The Dodd-Frank Act amended section 205(e) of the Advisers Act and directed the SEC to adjust for inflation, the dollar amount thresholds in rules under the section, rounded to the nearest $100,000. Separately, the Dodd-Frank Act also required adjusting the net worth standard for an “accredited investor” in rules under the Securities Act of 1933, such as Regulation D, to exclude the value of a person’s primary residence.
On February 15, 2012, the SEC codified an order that adjusts the dollar amount thresholds to account for the effects of inflation for investment adviser performance based fee calculations. And, rule 205-3 of the Investment Advisers Act was amended to provide that the SEC issue an order every five years in the future adjusting the dollar amount thresholds for inflation. The rules was also amended to 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 added certain transition provisions to the rule.
Rule 205-3 was amended to revise the dollar amount thresholds that currently apply to investment advisers, to codify the order 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. As proposed, new paragraph (e) states that the SEC 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. Also, the price index on which future inflation adjustments will be based is the Personal Consumption Expenditures Chain-Type Price Index (“PCE Index”), which is published by the Department of Commerce.
In addition, the net worth test in the definition of “qualified client” in rule 205-3 was amended to exclude the value of a natural person’s primary residence and certain debt secured by the property. The amendment of the net worth standard of rule 205-3 differs from the proposed amendment because any increase in the amount of debt secured by the primary residence in 60 days before the advisory contract is entered into would be included as a liability. The SEC stated that 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 excludes 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. 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. Also, the 60-day look-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; and 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.
A transition clause was added with paragraphs (1) and (2) of rule 205-3(c) 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. This clause was added to minimize the disruption of existing contractual relationships that met applicable requirements under the rule at the time the parties entered into them.
At the suggestion of one commenter, the proposed third paragraph of rule 205-3(c), was revised 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. Specifically, 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. However, 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. Therefore paragraph (3) of rule 205-3(c) was amended 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. 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.
The rule amendments 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 SEC stated they will not object if advisers rely or relied upon the amended transition provisions of rule 205-3(c) before that date.