[Federal Register Volume 76, Number 93 (Friday, May 13, 2011)]
[Proposed Rules]
[Pages 27959-27967]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2011-11801]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 275
[Release No. IA-3198; File No. S7-17-11]
RIN 3235-AK71
Investment Adviser Performance Compensation
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rule; notice of intent to issue order.
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SUMMARY: The Securities and Exchange Commission (``Commission'' or
``SEC'') intends to issue an order that would adjust two dollar amount
tests in the rule under the Investment Advisers Act of 1940 that
permits investment advisers to charge performance based compensation to
``qualified clients.'' The adjustments would revise the dollar amount
tests to account for the effects of inflation. The Commission is also
proposing to amend the rule to: provide that the Commission will issue
an order every five years adjusting for inflation the dollar amount
tests; exclude 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 add certain transition provisions to the
rule.
DATES: Comments on the proposed rule should be received on or before
July 11, 2011.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's Internet comment form (http://www.sec.gov/rules/proposed.shtml); or
Send an e-mail to [email protected]. Please include
File Number S7-17-11 on the subject line; or
Use the Federal eRulemaking Portal (http://www.regulations.gov). Follow the instructions for submitting comments.
Paper Comments
Send paper comments in triplicate to Elizabeth M. Murphy,
Secretary, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-1090.
All submissions should refer to File Number S7-17-11. This file number
should be included on the subject line if e-mail is used. To help us
process and review your comments more efficiently, please use only one
method. The Commission will post all comments on the Commission's
Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments
are also available for Web site viewing and printing in the
Commission's Public Reference Room, 100 F Street, NE., Washington, DC
20549, on official business days between the hours of 10 a.m. and 3
p.m. All comments received will be posted without change; we do not
edit personal identifying information from submissions. You should
submit only information that you wish to make available publicly.
Hearing Request: An order adjusting the dollar amount tests
specified in the definition of ``qualified client'' will be issued
unless the Commission orders a hearing. Interested persons may request
a hearing by writing to the
[[Page 27960]]
Commission's Secretary. Hearing requests should be received by the SEC
by 5:30 p.m. on June 20, 2011. Hearing requests should state the nature
of the writer's interest, the reason for the request, and the issues
contested.
FOR FURTHER INFORMATION CONTACT: Adam B. Glazer, 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 intends to issue an order,
and is proposing for public comment 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 Investment Advisers Act, including
rule 205-3, are to Title 17, Part 275 of the Code of Federal
Regulations [17 CFR 275].
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Table of Contents
I. Background
II. Discussion
A. Order Adjusting Dollar Amount Tests
B. Proposed Amendments to Rule 205-3
1. Inflation Adjustment of Dollar Amount Thresholds
2. Exclusion of the Value of Primary Residence From Net Worth
Determination
3. Transition Rules
C. Effective and Compliance Dates
III. Request for Comment
IV. Cost Benefit Analysis
V. Paperwork Reduction Act
VI. Regulatory Flexibility Act Certification
VII. Statutory Authority
Text of Proposed Rules
I. Background
Section 205(a)(1) of the Investment Advisers Act generally
prohibits 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
prohibited 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\ In 1970, Congress
provided an exception from the prohibition for advisory contracts
relating to the investment of assets in excess of $1,000,000,\4\ if an
appropriate ``fulcrum fee'' is used.\5\ Congress subsequently
authorized the Commission to exempt any advisory contract from the
performance fee prohibition if the contract is with persons that the
Commission determines do not need the protections of that
prohibition.\6\
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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\ 15 U.S.C. 80b-5(b)(2). Trusts, governmental plans,
collective trust funds, and separate accounts referred to in section
3(c)(11) of the Investment Company Act of 1940 [15 U.S.C. 80a-
3(c)(11)] are not eligible for this exception from the performance
fee prohibition under section 205(b)(2)(B) of the Advisers Act.
\5\ 15 U.S.C. 80b-5(b). A fulcrum fee generally involves
averaging the adviser's fee over a specified period and increasing
or decreasing the fee proportionately with the investment
performance of the company or fund in relation to the investment
record of an appropriate index of securities prices. See rule 205-2
under the Advisers Act; Definition of ``Specified Period'' Over
Which Asset Value of Company or Fund Under Management is Averaged,
Investment Advisers Act Release No. 347 (Nov. 10, 1972) [37 FR 24895
(Nov. 23, 1972)]. In 1980, Congress added another exception to the
prohibition against charging performance fees, for contracts
involving business development companies under certain conditions.
See section 205(b)(3) of the Advisers Act.
\6\ Section 205(e) of the Advisers Act. In 1996, Congress
included in the National Securities Markets Improvement Act of 1996
(``1996 Act'') two additional statutory exceptions from the
performance fee prohibition and new section 205(e) of the Advisers
Act. The 1996 Act added exceptions for contracts with companies
excepted from the definition of ``investment company'' in the
Investment Company Act of 1940 (``Investment Company Act'') [15
U.S.C. 80a] by section 3(c)(7) of the Investment Company Act [15
U.S.C. 80a-3(c)(7)] and contracts with persons who are not residents
of the United States. See sections 205(b)(4) and (b)(5). 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 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].''
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The Commission adopted rule 205-3 in 1985 to exempt an investment
adviser from the prohibition against charging a client performance fees
in certain circumstances.\7\ 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.\8\
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\7\ 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).
\8\ See 1985 Adopting Release, supra note 7, 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.\9\ The
Commission revised the former from $500,000 to $750,000, and the latter
from $1 million to $1.5 million.\10\
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\9\ 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'').
\10\ See id. at Section II.B.1.
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On July 21, 2010, President Obama signed into law the Dodd-Frank
Wall Street Reform and Consumer Protection Act (``Dodd-Frank
Act'').\11\ The Dodd-Frank Act, among other things, amended section
205(e) of the Advisers Act to state that, by July 21, 2011 and every
five years thereafter, the Commission shall adjust for inflation the
dollar amount tests included in rules issued under section 205(e).\12\
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'') \13\ to exclude the value
of a person's primary residence.\14\
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\11\ Pub. L. 111-203, 124 Stat. 1376 (2010).
\12\ 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).
\13\ 15 U.S.C. 77a et seq.
\14\ See section 413(a) of the Dodd-Frank Act.
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II. Discussion
Pursuant to section 418 of the Dodd-Frank Act, today we are
providing notice that the Commission intends to issue an order revising
the dollar amount tests of rule 205-3 to account for the effects of
inflation. We also are proposing for public comment amendments to rule
205-3 to provide that the Commission will subsequently
[[Page 27961]]
issue orders making future inflation adjustments every five years.\15\
In addition, we are proposing to amend rule 205-3 to exclude the value
of a person's primary residence from the determination of whether a
person meets the net worth standard required to qualify as a
``qualified client.'' Finally, we propose to modify the transition
provisions of the rule to take into account performance fee
arrangements that were permissible when they were entered into, so that
new dollar amount thresholds do not require investment advisers to
renegotiate the terms of arrangements that were permissible when the
parties entered into them. These proposals are discussed in more detail
below.
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\15\ 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.
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A. Order Adjusting Dollar Amount Tests
We intend to issue an order revising the dollar amounts of the
assets-under-management test and the net worth test in the definition
of ``qualified client'' in rule 205-3. As discussed above, the
Commission last revised these dollar amount tests in 1998 to take into
account the effects of inflation. At that time, the Commission revised
the assets-under-management test from $500,000 to $750,000 and revised
the net worth test from $1 million to $1.5 million. Pursuant to section
418 of the Dodd-Frank Act, which requires that we revise the dollar
amount thresholds of the rule by order not later than July 21, 2011,
and every five years thereafter, today we are providing notice \16\
that we intend to issue an order to revise the assets-under-management
and net worth tests of rule 205-3 to $1 million \17\ and $2 million
respectively.\18\
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\16\ See section 211(c) of the Advisers Act (requiring the
Commission to provide appropriate notice of and opportunity for
hearing for orders issued under the Advisers Act).
\17\ An investment adviser could 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.
This approach to calculating assets under management conforms
with the approach we took in our recent release proposing to
implement certain exemptions from registration with the Commission
under the Advisers Act. In that release, we proposed to include
uncalled capital commitments in the calculation of assets under
management used to determine whether an adviser qualifies for the
private fund adviser exemption. See Exemptions for Advisers to
Venture Capital Funds, Private Fund Advisers With Less Than $150
Million in Assets Under Management, and Foreign Private Advisers,
Investment Advisers Act Release No. 3111 (Nov. 19, 2010) [75 FR
77190 (Dec. 10, 2010)] at nn.192-94 and accompanying text.
\18\ As discussed further below, we also would revise the
definition of ``qualified client'' in rule 205-3(d) to reflect the
updated thresholds.
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These revised dollar amounts would take into account the effects of
inflation by reference to the historic and current levels of the
Personal Consumption Expenditures Chain-Type Price Index (``PCE
Index''),\19\ which is published by the Department of Commerce.\20\ The
PCE Index is often used as an indicator of inflation in the personal
sector of the U.S. economy.\21\ The Commission has used the PCE Index
in other contexts, including the determination of whether a person
meets a specific net worth minimum in Regulation R under the Securities
Exchange Act of 1934 (15 U.S.C. 78a) (``Exchange Act'').\22\
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\19\ The revised dollar amounts in the tests would 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 111.123, and the 1997 PCE Index was 85.395. Assets-
under-management test calculation to adjust for the effects of
inflation: 111.123/85.395 x $750,000 = $975,962; $975,962 rounded to
the nearest multiple of $100,000 = $1 million. Net worth test
calculation to adjust for the effects of inflation: 111.123/85.395 x
$1.5 million = $1,951,923; $1,951,923 rounded to the nearest
multiple of $100,000 = $2 million.
\20\ 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.
\21\ 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 (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).
\22\ See Definitions 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)] (``Regulation R
Release'') (adopting periodic inflation adjustments to the fixed-
dollar thresholds for both ``institutional customers'' and ``high
net worth customers'' under Rule 701 of Regulation R). See also
Amendments to Form ADV, Investment Advisers Act Release No. 3060
(July 28, 2010) [75 FR 49234 (Aug. 12, 2010)] (increasing for
inflation the threshold amount for prepayment of advisory fees that
triggers an adviser's duty to provide clients with an audited
balance sheet and the dollar threshold triggering the exception to
the delivery of brochures to advisory clients receiving only
impersonal advice). The Dodd-Frank Act also requires the use of the
PCE Index to calculate inflation adjustments for the cash limit
protection of each investor under the Securities Investor Protection
Act of 1970. See section 929H(a) of the Dodd-Frank Act.
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B. Proposed Amendments to Rule 205-3
1. Inflation Adjustment of Dollar Amount Thresholds
We also are proposing to amend rule 205-3 under the Advisers Act.
We would add a new paragraph (e) stating that the Commission will issue
an order every five years adjusting for inflation the dollar amounts of
the assets-under-management and net worth tests of the rule, as
required by the Dodd-Frank Act.\23\ Our proposed amendment would
specify that the PCE Index will be the inflation index used to
calculate future inflation adjustments of the dollar amount tests in
the rule.\24\ We believe the use of the PCE Index is appropriate
because, as discussed above, it is an indicator of inflation in the
personal sector of the U.S. economy and is used in other provisions of
the Federal securities laws.\25\ We also intend to revise paragraph (d)
of rule 205-3, which sets forth the assets-under-management and net
worth tests, to reflect the revised thresholds that we establish by the
order discussed
[[Page 27962]]
above.\26\ Finally, we anticipate that, if we adopt these proposed
amendments to rule 205-3, we would delegate to our staff the authority
to issue inflation adjustment orders every five years in the
future.\27\
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\23\ Proposed rule 205-3(e) would provide that the Commission
will issue an order effective 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.
\24\ Proposed rule 205-3(e) would provide 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
2015 PCE Index by the 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.
\25\ See supra notes 21-22 and accompanying text.
\26\ As discussed above, we would revise the assets-under-
management test to $1 million and the net worth test to $2 million.
\27\ To delegate this authority to the staff, we would amend our
rules of organization and program management to delegate to the
Director of the Division of Investment Management the authority to
issue notices and orders revising the dollar amount thresholds in
rule 205-3(d)(1)(i) (assets-under-management) and 205-3(d)(1)(ii)(A)
(net worth) for the effects of inflation pursuant to amended section
205(e) of the Advisers Act every five years after 2011. See rule 30-
5 of the Commission's Rules of Organization and Program Management
[17 CFR 200.30-5] (delegating authority to the Director of the
Division of Investment Management). We also anticipate that future
changes to the dollar amount tests that are issued by order, will be
reflected in technical amendments to rule 205-3(d).
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We request comment on the proposed amendments to rule 205-3
concerning the adjustment of the dollar amount thresholds to account
for inflation.
Is the proposed use of the PCE Index as a measure of
inflation appropriate? Is there another index or other measure that
would be more appropriate?
The rule would establish the dollar amount tests we
adopted in 1998 as the baseline for all future adjustments, as a
consistent denominator for all future calculations. Should we instead
establish each future adjustment of the dollar amount tests as a new
baseline for the next calculation of the dollar amount tests? If we
were to adopt that approach, because the Dodd-Frank Act requires that
revised thresholds be rounded to the nearest $100,000, could the
establishment of new baselines at the rounded amounts, each time the
thresholds are adjusted, result in the underestimation or
overestimation of the effects of inflation in subsequent periods?
2. Exclusion of the Value of Primary Residence from Net Worth
Determination
We also are proposing to amend the net worth standard in rule 205-
3, in the definition of ``qualified client,'' to exclude the value of a
natural person's primary residence and debt secured by the
property.\28\ This change, although not required by the Dodd-Frank Act,
is similar to that Act's requirement that we exclude the value of a
natural person's primary residence in the definition of ``accredited
investor'' in rules under the Securities Act.\29\ The value of a
person's residence may have little relevance to an individual's
financial experience \30\ 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.\31\
The Commission took a similar approach when it 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 Exchange Act \32\ and from the determination of
whether a natural person has a sufficient level of investments to be
considered a ``qualified purchaser'' under the Investment Company
Act.\33\
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\28\ Proposed rule 205-3(d)(1)(ii)(A) (excluding from the
assessment of net worth the value of a natural person's primary
residence ``calculated by subtracting from the estimated fair market
value of the property the amount of debt secured by the property, up
to the estimated fair market value of the property'').
\29\ 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
of 1933 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 a separate release, 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'').
\30\ 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 financial knowledge and
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.
\31\ 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.
\32\ See, e.g., Regulation R Release, supra note 22, 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).
\33\ 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.
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Our proposed amendment would exclude the value of a natural
person's primary residence and the amount of debt secured by the
property that is no greater than the property's current market
value.\34\ Therefore a mortgage on the residence would not be included
in the assessment of a natural person's net worth, unless the
outstanding debt on the mortgage, at the time that net worth is
calculated, exceeds the market value of the residence. If the
outstanding debt exceeds the market value of the residence, the amount
of the excess would be considered a liability in calculating net worth
under the proposed amendments to rule 205-3.
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\34\ Proposed rule 205-3(d)(1)(ii)(A).
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We request comment on the proposed exclusion of the value of a
person's primary residence from the calculation of a natural person's
net worth under rule 205-3.
Should we, as proposed, exclude the value of a natural
person's primary residence from the calculation of net worth? Or should
we include the value of a person's primary residence? Does such
ownership evidence financial experience and the ability to bear risks
associated with performance fee contracts? Should we, as proposed, also
exclude from the net worth standard in rule 205-3 debt secured by a
person's primary residence, up to the market value of the residence?
Does such debt affect the ability to bear risks associated with
performance fee contracts or investments that often are associated with
such contracts?
We note that although the Dodd-Frank Act requires the
Commission to exclude a natural person's primary residence from the net
worth standard for an ``accredited investor'' in rules under the
Securities Act, the Dodd-Frank Act does not require the Commission to
exclude a natural person's primary residence from the standards for a
``qualified client'' in rules under section 205(e) of the Advisers Act.
Instead, the Dodd-Frank Act requires that the dollar amount tests of
``qualified client'' be adjusted for inflation every five years. Should
our amendment of rule 205-3 accomplish only what the Dodd-Frank Act
mandates (i.e., inflation-adjustment of the dollar amount tests) and
not revise the net
[[Page 27963]]
worth test by excluding the value of a primary residence?
Should the rule require, as proposed, that debt secured by
the residence in excess of the market value of the residence at the
time the advisory contract is entered into be included as a liability
in the determination of the person's net worth? Should the rule instead
require that all debt that is secured by the primary residence
(regardless of whether it exceeds the fair market value of the
residence) be excluded from the calculation of net worth under rule
205-3? Alternatively, should the rule exclude the entire market value
of the residence from net worth, but require treatment of any
associated debt as a liability? Should the rule require inclusion of
debt secured by a primary residence as a liability if proceeds of the
debt are used to enter into an advisory contract that involves
performance compensation paid to an investment adviser? If so, how
would these proceeds of the debt be traced?
Should the rule provide that the calculation of net worth
must be made on a specified date prior to the day the advisory contract
is entered into, for example 30, 60, or 90 days? If not, would
investors be likely to inflate their net worth by borrowing against
their homes to attain qualified client status? If we were to require
that the net worth calculation be made a significant period of time in
advance of entering into the advisory contract, would such a
requirement make the calculation unduly complex?
Is the language of the proposed rule amendment
sufficiently precise? Should we substitute the word ``equity'' for the
word ``value'' when referring to the primary residence excluded from
the calculation of a natural person's net worth? Should we define the
term ``primary residence'' for purposes of rule 205-3? If so, should we
address the circumstances of a person who lives in multiple residences
for roughly equal amounts of time during the year? \35\
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\35\ As we stated in the Accredited Investor Proposing Release,
supra note 29, at nn.35-36 and accompanying text, helpful guidance
may be found in rules that apply in other contexts. For example, the
IRS Publication 523, Selling Your Home 3-4 (Jan. 5, 2011) lists the
following factors to be used, in addition to the amount of time a
person lives in each of several homes, to determine a person's
``principal residence'' under section 121 of the Internal Revenue
Code, 26 U.S.C. 121: place of employment; location of family
members' main home; mailing address for bills and correspondence;
address listed on Federal and state tax returns, driver's license,
car registration, and voter registration card; location of banks
used and recreational clubs and religious organizations.
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As noted above, the Commission proposed in a separate
release to adjust the net worth standards for accredited investors in
our rules under the Securities Act, to exclude the value of a natural
person's primary residence from the assessment of a natural person's
net worth.\36\ We request comment on whether the net worth standards
that we consider in connection with rule 205-3 should differ from any
standards we consider in connection with those proposed amendments.
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\36\ See supra note 29.
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3. Transition Rules
The proposed amendments would replace the current transition rules
section of rule 205-3 with two new subsections to 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, proposed rules 205-3(c)(1) and (2), are both designed so
that restrictions on the charging of performance fees apply to new
contractual arrangements and do not apply retroactively to existing
contractual arrangements, including investments in companies that are
excluded from the definition of an ``investment company'' under the
Investment Company Act by reason of section 3(c)(1) \37\ of that Act
(``private investment companies'').\38\ This approach would minimize
the disruption of existing contracts that meet applicable standards at
the time the parties entered into the contract.
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\37\ See rule 205-3(d)(3) (defining ``private investment
company'' for purposes of rule 205-3). Advisory contracts with
companies excepted from the definition of an ``investment company''
by reason of section 3(c)(7) of the Investment Company Act are not
subject to the Advisers Act performance fee prohibition. See section
205(b)(4) of the Advisers Act. Therefore these contractual
arrangements do not need, and are not included within, the exemptive
relief provided by rule 205-3.
\38\ 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 investment
advisers to private investment companies. See 1998 Adopting Release,
supra note 9; Goldstein v. Securities and Exchange Commission, 451
F.3d 873 (D.C. Cir. 2006).
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First, proposed rule 205-3(c)(1) would provide 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.\39\ 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 would apply to that person or
company. This proposed subsection would mean, for example, that if an
individual meets the $1.5 million net worth test and enters into an
advisory contract with a registered investment adviser, the client
could continue to maintain funds (and invest additional funds) with the
adviser under that contract even if the net worth test were
subsequently raised and he or she no longer met the new test. If,
however, another person were to become a party to that contract, the
current net worth threshold would apply to the new party when he or she
becomes a party to the contract.\40\
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\39\ Proposed rule 205-3(c)(1) would modify 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.
\40\ Proposed 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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We request comment on this proposed transition provision.
Should the rule be amended as proposed, to allow advisers
to continue to provide advisory services under performance fee
arrangements that were permitted under the rule in effect at the time
the contract was entered into, if the client does not meet the
eligibility criteria after an adjustment to the dollar amount tests or
for any other reason (e.g., a decrease in the client's net worth below
the dollar amount test)? Should the rule in these circumstances permit
the management of existing funds under previous contractual
arrangements, but prohibit an adviser from charging performance fees
with respect to funds committed after the effective date of the rule?
If so, how should the rule treat dividends and realized capital gains
reinvested by the adviser?
Second, proposed rule 205-3(c)(2) would provide that, if an
investment adviser was previously exempt pursuant to section 203 from
registration with the Commission and subsequently registers with the
Commission, section 205(a)(1) of the Act would not apply to the
contractual arrangements into which the adviser entered when it was
exempt from registration with the
[[Page 27964]]
Commission.\41\ This proposed subsection would mean, 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) would 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 become new investors in the
private investment company after the adviser registers with the
Commission, section 205(a)(1) would apply to the adviser's relationship
with them.
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\41\ Section 205(a)(1) would apply, however, to contractual
arrangements into which the adviser enters after it is no longer
exempt from registration with the Commission. See proposed rule 205-
3(c)(2). The approach of the proposed subsection is similar to the
transition subsections we adopted in 2004, in rules 205-3(c)(2)--
(3), when we adopted rules to require 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)]. Those transition
provisions were vacated by the U.S. Court of Appeals for the
District of Columbia Circuit when it vacated the Commission's
rulemaking in its entirety. See Goldstein v. SEC, supra note 38.
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We request comment on this proposed transition provision.
Should the rule be amended as proposed, to allow advisers
to continue to be compensated under performance fee arrangements that
were permitted when the adviser was exempt from registration with the
Commission? Should the rule in these circumstances permit the
management of existing funds under previous contractual arrangements,
but prohibit a newly registered investment adviser from charging a
performance fee with respect to any additional funds to be managed
under previously existing contracts?
Should the rule differentiate between the reasons why an
adviser was exempt from registration (e.g., due to a particular
subsection of the Advisers Act) but is no longer exempt? Should the
rule include different transition provisions depending upon the reason
why an adviser was exempt from registration but is no longer exempt?
C. Effective and Compliance Dates
We anticipate that, if we issue the order described above and adopt
the rule amendments we are proposing, we will allow an appropriate time
period before requiring compliance with the new standards. For rule
amendments, the Administrative Procedure Act generally requires at
least 30 days prior to the effectiveness of new rules, absent special
circumstances.\42\
---------------------------------------------------------------------------
\42\ See 5 U.S.C. 553(d).
---------------------------------------------------------------------------
We request comment on the transition period or delayed
compliance date that would be appropriate for any revised thresholds
that we issue by order, or for any rule amendments that we adopt.
Should we allow more time than the 30 days required under the
Administrative Procedure Act (e.g., 60 days, 90 days, 120 days)?
III. Request for Comment
The Commission requests comment on the rule amendments we propose
in this release. Commenters are requested to provide empirical data to
support their views. The Commission also requests suggestions for
additional changes to existing rules or forms, and comments on other
matters that might have an effect on the proposals contained in this
release.
IV. Cost Benefit Analysis
The Commission is sensitive to the costs and benefits imposed by
its rules. We have identified certain costs and benefits of the
proposed amendments, and we request comment on all aspects of this cost
benefit analysis, including identification and assessment of any costs
and benefits not discussed in this analysis. We seek comment and data
on the value of the benefits identified. We also welcome comments on
the accuracy of the cost estimates in this analysis, and request that
commenters provide data that may be relevant to these cost estimates.
In addition, we seek estimates and views regarding these costs and
benefits for particular investment advisers, including small advisers,
as well as any other costs or benefits that may result from the
adoption of these proposed amendments.
In proposing to amend rule 205-3 to provide that the Commission
will issue orders every five years adjusting for inflation the dollar
amount tests of the rule, we are responding to the Dodd-Frank Act's
amendment of section 205(e) of the Advisers Act requiring the
Commission to issue these orders.\43\ The proposed amendments to rule
205-3 also would exclude the value of a natural person's primary
residence and debt secured by the property from the determination of
whether a person has sufficient net worth to be considered a
``qualified client,'' and would modify the transition provisions of the
rule to take into account performance fee arrangements that were
permissible when they were entered into.
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\43\ Section 418 of the Dodd-Frank Act.
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A. Benefits
We expect that adjusting the dollar amount thresholds in rule 205-3
for the effects of inflation would benefit advisory clients. When the
Commission adopted the dollar amount thresholds in the definition of
``qualified client'' in rule 205-3 in 1985, it evaluated the most
appropriate dollar amount for both the assets-under-management and net
worth tests. 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.\44\ The adjustment of these dollar amount tests every
five years would carry forward these protections at dollar levels that
are based on the current price levels in the economy. We believe that
adjusting these eligibility criteria to reflect real dollar equivalents
would help to preserve these protections.
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\44\ See supra note 8 and accompanying text.
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The proposed exclusion of the value of an individual's primary
residence also would benefit clients. As discussed above, 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
associated with performance fee arrangements. Therefore, a client who
does not meet the net worth test of rule 205-3 without including the
value of her primary residence would be protected by the performance
fee restrictions in section 205 of the Advisers Act.\45\
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\45\ As discussed above, the proposed amendments to rule 205-3
also would 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.
---------------------------------------------------------------------------
The proposed amendments to the rule's transition provisions would
benefit advisory clients and investment advisers. The proposed
amendments 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 performance fees
would not be permissible under the contract if it were entered into at
a later date. These transition provisions are
[[Page 27965]]
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.
We request comment on these anticipated benefits, and on
whether the proposed rule amendments would result in additional
benefits to advisory clients and investment advisers.
B. Costs
We do not expect that adjusting the dollar amount tests in rule
205-3 would impose significant new costs on advisory clients or
investment advisers. As discussed above, section 418 of the Dodd-Frank
Act requires the Commission to periodically issue orders adjusting for
inflation the assets-under-management and net worth tests in rule 205-
3. Raising these eligibility criteria could mean that certain persons
who would have qualified under the current dollar amount thresholds
would no longer qualify under the dollar amount thresholds as adjusted
for the effects of inflation. As a result, 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 amount thresholds.
This effect may result in an investment adviser declining to provide
services to potential clients.\46\ However, this cost is a consequence
of the Dodd-Frank Act, and therefore we do not attribute this cost to
this rulemaking.
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\46\ As discussed above, the proposed amendments 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 performance fees would not be permissible
under the contract if it were entered into at a later date. See
supra Section II.B.3.
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Section 418 of the Dodd-Frank Act does not specify how the
Commission should measure inflation. We have proposed to use 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, although the rounding
required by the Dodd-Frank Act (to the nearest $100,000) would likely
negate any difference between indexes.
The proposed 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 proposed amendments 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 performance fees would not be permissible under
the contract if it were entered into at a later date.
The proposed amendments also would exclude the value of a person's
primary residence and 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. 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.\47\ Therefore, approximately 1.3
million households currently would not meet a $2 million net worth test
under the proposed revised test, and would therefore not be considered
``qualified clients,'' if the value of the primary residence is
excluded from the test. Excluding the value of the primary residence
(and debt secured by the property up to the current market value of the
residence) would mean 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, would no longer be ``qualified clients'' under
the proposed revised net worth test and therefore would be unable to
enter into performance fee contracts unless they meet another test of
rule 205-3.\48\
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\47\ 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.
\48\ The net worth test includes assets that a natural person
holds jointly with his or her spouse. See rule 205-3(d)(1)(ii)(A).
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As noted above, the proposed amendments would allow an investment
adviser and its clients to maintain existing performance fee
arrangements that were permissible when the advisory contract was
entered into. 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 would not meet the revised net worth
test.\49\ Commission staff estimates that about 40 percent of those
325,000 potential clients (i.e., 130,000) would separately meet the
``qualified client'' definition under the assets-under-management test,
and therefore could enter into performance fee arrangements.\50\ The
remaining 60 percent (195,000 households) would have access only to
those investment advisers (directly or through the private investment
companies they manage) that charge advisory fees other than performance
fees.\51\ Commission staff anticipates that the non-performance fee
arrangements into which these clients would enter would contain
management fees that yield advisers approximately the same amount of
fees that clients would have paid under performance fee arrangements.
Under these arrangements, if the adviser's performance does not reach
the level at which it would have accrued performance fees, a client
might end up paying higher overall fees than if he were paying
performance fees. For purposes of this cost benefit analysis,
Commission staff assumes that approximately 80 percent of the 195,000
households (i.e. 156,000 households) would enter into these non-
performance fee arrangements, and that the other 20 percent would
decide not to invest their assets with an adviser.\52\
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\49\ 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)
(estimating that approximately 20% of investment advisers charge
performance fees). Although that report indicated that 20% of
investment advisers charge performance fees and an average of only
37% of investors indicated they would seek investment advisory
services in the next five years, id. at 105 (Table 6.13), we have
used the 25% assumption in an effort to overestimate rather than
underestimate the costs, especially given the inherent uncertainty
surrounding hypothetical events. As noted above, the estimate
concerning 1.3 million households is derived from the 2007 Federal
Reserve Board Survey of Consumer Finances. See supra notes 47-48 and
accompanying text.
\50\ This estimate is based on data filed by registered
investment advisers on Form ADV.
\51\ 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.
\52\ 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,
would 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 51.
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[[Page 27966]]
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 would likely seek other investment opportunities, for
example, investing in mutual funds, closed-end funds, or exchange-
traded funds. Other households may forgo 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 proposed amendments that would exclude the
value of a person's primary residence from the calculation of a
person's net worth also might result in a reduction in the total fees
collected by investment advisers. Because advisers would no longer be
able to charge some clients performance fees, it is possible that the
overall fees collected by advisers might be reduced. As discussed
above, advisers may adjust their fees in order to obtain the same
revenue from clients who do not meet the definition of ``qualified
clients.'' In addition, advisers may choose to market their services to
a larger number of potential clients and thereby enter into advisory
contracts with others to whom they could charge performance fees.\53\
As a result, Commission staff estimates that the proposed amendments
are not likely to impose a significant net cost on advisers. Because of
the ability of investment advisers to attract qualified clients who
satisfy the proposed standards, and the ability of non-qualified
clients to invest in other investment opportunities that do not entail
performance fees, we expect that the proposed rule would not have a
significant impact on capital formation.\54\
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\53\ Commission staff notes that expanding marketing efforts
could result in additional costs that offset some of the new sources
of revenue. As noted above, Commission staff estimates that 39,000
households that would have entered into advisory contracts would not
enter into such contracts as a result of the proposed exclusion of a
client's primary residence from a determination of a client's net
worth. Based on ADV filings, Commission staff estimates that 3295
registered advisers charge performance fees. Therefore, Commission
staff estimates that on average each adviser would need to offset
the loss of approximately 12 households (39,000/3295 = 11.8
households) to avoid a reduction in total fees collected, either by
charging those households comparable fees other than performance
fees, or by attracting other clients that meet the net worth test.
\54\ 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. Therefore, the revenue loss to investment advisers
from the exclusion of these clients from the performance fee
exemption may be mitigated.
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We request comment on the economic costs of excluding the value of
the primary residence and debt secured by the property from the net
worth test for determining whether individual clients are ``qualified
clients.''
Would most households that no longer meet the net worth
standard due to the exclusion of the value of the primary residence,
still receive advisory services? Would investment advisers decline to
provide advisory services to potential clients who do not qualify as
``qualified clients''? Would investment advisers be able to offset the
potential lost performance fees? If not, what would be the amount of
lost fees that advisers would incur?
C. Request for Comment
The Commission requests comment on all aspects of the cost benefit
analysis, including the accuracy of the potential benefits and costs
identified and assessed in this release, as well as any other benefits
or costs that may result from the proposals. We encourage commenters to
identify, discuss, analyze, and supply relevant data regarding these or
additional benefits and costs. For purposes of the Small Business
Regulatory Enforcement Fairness Act of 1996,\55\ the Commission also
requests information regarding the potential annual effect of the
proposals on the U.S. economy. Commenters are requested to provide
empirical data to support their views.
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\55\ Pub. L. 104-121, Title II, 110 Stat. 857 (1996) (codified
in various sections of 5 U.S.C., 15 U.S.C., and as a note to 5
U.S.C. 601).
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V. Paperwork Reduction Act
The proposed amendments to rule 205-3 under the Advisers Act do not
contain a ``collection of information'' requirement within the meaning
of the Paperwork Reduction Act of 1995 (``PRA'').\56\ Accordingly, the
PRA is not applicable.
---------------------------------------------------------------------------
\56\ 44 U.S.C. 3501-3521.
---------------------------------------------------------------------------
VI. Regulatory Flexibility Act Certification
Section 3(a) of the Regulatory Flexibility Act of 1980 \57\
(``RFA'') requires the Commission to undertake an initial regulatory
flexibility analysis (``IRFA'') of the proposed rule amendments on
small entities unless the Commission certifies that the rule, if
adopted, would not have a significant economic impact on a substantial
number of small entities.\58\ Pursuant to 5 U.S.C. section 605(b), the
Commission hereby certifies that the proposed amendments to rule 205-3
under the Advisers Act, would not, if adopted, have a significant
economic impact on a substantial number of small entities. Under
Commission rules, for 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.\59\
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\57\ 5 U.S.C. 603(a).
\58\ 5 U.S.C. 605(b).
\59\ Rule 0-7(a).
---------------------------------------------------------------------------
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 require an initial investment from their clients
that would meet the current assets-under-management threshold
($750,000), which advisory contracts would be grandfathered into the
exemption provided by rule 205-3 under the proposed amendments.
Therefore, if these advisers in the future raise those minimum
investment levels to the revised level that we intend to issue 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 proposed net worth test that would
exclude the value of the client's primary residence. For these reasons,
the Commission believes that the proposed amendments to rule 205-3
would not, if adopted, have a significant economic impact on a
substantial number of small entities.
The Commission requests written comments regarding this
certification. The Commission solicits comments as
[[Page 27967]]
to whether the proposed amendments could have an effect on small
entities that has not been considered. We request that commenters
describe the nature of any impact on small entities and provide
empirical data to support the extent of such impact.
VII. Statutory Authority
The Commission is proposing 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 Proposed Rules
For the reasons set out in the preamble, Title 17, Chapter II of
the Code of Federal Regulations is proposed to be amended as follows:
PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940
1. The general authority citation for part 275 continues to read as
follows:
Authority: 15 U.S.C. 80b-2(a)(17), 80b-3, 80b-4, 80b-6(4), 80b-
6a, 80b-11, unless otherwise noted.
* * * * *
2. Section 275.205-3 is amended by:
a. Revising paragraph (c);
b. Revising paragraphs (d)(1)(i) and (ii); and
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 exempt from
registration. If an investment adviser was exempt from registration
with the Commission pursuant to section 203 of the Act (15 U.S.C. 80b-
3), section 205(a)(1) of the Act will not apply to an advisory contract
entered into when the adviser was exempt, 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 exempt; 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 no longer exempt.
(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,
excluding the value of the primary residence of such natural person,
calculated by subtracting from the estimated fair market value of the
property the amount of debt secured by the property, up to the
estimated fair market value of the property; 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, effective
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.
By the Commission.
Dated: May 10, 2011.
Elizabeth M. Murphy,
Secretary.
[FR Doc. 2011-11801 Filed 5-12-11; 8:45 am]
BILLING CODE 8011-01-P