provisions
D. Effective Date
III. Cost-Benefit Analysis
A. Benefits
B. Costs
IV. Paperwork Reduction Act
V. Regulatory Flexibility Act Certification
VI. Statutory Authority
Text of Rules
I. Introduction
Section 205(a)(1) of the Investment Advisers Act generally
restricts an investment adviser from entering into, extending,
renewing, or performing any investment advisory contract that provides
for compensation to the adviser based on a share of capital gains on,
or capital appreciation of, the funds of a client.\2\ Congress
restricted these compensation arrangements (also known as performance
compensation or performance fees) in 1940 to protect advisory clients
from arrangements it believed might encourage advisers to take undue
risks with client funds to increase advisory fees.\3\ Congress
subsequently authorized the Commission to exempt any advisory contract
from the performance fee restrictions if the contract is with persons
that the Commission determines do not need the protections of those
restrictions.\4\
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\2\ 15 U.S.C. 80b-5(a)(1).
\3\ H.R. Rep. No. 2639, 76th Cong., 3d Sess. 29 (1940).
Performance fees were characterized as ``heads I win, tails you
lose'' arrangements in which the adviser had everything to gain if
successful and little, if anything, to lose if not. S. Rep No. 1775,
76th Cong., 3d Sess. 22 (1940).
\4\ Section 205(3) of the Advisers Act. Section 205(e) of the
Advisers Act authorizes the Commission to exempt conditionally or
unconditionally from the performance fee prohibition advisory
contracts with persons that the Commission determines do not need
its protections. Section 205(e) provides that the Commission may
determine that persons do not need the protections of section
205(a)(1) on the basis of such factors as ``financial
sophistication, net worth, knowledge of an experience in financial
matters, amount of assets under management, relationship with a
registered investment adviser, and such other factors as the
Commission determines are consistent with [section 205].''
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The Commission adopted rule 205-3 in 1985 to exempt an investment
adviser from the restrictions against charging a client performance
fees in certain circumstances.\5\ The rule, when adopted, allowed an
adviser to charge performance fees if the client had at least $500,000
under management with the adviser immediately after entering into the
advisory contract (``assets-under-management test'') or if the adviser
reasonably believed the client had a net worth of more than $1 million
at the time the contract was entered into (``net worth test''). The
Commission stated that these standards would limit the availability of
the exemption to clients who are financially experienced and able to
bear the risks of performance fee arrangements.\6\
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\5\ 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, Investment Advisers Act Release
No. 996 (Nov. 14, 1985) [50 FR 48556 (Nov. 26, 1985)] (``1985
Adopting Release''). The exemption applies to the entrance into,
performance, renewal, and extension of advisory contracts. See rule
205-3(a).
\6\ See 1985 Adopting Release, supra note 5, at Sections I.C and
II.B. The rule also imposed other conditions, including specific
disclosure requirements and restrictions on calculation of
performance fees. See id. at Sections II.C-E.
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In 1998, the Commission amended rule 205-3 to, among other things,
change the dollar amounts of the assets-under-management test and net
worth test to adjust for the effects of inflation since 1985.\7\ The
Commission revised the former from $500,000 to $750,000, and the latter
from $1 million to $1.5 million.\8\
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\7\ See Exemption To Allow Investment Advisers To Charge Fees
Based Upon a Share of Capital Gains Upon or Capital Appreciation of
a Client's Account, Investment Advisers Act Release No. 1731 (July
15, 1998) [63 FR 39022 (July 21, 1998)] (``1998 Adopting Release'').
\8\ See id. at Section II.B.1.
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The Dodd-Frank Wall Street Reform and Consumer Protection Act
(``Dodd-Frank Act'') \9\ amended section 205(e) of the Advisers Act to
require that the Commission adjust for inflation the dollar amount
thresholds in rules under the section, rounded to the nearest
$100,000.\10\ Separately, the Dodd-Frank Act also required that we
adjust the net worth standard for an ``accredited investor'' in rules
under the Securities Act of 1933 (``Securities Act''),\11\ such as
Regulation D,\12\ to exclude the value of a person's primary
residence.\13\
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\9\ Public Law 111-203, 124 Stat. 1376 (2010).
\10\ See section 418 of the Dodd-Frank Act (requiring the
Commission to issue an order every five years revising dollar amount
thresholds in a rule that exempts a person or transaction from
section 205(a)(1) of the Advisers Act if the dollar amount threshold
was a factor in the Commission's determination that the persons do
not need the protections of that section).
\11\ 15 U.S.C. 77a-77z-3.
\12\ See 17 CFR 230.501-.508.
\13\ See section 413(a) of the Dodd-Frank Act.
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In May 2011, the Commission published a notice of intent to issue
an order revising the dollar amount thresholds of the assets-under-
management and the net worth tests of rule 205-3 to account for the
effects of inflation.\14\ Our release (``Proposing Release'') also
proposed to amend the rule itself to reflect any inflation adjustments
to the dollar amount thresholds that we might issue by order.\15\ In
addition, our proposed amendments (i) stated that the Commission would
issue an order every five years adjusting for inflation the dollar
amount thresholds, (ii) excluded the value of a person's primary
residence from the test of whether a person has sufficient net worth to
be considered a ``qualified client,'' and (iii) modified certain
transition provisions of the rule.
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\14\ See Investment Adviser Performance Compensation, Investment
Advisers Act Release No. 3198 (May 10, 2011) [76 FR 27959 (May 13,
2011)] (``Proposing Release''). Rule 205-3 is the only exemptive
rule issued under section 205(e) of the Advisers Act that includes
dollar amount tests, which are the assets-under-management and net
worth tests. See supra text accompanying note 10.
\15\ Id.
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On July 12, 2011, we issued an order revising the threshold of the
assets-under-management test to $1 million,
[[Page 10360]]
and of the net worth test to $2 million.\16\ We received approximately
50 comments on our proposed rule amendments.\17\ Today we are adopting
amendments to rule 205-3 largely as we proposed them, with
modifications to address issues raised by commenters, as discussed
further below.
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\16\ 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) [76
FR 41838 (July 15, 2011)] (``Order''). The Order is effective as of
September 19, 2011. Id. The order applies to contractual
relationships entered into on or after the effective date, and does
not apply retroactively to contractual relationships previously in
existence.
\17\ The comment letters we received on the Proposing Release
are available on our Web site at http://www.sec.gov/comments/s7-17-11/s71711.shtml.
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II. Discussion
A. Inflation Adjustment of Dollar Amount Thresholds
We are amending rule 205-3 in three ways to carry out the required
inflation adjustment of the dollar amount thresholds of the rule.
First, we are revising the dollar amount thresholds that currently
apply to investment advisers, to codify the order we issued on July 12,
2011. As amended, paragraph (d) of rule 205-3 provides that the assets-
under-management threshold is $1 million and that the net worth
threshold is $2 million, which are the revised amounts we issued by
order.\18\ Although some commenters objected to raising these dollar
amount thresholds,\19\ section 205(e) of the Advisers Act requires that
we adjust the amounts for inflation.\20\
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\18\ The calculation used to determine the revised dollar
amounts in the tests is described below. See infra note 25. As we
noted in the Proposing Release, an investment adviser can include in
determining the amount of assets under management the assets that a
client is contractually obligated to invest in private funds managed
by the adviser. Only bona fide contractual commitments may be
included, i.e., those that the adviser has a reasonable belief that
the investor will be able to meet. See Proposing Release, supra note
15, at n.17.
\19\ Some commenters maintained, for example, that raising the
dollar amount thresholds would limit the investment options for
those investors that fall below the new thresholds, and would harm
smaller funds that rely on investments from investors with more
limited resources to operate. See, e.g., Comment Letter of Crescat
Portfolio Management LLC (May 11, 2011) (``Crescat Portfolio Comment
Letter''); Comment Letter of Hyonmyong Cho (June 8, 2011) (``H. Cho
Comment Letter''); Comment Letter of Harold Clyde (June 4, 2011)
(``H. Clyde Comment Letter''); Comment Letter of Douglas Estadt
(June 7, 2011) (``D. Estadt Comment Letter''). Other commenters
supported raising the dollar amount thresholds, noting that this
change would ensure that the ``qualified client'' standard is
limited to clients who are financially experienced and able to bear
the risks of performance fee arrangements. See, e.g., Comment Letter
of Better Markets, Inc. (July 11, 2011) (``Better Markets Comment
Letter''); Comment Letter of Certified Financial Planner Board of
Standards, Inc. (July 11, 2011) (``CFP Board Comment Letter'');
Comment Letter of Managed Funds Association (July 8, 2011) (``MFA
Comment Letter''); Comment Letter of North American Securities
Administrators Association, Inc. (July 11, 2011) (``NASAA Comment
Letter'').
\20\ See supra note 10.
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Second, we are adding to rule 205-3, as proposed, a new paragraph
(e) that states that the Commission will issue an order every five
years adjusting for inflation the dollar amount thresholds of the
assets-under-management and net worth tests of the rule.\21\ These
periodic adjustments are required by the Advisers Act,\22\ and most
commenters supported this amendment to the rule.\23\
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\21\ Rule 205-3(e) provides that the Commission will issue an
order on or about May 1, 2016 and approximately every five years
thereafter adjusting the assets-under-management and net worth tests
for the effects of inflation. These adjusted amounts will apply to
contractual relationships entered into on or after the effective
date of the order, and will not apply retroactively to contractual
relationships previously in existence. See supra note 16. The
proposed rule would have stated that the Commission's order would be
effective on or about May 1. We have deleted the word ``effective''
in the final rule to reflect the fact that the effective date will
likely be later than May 1. See Order, supra note 16 (setting
effective date of the order approximately 60 days after the order's
issuance).
\22\ See supra note 10.
\23\ See Comment Letter of Chris Barnard (May 31, 2011) (``C.
Barnard Comment Letter''); Better Markets Comment Letter; CFP Board
Comment Letter; Comment Letter of Investment Adviser Association
(July 11, 2011) (``IAA Comment Letter''); MFA Comment Letter. One
commenter stated that the dollar amount tests should be reevaluated
more frequently. See NASAA Comment Letter.
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Amended rule 205-3(e) also specifies the price index on which
future inflation adjustments will be based.\24\ The index is the
Personal Consumption Expenditures Chain-Type Price Index (``PCE
Index''),\25\ which is published by the Department of Commerce.\26\ The
dollar amount tests we adopted in 1998 will be the baseline for future
calculations.\27\ As we noted in the Proposing Release, the use of the
PCE Index is appropriate because it is an indicator of inflation in the
personal sector of the U.S. economy \28\ and is used in other
provisions of the federal securities laws.\29\ Commenters agreed that
the PCE Index is an appropriate indicator of inflation \30\ and that
the 1998 dollar amounts are the proper baseline for future inflation
adjustments.\31\
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\24\ See rule 205-3(e)(1).
\25\ The revised dollar amounts in the tests reflect inflation
as of the end of 2010, and are rounded to the nearest $100,000 as
required by section 418 of the Dodd-Frank Act. The 2010 PCE Index is
111.112, and the 1997 PCE Index is 85.433. These values are slightly
different from those provided in the Proposing Release because of
periodic adjustments issued by the Department of Commerce. See
Proposing Release, supra note 15, at n.19; see also infra note 26.
Assets-under-management test calculation to adjust for the effects
of inflation: 111.112/85.433 x $750,000 = $975,431; $975,431 rounded
to the nearest multiple of $100,000 = $1 million. Net worth test
calculation to adjust for the effects of inflation: 111.112/85.433 x
$1.5 million = $1,950,862; $1,950,862 rounded to the nearest
multiple of $100,000 = $2 million.
\26\ The values of the PCE Index are available from the Bureau
of Economic Analysis, a bureau of the Department of Commerce. See
http://www.bea.gov. See also http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=64&ViewSeries=NO&Java=no&Request3Place=N&3Place=N&FromView=YES&Freq=Year&FirstYear=1997&LastYear=2010&3Place=N&Update=Update&JavaBox=no#Mid.
\27\ Rule 205-3(e) provides that the assets-under-management and
net worth tests will be adjusted for inflation by (i) dividing the
year-end value of the PCE Index for the calendar year preceding the
calendar year in which the order is being issued, by the year-end
value of the PCE Index for the calendar year 1997, (ii) multiplying
the threshold amounts adopted in 1998 ($750,000 and $1.5 million) by
that quotient, and (iii) rounding each product to the nearest
multiple of $100,000. For example, for the order the Commission
would issue in 2016, the Commission would (i) divide the year-end
2015 PCE Index by the year-end 1997 PCE Index, (ii) multiply the
quotient by $750,000 and $1.5 million, and (iii) round each of the
two products to the nearest $100,000.
\28\ See Clinton P. McCully, Brian C. Moyer, and Kenneth J.
Stewart, ``Comparing the Consumer Price Index and the Personal
Consumption Expenditures Price Index,'' Survey of Current Business
(Nov. 2007) at 26 n.1 (available at http://www.bea.gov/scb/pdf/2007/11%20november/1107_cpipce.pdf) (PCE Index measures changes in
``prices paid for goods and services by the personal sector in the
U.S. national income and product accounts'' and is primarily used
for macroeconomic analysis and forecasting). See also Federal
Reserve Board, Monetary Policy Report to the Congress (Feb. 17,
2000) at n.1 (available at http://www.federalreserve.gov/boarddocs/hh/2000/february/ReportSection1.htm#FN1) (noting the reasons for
using the PCE Index rather than the consumer price index).
\29\ See Proposing Release, supra note 15, at n.22 and
accompanying text.
\30\ See Better Markets Comment Letter; IAA Comment Letter;
Comment Letter of Georg Merkl (July 11, 2011) (``G. Merkl Comment
Letter''). Although two commenters asserted that inflation is not
the proper unit of measure by which to adjust net worth
requirements, see Comment Letter of David Hale (May 20, 2011) and
Comment Letter of Joseph V. Delaney (undated) (``J. Delaney Comment
Letter''), section 205(e) of the Advisers Act requires that we
adjust the dollar amount thresholds of rule 205-3 for inflation.
\31\ See C. Barnard Comment Letter; G. Merkl Comment Letter.
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B. Exclusion of the Value of Primary Residence From Net Worth
Determination
We also are amending the net worth test in the definition of
``qualified client'' in rule 205-3 to exclude the value of a natural
person's primary residence and certain debt secured by the
property.\32\ This change, although not required by the Dodd-Frank Act,
is similar to the change that Act requires the Commission to make to
rules under
[[Page 10361]]
the Securities Act, such as Regulation D.\33\
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\32\ Rule 205-3(d)(1)(ii)(A).
\33\ See section 413(a) of the Dodd-Frank Act (requiring the
Commission to adjust any net worth standard for an ``accredited
investor'' as set forth in Commission rules under the Securities Act
to exclude the value of a natural person's primary residence). The
Dodd-Frank Act does not require that the net worth standard for an
accredited investor be adjusted periodically for the effects of
inflation, although it does require the Commission at least every
four years to ``undertake a review of the definition, in its
entirety, of the term `accredited investor' * * * [as defined in
Commission rules] as such term applies to natural persons, to
determine whether the requirements of the definition should be
adjusted or modified for the protection of investors, in the public
interest, and in light of the economy.'' See section 413(b)(2)(A) of
the Dodd-Frank Act. In January 2011, we proposed rule amendments to
adjust the net worth standards for accredited investors in our rules
under the Securities Act. See Net Worth Standard for Accredited
Investors, Securities Act Release No. 9177 (Jan. 25, 2011) [76 FR
5307 (Jan. 31, 2011)] (``Accredited Investor Proposing Release'').
We recently adopted those amendments substantially as proposed. See
Net Worth Standard for Accredited Investors, Securities Act Release
No. 9287 (Dec. 21, 2011) [76 FR 81793 (Dec. 29, 2011)] (``Accredited
Investor Adopting Release'').
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We proposed to exclude the value of a person's primary residence
and the debt secured by the residence, up to the fair market value of
the residence, from the calculation of a person's net worth.\34\ A
number of commenters supported the proposed exclusion.\35\ Many agreed
with our statement in the Proposing Release that the value of an
individual's residence may have little relevance to the person's
financial experience and ability to bear the risks of performance fee
arrangements.\36\ The Certified Financial Planner Board of Standards
noted in its comment letter that the value of an individual's equity in
a residence is more likely to be a function of the length of time that
the investor has owned the home, than to be a function of the
investor's experience or sophistication. Commenters also stated that
excluding the value of the residence would promote regulatory
consistency because it parallels the treatment of a person's primary
residence in determinations of net worth under other securities
rules.\37\
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\34\ See Proposing Release, supra note 15, at n.28 and
accompanying text.
\35\ See, e.g., C. Barnard Comment Letter; CFP Board Comment
Letter; MFA Comment Letter; NASAA Comment Letter.
\36\ See, e.g., C. Barnard Comment Letter; CFP Board Comment
Letter; NASAA Comment Letter.
\37\ See, e.g., Better Markets Comment Letter; CFP Board Comment
Letter; NASAA Comment Letter.
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Many commenters objected to the exclusion of the value of a
person's primary residence from the calculation of net worth.
Commenters expressed concern that the exclusion would limit the
investment options of less wealthy investors and restrict their access
to advisory arrangements that include performance fees.\38\ Some argued
that excluding the value of a residence would harm advisers to smaller
funds that rely on investments from less wealthy investors.\39\ Others
argued that home ownership, compared to home rental, may in fact
evidence greater rather than less financial experience on the part of
individuals.\40\
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\38\ See, e.g., Comment Letter of Matthew Gee (June 14, 2011);
Comment Letter of Gunderson Dettmer Stough Villeneuve Franklin
Hachigan LLP (July 8, 2011) (``Gunderson Dettmer Comment Letter'');
Comment Letter of Alvin Suvil (July 17, 2011) (``A. Suvil Comment
Letter'').
\39\ See, e.g., Comment Letter of Roger Alsop (June 16, 2011)
(``R. Alsop Comment Letter''); J. Delaney Comment Letter; Comment
Letter of Molly Huntsman (June 23, 2011) (``M. Huntsman Comment
Letter''); Comment Letter of Greg Thornton (June 2, 2011); Comment
Letter of Greg J. Wimmer (June 3, 2011).
\40\ See M. Gee Comment Letter; Comment Letter of Douglas Wood
(June 13, 2011) (``D. Wood Comment Letter''). Some commenters
appeared to object to excluding residence from net worth on public
policy grounds because the exclusion would discourage home
ownership. See, e.g., Comment Letter of Ron Cuningham (June 25,
2011) (``R. Cuningham Comment Letter''); D. Wood Comment Letter.
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We continue to believe that the value of a person's residence
generally has little relevance to the individual's financial experience
and ability to bear the risks of performance fee arrangements, and
therefore little relevance to the individual's need for the Act's
protections from performance fee arrangements.\41\ Although the process
of purchasing and financing a home can contribute to an individual's
financial experience, the value of the individual's equity interest in
the residence reflects the prevailing market values at the time and can
be a function of time in paying down the associated debt rather than a
function of deliberate investment decision-making. In addition, because
of the generally illiquid nature of residential assets, the value of an
individual's home equity may not help the investor to bear the risks of
loss that are inherent in performance fee arrangements.
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\41\ For example, an individual who meets the net worth test
only by including the value of his primary residence in the
calculation is unlikely to be as able to bear the risks of
performance fee arrangements as an individual who meets the test
without including the value of her primary residence. We stated in
2006, when we proposed a minimum net worth threshold for
establishing when an individual could invest in hedge funds pursuant
to the safe harbor of Regulation D, that the value of an
individual's personal residence may bear little or no relationship
to that person's knowledge and financial sophistication. See
Prohibition of Fraud by Advisers to Certain Pooled Investment
Vehicles; Accredited Investors in Certain Private Investment
Vehicles, Investment Advisers Act Release No. 2576 (Dec. 27, 2006)
[72 FR 400 (Jan. 4, 2007)] at Section III.B.3.
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Our exclusion of the value of a person's primary residence from the
net worth calculation under the rule is similar to the approach that
the Commission has taken in other rules to determine the financial
qualifications of investors. For example, the Commission excluded the
value of a person's primary residence and associated liabilities from
the determination of whether a person is a ``high net worth customer''
in Regulation R under the Securities Exchange Act of 1934.\42\ The
Commission also excluded the value of a residence from the
determination of whether an individual has sufficient investments to be
considered a ``qualified purchaser'' under the Investment Company Act
of 1940 (``Investment Company Act'') who can invest in certain private
funds that are not registered under that Act.\43\ As discussed above,
this approach is also reflected in the Commission's recent amendments
to the definition of ``accredited investor'' in rules under the
Securities Act, including Regulation D, as required by the Dodd-Frank
Act.\44\
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\42\ See, e.g., Definition of Terms and Exemptions Relating to
the ``Broker'' Exceptions for Banks, Securities Exchange Act Release
No. 56501 (Sept. 24, 2007) [72 FR 56514 (Oct. 3, 2007)] at Section
II.C.1 (excluding primary residence and associated liabilities from
the fixed-dollar threshold for ``high net worth customers'' under
Rule 701 of Regulation R, which permits a bank to pay an employee
certain fees for the referral of a high net worth customer or
institutional customer to a broker-dealer without requiring
registration of the bank as a broker-dealer).
\43\ Section 3(c)(7) of the Investment Company Act provides an
exclusion from the definition of ``investment company'' for any
``issuer, the outstanding securities of which are owned exclusively
by persons who, at the time of acquisition of such securities, are
qualified purchasers, and which is not making and does not at that
time propose to make a public offering of such securities.'' A
``qualified purchaser'' under section 2(a)(51) of the Investment
Company Act [15 U.S.C. 80a-2(a)(51)] includes, among others, any
natural person who owns not less than $5 million in investments, as
defined by the Commission. Rule 2a51-1 under the Investment Company
Act includes within the meaning of ``investments'' real estate held
for investment purposes. 17 CFR 270.2a51-1(b)(2). A personal
residence is not considered an investment under rule 2a51-1,
although residential property may be treated as an investment if it
is not treated as a residence for tax purposes. See Privately
Offered Investment Companies, Investment Company Act Release No.
22597 (Apr. 3, 1997) [62 FR 17512 (Apr. 9, 1997)] at text
accompanying and following n.48.
\44\ See supra note 33 and accompanying text.
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Some commenters voiced particular concern about the exclusion of
the residential value at the same time that we adjust the dollar amount
thresholds for inflation, and argued that the two changes together
could cause too much change at one time.\45\ We note that we revised
the dollar amount threshold of the net worth test last July and that
the
[[Page 10362]]
revision was effective in September. Our current amendment of the net
worth test to exclude the value of a residence, which will be effective
in May 2012, will be effective approximately eight months after the
previous change to the net worth test. Any further revisions of the
dollar amount thresholds of rule 205-3 to adjust for inflation are not
scheduled to occur until 2016.\46\
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\45\ See, e.g., R. Alsop Comment Letter; R. Cuningham Comment
Letter; M. Huntsman Comment Letter; A. Suvil Comment Letter.
\46\ See rule 205-3(e).
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Some of the commenters who disagreed with the proposal to raise the
dollar amount threshold of the net worth standard or to exclude the
value of a residence from net worth, also disagreed that a person's net
worth should be used as a measure of eligibility for the exemption from
the performance fee restrictions.\47\ These commenters did not
recommend an alternative standard that is objective and verifiable, and
that would effectively distinguish between those investors who do, and
those who do not, need the protections of the Act's performance fee
restrictions.\48\
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\47\ See, e.g., J. Delaney Comment Letter; Comment Letter of
David Hale (May 20, 2011); Comment Letter of Tom Irvin (May 18,
2011).
\48\ One commenter suggested that a ``qualified client'' include
an individual with a bachelor's degree in a finance-related major or
a master's degree in any area from an accredited U.S. university.
See Comment Letter of Troy Clark (June 23, 2011). Although the
suggested finance-related major requirement would help to determine
whether an individual is financially knowledgeable, the suggested
master's degree requirement would not, and neither requirement would
establish whether an investor has sufficient practical experience in
making investment decisions or is capable of bearing the risks of
loss associated with performance fee arrangements.
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Our amendment of the net worth standard of rule 205-3 differs from
the proposed amendment in one respect. The approach we are adopting
today will generally require any increase in the amount of debt secured
by the primary residence in the 60 days before the advisory contract is
entered into to be included as a liability. As discussed below, this
change will prevent debt that is incurred shortly before entry into an
advisory contract from being excluded from the calculation of net worth
merely because it is secured by the individual's home.
As proposed, the amended rule would have excluded the value of a
person's primary residence and the amount of all debt secured by the
property that is no greater than the property's current market
value.\49\ The proposed treatment of debt secured by the primary
residence was the same as we proposed for the calculation of net worth
for accredited investors in our rules under the Securities Act.\50\
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\49\ Proposed rule 205-3(d)(1)(ii)(A).
\50\ See Accredited Investor Proposing Release, supra note 33,
at text preceding n.28. One commenter recommended that all debt
secured by the residence (not just debt up to the fair market value
of the residence) be excluded from the net worth calculation. See G.
Merkl Comment Letter. The commenter argued that excluding the debt
secured by the residence up to the fair market value of the
residence would require an investor to obtain a valuation of the
residence from a real estate agent, which would be burdensome and
costly. We note that the rule requires an estimate of the fair
market value, but does not require a third party opinion on
valuation for the primary residence. Furthermore, many online
services provide residence valuations at no charge. In addition, if
the amount of mortgage debt exceeds the value of the primary
residence, excluding the entire debt would result in a higher net
worth than under a conventional calculation that takes into account
all assets and all liabilities. The commenter also acknowledged
that, although he disagreed with the net worth test as a measure of
financial sophistication, for purposes of calculating residence-
related indebtedness a ``close proximity between the time of taking
on new debt and entering into the advisory contract could work.''
Cf. rule 205-3(d)(1)(ii)(A)(2) (requiring that all residence-related
indebtedness incurred within 60 days before the advisory contract is
entered into, other than as a result of the acquisition of the
primary residence, be subtracted from a client's net worth for
purposes of determining whether the client is a ``qualified
client'').
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In the Proposing Release, we requested comment on whether the
amendments to the rule should contain a timing provision to prevent
investors from inflating their net worth by borrowing against their
homes, effectively converting their home equity--which is excluded from
the net worth calculation under the amendments adopted today--into cash
or other assets that would be included in the net worth
calculation.\51\ In particular, we indicated that the amendments could
provide that the net worth calculation must be made as of a date 30,
60, or 90 days prior to entry into the investment advisory
contract.\52\ This request for comment was similar to the one we made
when we proposed amendments to the net worth standard in rules under
the Securities Act, including Regulation D.\53\
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\51\ See Proposing Release, supra note 15, at Section II.B.2.
\52\ Id. Two commenters stated that the net worth calculation
should not be required to be made on a specified date prior to the
day the advisory contract is entered into. See C. Barnard Comment
Letter; G. Merkl Comment Letter. Another commenter stated that the
net worth calculation should be required to be made on a specified
date prior to the day the advisory contract is entered into to
assist in protecting against refinancing transactions intended
solely to inflate net worth. See NASAA Comment Letter.
\53\ See Accredited Investor Proposing Release, supra note 33,
at Specific Request for Comment Number 7 in Section II.A.
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As in the recently adopted accredited investor rule amendments
adjusting the net worth standard,\54\ the rule amendments to the
qualified client net worth standard include a specific provision
addressing the treatment of incremental debt secured by the primary
residence that is incurred in the 60 days before the advisory contract
is entered into.\55\ Debt secured by the primary residence generally
will not be included as a liability in the net worth calculation under
the rule, except to the extent it exceeds the estimated value of the
primary residence. Under the final rule amendments, however, any
increase in the amount of debt secured by the primary residence in the
60 days before the advisory contract is entered into generally will be
included as a liability, even if the estimated value of the primary
residence exceeds the aggregate amount of debt secured by such primary
residence.\56\ Net worth will be calculated only once, at the time the
advisory contract is entered into. The individual's primary residence
will be excluded from assets and any indebtedness secured by the
primary residence, up to the estimated value of the primary residence
at that time, will be excluded from liabilities, except if there is
incremental debt secured by the primary residence incurred in the 60
days before the advisory contract is entered into. If any such
incremental debt is incurred, net worth will be reduced by the amount
of the incremental debt. In other words, the 60-day look-back provision
requires investors to identify any increase in mortgage debt over the
60-day period prior to entering into an advisory contract and count
that debt as a liability in calculating net worth.
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\54\ See Accredited Investor Adopting Release, supra note 33, at
text following n.34.
\55\ See rule 205-3(d)(1)(ii)(A)(2).
\56\ The fair market value of the primary residence is
determined as of the time the advisory contract is entered into,
even if the investor has changed his or her primary residence during
the 60-day period. The rule provides an exception to the 60-day
look-back provision for increases in debt secured by a primary
residence where the debt results from the acquisition of the primary
residence. Without this exception, an individual who acquires a new
primary residence in the 60-day period before the advisory contract
is entered into may have to include the full amount of the mortgage
incurred in connection with the purchase of the primary residence as
a liability, while excluding the full value of the primary
residence, in a net worth calculation. The 60-day look-back
provision is intended to address incremental debt secured against a
primary residence that is incurred for the purpose of circumventing
the net worth standard of the rule. It is not intended to address
debt secured by a primary residence that is incurred in connection
with the acquisition of a primary residence within the 60-day
period.
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This approach should significantly reduce the incentive for persons
to induce potential clients to take on incremental debt secured against
their homes to facilitate a near-term investment. We believe a 60-day
look-
[[Page 10363]]
back period is long enough to decrease the likelihood of circumvention
of the standard by taking on new debt and waiting for the look-back
period to expire. The 60-day period also is designed to be short enough
to accommodate investors who may have increased their mortgage debt in
the ordinary course at some point prior to entering into an advisory
contract.
Another alternative to address the possibility of parties
attempting to circumvent the standard would have been to provide that
any debt secured by the primary residence that was incurred after the
original purchase date of the primary residence would have been counted
as a liability, whether or not the fair market value of the primary
residence exceeded the value of the total amount of debt secured by the
primary residence. We believe that such a standard would be overly
restrictive and not provide for ordinary course changes to debt secured
by a primary residence, such as refinancing and drawings on home equity
lines. We believe that the approach we are adopting here will protect
investors by addressing circumstances in which they may have been
induced to incur new debt secured by the primary residence for the
purpose of inflating net worth under the rule, while still permitting
ordinary course changes to debt secured by the primary residence. This
approach is similar to the approach the Commission recently adopted for
accredited investor rule amendments adjusting the net worth standard,
and it responds to commenters who urged the Commission to promote
regulatory consistency in the treatment of primary residences in other
similar contexts in order to promote fairness, facilitate enforcement,
and provide clarity for both industry and regulators.\57\
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\57\ See Accredited Investor Adopting Release, supra note 33, at
text following n.46; see, e.g., Better Markets Comment Letter; NASAA
Comment Letter.
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C. Transition Provisions
We proposed two new transition provisions that would allow an
investment adviser and its clients to maintain existing performance fee
arrangements that were permissible when the advisory contract was
entered into, even if the performance fees would not be permissible
under the contract if it were entered into at a later date. We are
adopting the two transition rules substantially as proposed, which
commenters supported.\58\ At the suggestion of one commenter we also
are adopting an additional transition provision to address certain
transfers of interest, as discussed below.\59\ The amendments replace
the current transition rules section of rule 205-3.
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\58\ Rule 205-3(c)(1); rule 205-3(c)(2). See, e.g., C. Barnard
Comment Letter; Gunderson Dettmer Comment Letter; M. Huntsman
Comment Letter; IAA Comment Letter; MFA Comment Letter.
\59\ See rule 205-3(c)(3).
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Paragraphs (1) and (2) of rule 205-3(c) are designed so that
restrictions on performance fees apply only to new contractual
arrangements and do not apply to new investments by clients (including
equity owners of ``private investment companies'') 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 rule.\60\ This approach minimizes the disruption of
existing contractual relationships that met applicable requirements
under the rule at the time the parties entered into them.
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\60\ A ``private investment company'' is a company that is
excluded from the definition of an ``investment company'' under the
Investment Company Act by reason of section 3(c)(1) of that Act.
Rule 205-3(d)(3). Under rule 205-3(b), the equity owner of a private
investment company, or of a registered investment company or
business development company, is considered a client of the adviser
for purposes of rule 205-3(a). We adopted this provision in 1998,
and the provision was not affected by our subsequent rule amendments
and related litigation concerning the registration of certain hedge
fund advisers. See 1998 Adopting Release, supra note 7; Goldstein v.
Securities and Exchange Commission, 451 F.3d 873 (DC Cir. 2006).
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Rule 205-3(c)(1)\61\ provides that, if a registered investment
adviser entered into a contract and satisfied the conditions of the
rule that were in effect when the contract was entered into, the
adviser will be considered to satisfy the conditions of the rule.\62\
If, however, a natural person or company that was not a party to the
contract becomes a party, the conditions of the rule in effect at the
time they become a party will apply to that person or company. This
provision means, for example, that if an individual met the $1.5
million net worth test in effect before the effective date of our 2011
order and entered into an advisory contract with a registered
investment adviser before that date, the client could continue to
maintain assets (and invest additional assets) with the adviser under
that contract even though the net worth test was subsequently raised to
$2 million and he or she no longer met the new test. If, however,
another person becomes a party to that contract, the current net worth
threshold will apply to the new party when he or she becomes a party to
the contract.\63\
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\61\ Rule 205-3(c)(1), as amended, modifies the existing
transition rule in rule 205-3(c)(1), which permits advisers and
their clients that entered into a contract before August 20, 1998,
and satisfied the eligibility criteria in effect on the date the
contract was entered into, to maintain their existing performance
fee arrangements.
\62\ One commenter supported the provisions allowing advisers to
continue to provide advisory services under performance fee
arrangements that were permitted at the time the contract was
entered into but stated that the rule should prohibit an adviser
from charging performance fees to investors that are not qualified
clients with respect to money committed after the effective date for
the rule amendments. See G. Merkl Comment Letter. We believe such an
approach would be unnecessarily disruptive to advisory
relationships.
\63\ Rule 205-3(c)(1). Similarly, a person who invests in a
private investment company advised by a registered investment
adviser must satisfy the rule's conditions when he or she becomes an
investor in the company. See rule 205-3(b) (equity owner of a
private investment company is considered a client of a registered
investment adviser for purposes of rule 205-3(a)).
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Rule 205-3(c)(2) provides that, if a registered investment adviser
previously was not required to register with the Commission pursuant to
section 203 of the Act and did not register, section 205(a)(1) of the
Act will not apply to the contractual arrangements into which the
registered adviser entered when it was not registered with the
Commission.\64\ This means, for example, that if an investment adviser
to a private investment company with 50 individual investors was exempt
from registration with the Commission in 2009, but then subsequently
registered with the Commission because it was no longer exempt from
registration or because it chose voluntarily to register, section
205(a)(1) will not apply to the contractual arrangements the adviser
entered into before it registered, including the accounts of the 50
individual investors with the private investment company and any
additional investments they make in that company. If, however, any
other individuals
[[Page 10364]]
become new investors in the private investment company or if the
original investors became investors in a different private investment
company managed by the adviser after the adviser registers with the
Commission, section 205(a)(1) will apply to the adviser's relationship
with the investors with regard to their new investments.\65\
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\64\ Section 205(a)(1) will apply, however, to contractual
arrangements into which the adviser enters after it is required to
register with the Commission. See rule 205-3(c)(2). The approach of
subsection (c)(2) is similar to the transition provisions we adopted
for the registration of investment advisers to private funds. See
Registration Under the Advisers Act of Certain Hedge Fund Advisers,
Investment Advisers Act Release No. 2333 (Dec. 2, 2004) [69 FR 72054
(Dec. 10, 2004)]. We are adopting the subsection substantially as
proposed, but have made minor changes to clarify that the transition
provision applies only to contractual arrangements with advisers
that were not required to register and did not register with the
Commission. Our proposed subsection would have applied to
contractual arrangements with any registered investment adviser that
previously was ``exempt'' from the requirement to register with the
Commission. The revised language clarifies that the transition
provision applies to contractual arrangements with advisers when
they were not required to register (even if they were not
``exempt''), and does not apply to contractual arrangements entered
into with advisers when they were registered (even if they were not
required to register). Investment advisers that previously
registered already are subject to section 205(a)(1) and rule 205-3,
and therefore would not need the transition relief of rule 205-
3(c)(2).
\65\ One commenter recommended that we revise the rule to
accommodate fund-of-funds purchases when the acquiring funds are
private investment companies. See MFA Comment Letter. The commenter
recommended that the rule ``clarify'' that an acquiring private
investment company is able to pay performance fees to the adviser of
an acquired private investment company even if some of the investors
in the acquiring private investment company are not qualified
clients at the time the investment is made in the acquired private
investment company. We are not making the suggested revision to the
final rule, because it would permit advisers to pool small client
accounts to circumvent the eligibility standards of rule 205-3(d)(1)
and would permit performance fee arrangements that currently are not
permissible under rule 205-3(b). As we stated in 1998, rule 205-3(b)
specifies that the requirement to look through to each investor of a
private investment company applies to each tier of a funds-of-funds
structure. See 1998 Adopting Release, supra note 7, at Section II.C.
(``Under [Rule 205-3(b)], each `tier' of such entities must be
examined in this manner. Thus, if a private investment company
seeking to enter into a performance fee contract (first tier
company) is owned by another private investment company (the second
tier company), the look through provision applies to the second (and
any other) level private investment company, and thus the adviser
must look to the ultimate client to determine whether the
arrangement satisfies the requirements of the rule.'').
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Finally, at the suggestion of one commenter, we have revised the
third paragraph of rule 205-3(c), to allow for limited transfers of
interests from a qualified client to a person that was not a party to
the contract and is not a qualified client at the time of the
transfer.\66\ The approach we are taking is similar to the approach we
adopted in rule 3c-6 under the Investment Company Act. Rule 3c-6
provides that, in the case of a transfer of ownership interest in a
private investment company by gift or bequest, or pursuant to an
agreement relating to a legal separation or divorce, the beneficial
owner of the interest will be considered to be the person who
transferred the interest.\67\ We believe that, when those types of
transfers occur, the transferee does not make a separate investment
decision to enter into an advisory contract with the adviser, but is
the recipient, perhaps involuntarily, of the benefits of a pre-existing
contractual relationship. Because of the circumstances of these
transfers, we believe the transferee is not of the type that needs the
protections of the performance fee restrictions. We are therefore
amending paragraph (3) of rule 205-3(c) to provide that, if an owner of
an interest in a private investment company transfers an interest by
gift or bequest, or pursuant to an agreement related to a legal
separation or divorce, the transfer will not cause the transferee to
``become a party'' to the contract and will not cause section 205(a)(1)
of the Act to apply to such transferee. Thus, transfers in these
circumstances will not cause the transferee to have to meet the
definition of a qualified client under rule 205-3.\68\
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\66\ See Gunderson Dettmer Comment Letter.
\67\ See rule 3c-6(b) under the Investment Company Act [17 CFR
270.3c-6(b)].
\68\ A gift transfer, however, would need to be a bona fide gift
and could not be used as a means to avoid the protections of section
205 of the Act, for example by transferring an interest in a private
fund supposedly as a gift but in reality in exchange for payment.
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D. Effective Date
The rule amendments we are adopting today will be effective on May
22, 2012. In addition, in order to minimize the disruption of
contractual relationships that met applicable requirements at the time
the parties entered into them, the Commission will not object if
advisers rely or relied upon the amended transition provisions of rule
205-3(c) before that date.\69\
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\69\ As discussed above, some advisers may have entered into
contractual relationships with clients who met the requirements of
the rule at the time the parties entered into them, but who no
longer meet the requirements of the amended rule. See supra Section
II.C. For example, some registered investment advisers may have
entered into advisory contracts with clients who met the $1.5
million net worth test when that test was applicable, but who would
not meet the $2 million net worth test of the revised rule.
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III. Cost-Benefit Analysis
The Commission is sensitive to the costs and benefits imposed by
its rules. In the Proposing Release, we analyzed the costs and benefits
of the proposed rules and sought comment on all aspects of the cost-
benefit analysis, including identification and assessment of any costs
and benefits not discussed in the analysis. Only two commenters
addressed the cost-benefit analysis.\70\ These commenters focused on
the costs of the rule but did not provide any empirical data.
---------------------------------------------------------------------------
\70\ See Comment Letter of Phillip Goldstein (May 24, 2011)
(``P. Goldstein Comment Letter''); G. Merkl Comment Letter.
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As stated above, section 205(a)(1) of the Advisers Act generally
restricts an investment adviser from entering into an advisory contract
that provides for performance-based compensation.\71\ Congress
restricted performance compensation arrangements to protect advisory
clients from arrangements it believed might encourage advisers to take
undue risks with client funds to increase advisory fees.\72\ Congress
subsequently authorized the Commission in section 205(e) of the
Advisers Act to exempt any advisory contract from the performance fee
restrictions if the contract is with persons that the Commission
determines do not need the protections of those restrictions. Section
205(e) provides that the Commission may determine that persons do not
need the protections of section 205(a)(1) on the basis of such factors
as ``financial sophistication, net worth, knowledge of and experience
in financial matters, amount of assets under management, relationship
with a registered investment adviser, and such other factors as the
Commission determines are consistent with [section 205].''
---------------------------------------------------------------------------
\71\ See supra Section I.
\72\ Id.
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The Commission adopted rule 205-3 to exempt an investment adviser
from the restrictions against charging a client performance fees where
a client has a specified net worth or amount of assets under
management. Section 418 of the Dodd-Frank Act amended section 205(e) to
require that the Commission adjust for inflation the dollar amount
thresholds in rules promulgated under section 205(e) within one year of
enactment of the Dodd-Frank Act and every five years thereafter.
Generally an inflation adjustment is designed to help make the dollar
amount thresholds in a provision continue to serve the same purposes
over time. The amendments to rule 205-3 providing that the Commission
will issue orders every five years adjusting for inflation the dollar
amount thresholds of the rule will codify the Dodd-Frank Act's
amendment of section 205(e) of the Advisers Act that requires the
Commission to issue these orders.\73\ Also, pursuant to section 418's
requirements, the Commission issued an order in July 2011 revising the
threshold of the assets-under-management test to $1 million, and of the
net worth test to $2 million. The rule amendments will codify in the
rule the changes already made to the dollar amount thresholds in the
July 2011 Order, and will have no separate economic effect.
---------------------------------------------------------------------------
\73\ Section 418 of the Dodd-Frank Act.
---------------------------------------------------------------------------
As proposed, we are amending rule 205-3 to exclude the value of a
natural person's primary residence and certain debt secured by the
property from the determination of whether a person has sufficient net
worth to be considered a ``qualified client.'' We are also modifying
the transition provisions of the rule to take into account performance
fee arrangements that were permissible when they were entered
[[Page 10365]]
into. We analyze the costs and benefits of these provisions below.
A. Benefits
The exclusion of the value of an individual's primary residence
will benefit certain investors. As discussed above, the Act's
restrictions on performance fee arrangements are designed to protect
advisory clients from arrangements that encourage advisers to take
undue risks with client funds to increase advisory fees, while rule
205-3 is designed to permit clients who are financially experienced and
able to bear the risks of performance fee arrangements to enter into
those arrangements.\74\ We believe that the value of an individual's
primary residence may bear little or no relationship to that person's
financial experience or ability to bear the risks of performance fee
arrangements. The value of the individual's equity interest in the
residence reflects the prevailing market values at the time and can be
a function of time in paying down the associated debt rather than a
function of deliberate investment decision-making. In addition, because
of the generally illiquid nature of residential assets, the value of an
individual's home equity may not help the investor to bear the risks of
loss that are inherent in performance fee arrangements. Therefore, some
of the clients who do not meet the net worth test of rule 205-3 without
including the value of their primary residence may not possess the
financial experience or ability to bear the risks of performance fee
arrangements. We estimate that the exclusion of the value of an
individual's primary residence will result in up to 1.3 million
households that no longer qualify as ``qualified clients'' under the
revised net worth test and therefore will now be protected by the
performance fee restrictions in section 205 of the Advisers Act.\75\
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\74\ See supra notes 3 and 6.
\75\ See infra notes 79-81. As discussed above, the amendments
to rule 205-3 also exclude from the net worth test the amount of
debt secured by the primary residence that is no greater than the
property's current market value. The exclusion of the debt might
limit these benefits in some circumstances. For example, if a client
meets the net worth test as a result of the exclusion of debt
secured by the primary residence and the market value of the primary
residence were to decline to the extent that the debt could not be
satisfied by the sale of the residence, the client might be less
able to bear the risks related to the performance fee contract and
the investments that the adviser might make on behalf of the client.
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As discussed above, the exclusion of the value of an individual's
primary residence from the calculation of net worth under the rule is
similar to changes that Congress required the Commission to make to
rules under the Securities Act, including Regulation D.\76\ As we noted
when we recently adopted those rule amendments, section 413(a) of the
Dodd-Frank Act required us to adjust the ``accredited investor'' net
worth standards of certain rules under the Securities Act that apply to
individuals, by ``excluding the value of the primary residence.'' \77\
The amendment to rule 205-3 under the Advisers Act we are adopting
today, as some commenters argued, will promote regulatory consistency
in the treatment of primary residences between this rule and other
rules that the Commission has adopted that distinguish high net worth
individuals from less wealthy individuals.\78\
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\76\ See supra note 33.
\77\ See Accredited Investor Adopting Release, supra note 33, at
n.18 and accompanying text.
\78\ See supra notes 42-44 and 57 and accompanying text.
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The amendments to the rule's transition provisions will allow
advisory clients and investment advisers to avoid certain costs
resulting from the statutory mandate to adjust for inflation and the
Commission's resultant July 2011 Order. The amendments allow an
investment adviser and its clients to maintain existing performance fee
arrangements that were permissible when the advisory contract was
entered into, even if performance fees would not be permissible under
the contract if it were entered into at a later date. These transition
provisions are designed so that the restrictions on the charging of
performance fees apply to new contractual arrangements and do not apply
retroactively to existing contractual arrangements, including
investments in private investment companies. Otherwise, advisory
clients and investment advisers might have to terminate contractual
arrangements into which they previously entered and enter into new
arrangements, which could be costly to investors and advisers.
B. Costs
The amendments exclude the value of a person's primary residence
and generally exclude debt secured by the property (if no greater than
the current market value of the residence) from the calculation of a
person's net worth.\79\ Based on data from the Federal Reserve Board,
approximately 5.5 million households have a net worth of more than $2
million including the equity in the primary residence (i.e., value
minus debt secured by the property), and approximately 4.2 million
households have a net worth of more than $2 million excluding the
equity in the primary residence.\80\ Therefore, approximately 1.3
million households will not meet a $2 million net worth test under the
revised test, and will therefore not be considered ``qualified
clients,'' when the value of the primary residence is excluded from the
test.\81\ Excluding the value of the primary residence (and debt
secured by the property up to the current market value of the
residence) means that 1.3 million households that would have met the
net worth threshold if the value of the residence were included, as is
currently permitted, will no longer be ``qualified clients'' under the
revised net worth test and therefore will be unable to enter into
performance fee contracts unless they meet another test of rule 205-
3.\82\
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\79\ As discussed above, any increase in the amount of debt
secured by the primary residence in the 60 days before the
securities are purchased will be included in the net worth
calculation as a liability, regardless of the estimated value of the
residence. See supra Section II.B; rule 205-3(d)(1)(ii)(A)(2).
\80\ These figures are derived from the 2007 Federal Reserve
Board Survey of Consumer Finances. These figures represent the net
worth of households rather than individual persons who might be
clients. More information regarding the survey may be obtained at
http://www.federalreserve.gov/pubs/oss/oss2/scfindex.html.
\81\ Although some of these 1.3 million households may be
grandfathered by the transition provisions of the rule, we assume
for the purposes of our analysis that none of these households will
be grandfathered. This assumption may therefore result in an
overestimation of the costs of the rule amendments.
\82\ This estimate, as described in the Proposing Release, was
not premised on the notion that investors would borrow against the
equity in their primary residence shortly before the calculation of
net worth. See Proposing Release, supra note 15, at nn. 47-48 and
accompanying text. The 60-day look-back provision in rule 205-3 that
we are adopting today, because it reduces the incentives to incur
debt secured by residences in order to boost net worth under the
rule, strengthens the accuracy of our estimate. See supra notes 55-
57 and accompanying text.
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For purposes of this cost-benefit analysis, Commission staff
assumes that 25 percent of the 1.3 million households would have
entered into new advisory contracts that contained performance fee
arrangements after the compliance date of the amendments, and therefore
approximately 325,000 clients will not meet the revised net worth
test.\83\
[[Page 10366]]
Commission staff estimates that about 40 percent of those 325,000
potential clients (i.e., 130,000) will separately meet the ``qualified
client'' definition under the assets-under-management test, and
therefore will be able to enter into performance fee arrangements.\84\
The remaining 60 percent (195,000 households) will have access only to
those investment advisers (directly or through the private investment
companies they manage) that charge advisory fees other than performance
fees.\85\ Some of these investors may be negatively affected by their
inability to enter into performance-based compensation arrangements
with investment advisers (which arrangements in some ways align the
advisers' interests with the clients' interests). These investors also
may experience differences in their investment options and returns,
changes in advisory service, and the cost of being unable to enter into
advisory contracts with their preferred advisers. For purposes of this
cost-benefit analysis, Commission staff assumes that approximately 80
percent of the 195,000 households (i.e., 156,000 households) will enter
into non-performance fee arrangements, and that the other 20 percent
(i.e., 39,000 households) will decide not to invest their assets with
an adviser.\86\ Commission staff anticipates that the non-performance
fee arrangements into which these clients will enter may contain
management fees that yield advisers approximately the same amount of
fees that clients would have paid under performance fee arrangements.
Under these non-performance fee arrangements, if the adviser's
performance is not positive or does not reach the level at which it
would have accrued performance fees (i.e., the ``hurdle rate'' of
return), a client might end up paying higher overall fees than if he
had paid performance fees.\87\
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\83\ The assumption that 25% of these investors would have
entered into new performance fee arrangements is based on data
compiled in a 2008 report sponsored by the Commission. See Angela A.
Hung et al., Investor and Industry Perspectives on Investment
Advisers and Broker-Dealers 130 (Table C.1) (2008) (available at
http://www.sec.gov/news/press/2008/2008-1_randiabdreport.pdf). That
report indicated that 20% of investment advisers charge performance
fees. Id. at 105 (Table 6.13). Commission staff assumes the
percentage of investment advisers charging performance fees reflects
investor demand for these advisory arrangements. Although the report
indicates that 20% of investment advisers charge performance fees,
the use of a 25% assumption is intended to overestimate rather than
underestimate costs, especially given the inherent uncertainty
surrounding hypothetical events. It is also notable that an average
of only 37% of investors indicated they would seek investment
advisory services in the next five years. The estimate concerning
1.3 million households is derived from the 2007 Federal Reserve
Board Survey of Consumer Finances. See supra note 80 and
accompanying and following text.
\84\ This estimate is based on data filed by registered
investment advisers on Form ADV.
\85\ Commission staff estimates that less than one percent of
registered investment advisers are compensated solely by performance
fees, based on data from filings by registered investment advisers
on Form ADV.
\86\ This assumption is based on the idea that a substantial
majority of investment advisers that typically charge performance
fees and that in the future would calculate a potential client's net
worth and determine that it does not meet the $2 million threshold,
will offer alternate compensation arrangements in order to offer
their services. As noted above, Commission staff estimates that less
than one percent of registered advisers charge performance fees
exclusively. See supra note 85.
\87\ Performance fee arrangements typically include a ``hurdle
rate,'' which is a minimum rate of return that must be exceeded
before the performance fee can be charged. See, e.g., Tamar Frankel,
The Regulation of Money Managers Sec. 12.03[F] (2d ed. Supp. 2009).
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Commission staff estimates that the remaining 39,000 households
that would have entered into advisory contracts, if the value of the
client's primary residence were not excluded from the calculation of a
person's net worth, will not enter into advisory contracts. Some of
these households will likely seek other investment opportunities. Other
households may forego professional investment management altogether
because of the higher value they place on the alignment of advisers'
interests with their own interests associated with the use of
performance fee arrangements.
We recognize that the exclusion of the value of a person's primary
residence from the calculation of a person's net worth will reduce the
pool of potential qualified clients for advisers. This, in turn, might
result in a reduction in the total fees collected by investment
advisers. In order to replace those clients and lost revenue, some
advisers may choose to market their services to more potential clients,
which may result in increased marketing and administrative costs.\88\
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\88\ Although advisers that charge performance fees typically
require investment minimums of $10,000 or more, one of the steps
that advisers may take to market their services to a larger number
of potential clients is to reduce their investment minimums. This
may result in slightly higher administrative costs for investment
advisers that choose to take such action.
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Although some commenters asserted that these amendments would harm
small advisers or less wealthy clients, commenters did not provide any
quantitative data to support their statements.\89\ As discussed above,
advisers may charge advisory fees other than performance fees in order
to obtain revenue from clients who do not meet the definition of
``qualified clients.'' In addition, clients who no longer meet the net
worth test as a result of the exclusion of their primary residence
likely would have invested a smaller amount of assets than other
clients who continue to meet the test. As a result, the revenue loss to
investment advisers from the exclusion of these clients from the
performance fee exemption may be mitigated. Moreover, as mentioned
above, less wealthy clients can enter into non-performance based
compensation arrangements and seek other investment opportunities.
Therefore, for the reasons discussed above, we believe that the
amendments are unlikely to impose a significant net cost on most
advisers and clients.
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\89\ See supra notes 38-39 and accompanying text.
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One commenter asserted that because liabilities in excess of the
value of the primary residence would be included in the net worth
calculation the Commission should include in its analysis the cost to
clients of obtaining valuations from real estate agents.\90\ First,
currently investors may include the value of their primary residence in
the calculation of their net worth and, as such, those investors that
choose to do so must be estimating the value of the primary residence
in order to calculate their net worth. Second, the rule requires an
estimate, but does not require a third party opinion on valuation
either for the primary residence or for any other assets or
liabilities. Third, as we noted previously, many online services
provide residence valuations at no charge.\91\
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\90\ See G. Merkl Comment Letter.
\91\ See supra note 50.
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Some commenters argued that excluding the value of an investor's
primary residence from the net worth test of the rule at the same time
as adjusting the rule's dollar amount thresholds for inflation would
cause too much change at one time.\92\ Although we attribute the costs
of inflation-adjusting the dollar amount thresholds of the rule to the
Dodd-Frank Act and the order we issued thereunder, we have considered
the relative magnitude of each of these changes to the net worth
standard in determining the significance of making these changes at the
same time. Based on data from the Federal Reserve Board, approximately
7 million households have a net worth of more than $1.5 million (the
previous net worth threshold, including primary residence), and
approximately 5.5 million households have a net worth of more than $2
million (the revised net worth threshold we established by order in
July 2011, including primary residence).\93\ Therefore, inflation-
adjusting the dollar amount threshold of the net worth test from $1.5
to $2 million will have caused about 1.5 million households to no
longer meet the net worth test of the rule. Therefore the numerical
effect of the inflation adjustment of the net worth test's dollar
amount threshold (1.5 million households) is slightly greater than the
exclusion of primary residence from the net worth test (1.3 million
[[Page 10367]]
households).\94\ As discussed above, we are not making these two
changes to the rule at the same time.\95\ We revised the dollar amount
threshold of the net worth test for inflation in July 2011 (as required
by statute), and the revision was effective in September 2011. Our
current amendment of the net worth test to exclude the value of a
primary residence, which will be effective in May 2012, will be
effective approximately eight months after the previous change to the
net worth test.\96\ We believe that what has turned out to be a two-
step process (adjustment for inflation followed by exclusion of primary
residence), with roughly equal results on the numbers of ``qualified
clients,'' will help to ameliorate the economic impact of the two rule
revisions on investment advisers. In addition, we are concerned that
delaying beyond 90 days the effective date of excluding primary
residence from the net worth standard might encourage some advisers to
focus their efforts on entering into performance fee arrangements with
clients who will not meet the rule's net worth standards after the
effective date.
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\92\ See supra note 45 and accompanying text.
\93\ See supra note 80.
\94\ See supra text accompanying note 81.
\95\ See supra note 46 and preceding text.
\96\ Any further revisions of the dollar amount thresholds of
rule 205-3 to adjust for inflation are not scheduled to occur until
2016. See rule 205-3(e).
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The amendments to the rule's transition provisions are not likely
to impose any new costs on advisory clients or investment advisers. As
discussed above, the amendments allow an investment adviser and its
clients to maintain existing performance fee arrangements that were
permissible when the advisory contract was entered into, even if
performance fees would not be permissible under the contract if it were
entered into at a later date. The amendments also allow for the
transfer of an ownership interest in a private investment company by
gift or bequest, or pursuant to an agreement relating to a legal
separation or divorce to a party that is not a qualified client.\97\
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\97\ Rule 205-3(c)(3). The rule provides that for purposes of
paragraphs 205-3(c)(1) (transition rule for registered investment
advisers) and 205-3(c)(2) (transition rule for registered investment
advisers that were previously not registered) the transfer of an
equity ownership interest in a private investment company by gift or
bequest, or pursuant to an agreement related to a legal separation
or divorce, will not cause the transferee to become a party to the
contract and will not cause section 205(a)(1) of the Act to apply to
such transferee.
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We do not expect that adjustment of the dollar amount thresholds in
rule 205-3, which codifies the adjustments that the Commission effected
in its July 2011 order, will impose new costs on advisory clients or
investment advisers. The adjustments will have no effect on existing
contractual relationships that met applicable requirements under the
rule at the time the parties entered into them, because those
relationships may continue under the transition provisions of the rule.
Although an investment adviser could be prohibited from charging
performance fees to new clients to whom it could have charged
performance fees if the advisory contract had been entered into before
the adjustment of the dollar thresholds, we attribute this effect to
the Dodd-Frank Act rather than to this rulemaking. One commenter stated
that rather than addressing the contention that the adjustment to the
dollar amount thresholds is unfair to small investors, the Commission
``passed the buck'' back to Congress.\98\ The Commission, however, is
required to adjust the dollar amount thresholds for the effects of
inflation. Exempting less wealthy investors from the limits would be
contrary to the purpose of the dollar amount thresholds, which is to
limit the availability of the exemption to clients who are financially
experienced and able to bear the risks of performance fee arrangements.
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\98\ See P. Goldstein Comment Letter.
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Section 418 of the Dodd-Frank Act does not specify how the
Commission should measure inflation in adjusting the dollar amount
thresholds. We proposed, and are adopting, the PCE Index because it is
widely used as a broad indicator of inflation in the economy and
because the Commission has used the PCE Index in other contexts. It is
possible that the use of the PCE Index to measure inflation might
result in a larger or smaller dollar amount for the two thresholds than
the use of a different index, but the rounding required by the Dodd-
Frank Act (to the nearest $100,000) likely negates any difference
between indexes.
IV. Paperwork Reduction Act
The amendments to rule 205-3 under the Investment Advisers Act do
not contain any ``collection of information'' requirements as defined
by the Paperwork Reduction Act of 1995, as amended (``PRA'').\99\
Accordingly, the PRA is not applicable. We received no comments on any
PRA issues.
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\99\ 44 U.S.C. 3501-3520.
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V. Regulatory Flexibility Act Certification
The Commission certified in the Proposing Release, pursuant to
section 605(b) of the Regulatory Flexibility Act of 1980
(``RFA''),\100\ that the proposed rule amendments would not, if
adopted, have a significant impact on a substantial number of small
entities.\101\ As we explained in the Proposing Release, under
Commission rules, for the purposes of the Advisers Act and the RFA, an
investment adviser generally is a small entity if it: (i) Has assets
under management having a total value of less than $25 million; (ii)
did not have total assets of $5 million or more on the last day of its
most recent fiscal year; and (iii) does not control, is not controlled
by, and is not under common control with another investment adviser
that has assets under management of $25 million or more, or any person
(other than a natural person) that had total assets of $5 million or
more on the last day of its most recent fiscal year (``small
adviser'').\102\
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\100\ 5 U.S.C. 605(b).
\101\ See Proposing Release, supra note 15, at Section VI.
\102\ Rule 0-7(a).
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Based on information in filings submitted to the Commission, 617 of
the approximately 11,888 investment advisers registered with the
Commission are small entities. Only approximately 20 percent of the 617
registered investment advisers that are small entities (about 122
advisers) charge any of their clients performance fees. In addition, 24
of the 122 advisers required at the time of the Proposing Release an
initial investment from their clients that would meet the then current
assets-under-management threshold ($750,000), which advisory contracts
will be grandfathered into the exemption provided by rule 205-3 under
the amendments. Therefore, if these advisers in the future raise those
minimum investment levels to the revised level that we issued by order
($1 million), those advisers could charge their clients performance
fees because the clients would meet the assets-under-management test,
even if they would not meet the revised net worth test that excludes
the value of the client's primary residence. For these reasons, the
Commission believes that the amendments to rule 205-3 will not have a
significant economic impact on a substantial number of small entities.
The Commission requested written comments regarding the certification.
One commenter stated that the Proposing Release includes ``suspicious''
quantified data to support the claim as to how few advisers will be
affected by the required review every five years.\103\ The commenter
provided no further detail about why the quantified data was
suspicious, or any
[[Page 10368]]
alternative empirical data, and did not address the number of small
advisers that would be affected.\104\
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\103\ See Comment Letter of David Flatray (May 29, 2011).
\104\ Id.
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VI. Statutory Authority
The Commission is adopting amendments to rule 205-3 pursuant to the
authority set forth in section 205(e) of the Investment Advisers Act of
1940 [15 U.S.C. 80b-5(e)].
List of Subjects in 17 CFR Part 275
Reporting and recordkeeping requirements, Securities.
Text of Rules
0
For the reasons set out in the preamble, Title 17, Chapter II of the
Code of Federal Regulations is amended as follows:
PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940
0
1. The general authority citation for Part 275 continues to read as
follows:
Authority: 15 U.S.C. 80b-2(a)(11)(G), 80b-2(a)(11)(H), 80b-
2(a)(17), 80b-3, 80b-4, 80b-4a, 80b-6(4), 80b-6a, 80b-11, unless
otherwise noted.
* * * * *
0
2. Section 275.205-3 is amended by:
0
a. Revising paragraph (c);
0
b. Revising paragraphs (d)(1)(i) and (ii); and
0
c. Adding paragraph (e).
The revisions and addition read as follows:
Sec. 275.205-3 Exemption from the compensation prohibition of section
205(a)(1) for investment advisers.
* * * * *
(c) Transition rules--(1) Registered investment advisers. If a
registered investment adviser entered into a contract and satisfied the
conditions of this section that were in effect when the contract was
entered into, the adviser will be considered to satisfy the conditions
of this section; Provided, however, that if a natural person or company
who was not a party to the contract becomes a party (including an
equity owner of a private investment company advised by the adviser),
the conditions of this section in effect at that time will apply with
regard to that person or company.
(2) Registered investment advisers that were previously not
registered. If an investment adviser was not required to register with
the Commission pursuant to section 203 of the Act (15 U.S.C. 80b-3) and
was not registered, section 205(a)(1) of the Act will not apply to an
advisory contract entered into when the adviser was not required to
register and was not registered, or to an account of an equity owner of
a private investment company advised by the adviser if the account was
established when the adviser was not required to register and was not
registered; Provided, however, that section 205(a)(1) of the Act will
apply with regard to a natural person or company who was not a party to
the contract and becomes a party (including an equity owner of a
private investment company advised by the adviser) when the adviser is
required to register.
(3) Certain transfers of interests. Solely for purposes of
paragraphs (c)(1) and (c)(2) of this section, a transfer of an equity
ownership interest in a private investment company by gift or bequest,
or pursuant to an agreement related to a legal separation or divorce,
will not cause the transferee to ``become a party'' to the contract and
will not cause section 205(a)(1) of the Act to apply to such
transferee.
(d) * * *
(1) * * *
(i) A natural person who, or a company that, immediately after
entering into the contract has at least $1,000,000 under the management
of the investment adviser;
(ii) A natural person who, or a company that, the investment
adviser entering into the contract (and any person acting on his
behalf) reasonably believes, immediately prior to entering into the
contract, either:
(A) Has a net worth (together, in the case of a natural person,
with assets held jointly with a spouse) of more than $2,000,000. For
purposes of calculating a natural person's net worth:
(1) The person's primary residence must not be included as an
asset;
(2) Indebtedness secured by the person's primary residence, up to
the estimated fair market value of the primary residence at the time
the investment advisory contract is entered into may not be included as
a liability (except that if the amount of such indebtedness outstanding
at the time of calculation exceeds the amount outstanding 60 days
before such time, other than as a result of the acquisition of the
primary residence, the amount of such excess must be included as a
liability); and
(3) Indebtedness that is secured by the person's primary residence
in excess of the estimated fair market value of the residence must be
included as a liability; or
(B) Is a qualified purchaser as defined in section 2(a)(51)(A) of
the Investment Company Act of 1940 (15 U.S.C. 80a-2(a)(51)(A)) at the
time the contract is entered into; or
* * * * *
(e) Inflation adjustments. Pursuant to section 205(e) of the Act,
the dollar amounts specified in paragraphs (d)(1)(i) and (d)(1)(ii)(A)
of this section shall be adjusted by order of the Commission, on or
about May 1, 2016 and issued approximately every five years thereafter.
The adjusted dollar amounts established in such orders shall be
computed by:
(1) Dividing the year-end value of the Personal Consumption
Expenditures Chain-Type Price Index (or any successor index thereto),
as published by the United States Department of Commerce, for the
calendar year preceding the calendar year in which the order is being
issued, by the year-end value of such index (or successor) for the
calendar year 1997;
(2) For the dollar amount in paragraph (d)(1)(i) of this section,
multiplying $750,000 times the quotient obtained in paragraph (e)(1) of
this section and rounding the product to the nearest multiple of
$100,000; and
(3) For the dollar amount in paragraph (d)(1)(ii)(A) of this
section, multiplying $1,500,000 times the quotient obtained in
paragraph (e)(1) of this section and rounding the product to the
nearest multiple of $100,000.
Dated: February 15, 2012.
By the Commission.
Elizabeth M. Murphy,
Secretary.
[FR Doc. 2012-4046 Filed 2-21-12; 8:45 am]
BILLING CODE 8011-01-P