Investment Adviser Performance Compensation, 27959-27967 [2011-11801]
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Federal Register / Vol. 76, No. 93 / Friday, May 13, 2011 / Proposed Rules
power and responsibilities among the
various levels of government.
For the reasons discussed above, I
certify that the proposed regulation:
1. Is not a ‘‘significant regulatory
action’’ under Executive Order 12866;
2. Is not a ‘‘significant rule’’ under the
DOT Regulatory Policies and Procedures
(44 FR 11034, February 26, 1979); and
3. Will not have a significant
economic impact, positive or negative,
on a substantial number of small entities
under the criteria of the Regulatory
Flexibility Act.
We prepared an economic evaluation
of the estimated costs to comply with
this proposed AD. See the AD docket to
examine the economic evaluation.
Authority for This Rulemaking
Title 49 of the United States Code
specifies the FAA’s authority to issue
rules on aviation safety. Subtitle I,
section 106, describes the authority of
the FAA Administrator. Subtitle VII,
Aviation Programs, describes in more
detail the scope of the Agency’s
authority.
We are issuing this rulemaking under
the authority described in subtitle VII,
part A, subpart III, section 44701,
‘‘General requirements.’’ Under that
section, Congress charges the FAA with
promoting safe flight of civil aircraft in
air commerce by prescribing regulations
for practices, methods, and procedures
the Administrator finds necessary for
safety in air commerce. This regulation
is within the scope of that authority
because it addresses an unsafe condition
that is likely to exist or develop on
products identified in this rulemaking
action.
List of Subjects in 14 CFR Part 39
Air transportation, Aircraft, Aviation
safety, Safety.
The Proposed Amendment
Accordingly, under the authority
delegated to me by the Administrator,
the FAA proposes to amend 14 CFR part
39 as follows:
WReier-Aviles on DSKGBLS3C1PROD with PROPOSALS
BILLING CODE 4910–13–P
SECURITIES AND EXCHANGE
COMMISSION
RIN 3235–AK71
Authority: 49 U.S.C. 106(g), 40113, 44701.
[Amended]
Investment Adviser Performance
Compensation
Securities and Exchange
Commission.
ACTION: Proposed rule; notice of intent
to issue order.
AGENCY:
2. Section 39.13 is amended by
adding a new airworthiness directive
(AD) to read as follows:
Bell Helicopter Textron Canada: Docket No.
FAA–2011–0449; Directorate Identifier
2010–SW–021–AD.
Applicability: Model 206A, 206B, and
206B3 helicopters, with Litter Kit, part
15:16 May 12, 2011
[FR Doc. 2011–11753 Filed 5–12–11; 8:45 am]
[Release No. IA–3198; File No. S7–17–11]
1. The authority citation for part 39
continues to read as follows:
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Issued in Fort Worth, Texas, on January 31,
2011.
Kim Smith,
Manager, Rotorcraft Directorate, Aircraft
Certification Service.
17 CFR Part 275
PART 39—AIRWORTHINESS
DIRECTIVES
§ 39.13
number 206–706–122 or 206–706–324,
installed, certificated in any category.
Compliance: Within 6 months, unless
accomplished previously.
To add an operating limitation when a
litter kit is installed to prohibit flight,
including hover, with the litter doorpost
removed to prevent loss of structural
integrity of the fuselage, do the following:
(a) Revise the Rotorcraft Flight Manual
(RFM) by inserting into the Operating
Limitations, Section 1, of the RFM the
following statement: ‘‘Flight, including hover,
with the litter doorpost removed is
prohibited.’’ This revision may be made by
pen and ink changes, inserting a copy of this
AD into the RFM, or inserting a copy of the
RFM Supplement (RFMS) dealing with Litter
Kits as follows: For Model 206A
helicopters—inserting RFMS BHT–206A–
FMS–8, dated December 30, 2009, into RFM
BHT–206A–FM–1, dated July 2, 2009; for
Model 206B helicopters—inserting RFMS
BHT–206B–FMS–8, dated December 30,
2009, into RFM BHT–206B–FM–1, dated July
2, 2009; and for Model 206B3 helicopters—
inserting RFMS BHT–206B3–FMS–2, dated
December 30, 2009, into RFM BHT–206B3–
FM–1, dated March 24, 2010.
(b) To request a different method of
compliance or a different compliance time
for this AD, follow the procedures in 14 CFR
39.19. Contact the Manager, Safety
Management Group, ATTN: Mark Wiley,
Aviation Safety Engineer, FAA, Rotorcraft
Directorate, Regulations and Guidance
Group, 2601 Meacham Blvd., Fort Worth,
Texas 76137, telephone (817) 222–5134, fax
(817) 222–5961, for information about
previously approved alternative methods of
compliance.
(c) The Joint Aircraft System/Component
(JASC) Code is 5300: Fuselage structure
(general).
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The Securities and Exchange
Commission (‘‘Commission’’ or ‘‘SEC’’)
intends to issue an order that would
adjust two dollar amount tests in the
SUMMARY:
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27959
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 (https://www.sec.gov/
rules/proposed.shtml); or
• Send an e-mail to rulecomments@sec.gov. Please include File
Number S7–17–11 on the subject line;
or
• Use the Federal eRulemaking Portal
(https://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
(https://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
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Federal Register / Vol. 76, No. 93 / Friday, May 13, 2011 / Proposed Rules
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
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
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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,
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].
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).
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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
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
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].’’
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).
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the adviser immediately after entering
into the advisory contract (‘‘assetsunder-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
In 1998, the Commission amended
rule 205–3 to, among other things,
change the dollar amounts of the assetsunder-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
On July 21, 2010, President Obama
signed into law the Dodd-Frank Wall
Street Reform and Consumer Protection
Act (‘‘Dodd-Frank Act’’).11 The DoddFrank 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
II. Discussion
Pursuant to section 418 of the DoddFrank 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
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.
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.
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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Federal Register / Vol. 76, No. 93 / Friday, May 13, 2011 / Proposed Rules
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.
A. Order Adjusting Dollar Amount Tests
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We intend to issue an order revising
the dollar amounts of the assets-undermanagement 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 assetsunder-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 DoddFrank 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-undermanagement and net worth tests of rule
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 assetsunder-management and net worth tests.
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).
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205–3 to $1 million 17 and $2 million
respectively.18
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
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.
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
× $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 × $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 https://www.bea.gov.
See also https://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 https://
www.federalreserve.gov/boarddocs/hh/2000/
february/ReportSection1.htm#FN1) (noting the
reasons for using the PCE Index rather than the
consumer price index).
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Securities Exchange Act of 1934 (15
U.S.C. 78a) (‘‘Exchange Act’’).22
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-undermanagement 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-undermanagement and net worth tests, to
reflect the revised thresholds that we
establish by the order discussed
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.
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-undermanagement 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.
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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
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?
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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
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-undermanagement) 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).
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’’).
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‘‘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
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 DoddFrank 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
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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.
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 DoddFrank 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 DoddFrank 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
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.
34 Proposed rule 205–3(d)(1)(ii)(A).
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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
• As noted above, the Commission
proposed in a separate release to adjust
the net worth standards for accredited
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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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.
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.
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
36 See
supra note 29.
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).
37 See
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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
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
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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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.
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?
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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
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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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
• 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 DoddFrank 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
42 See
5 U.S.C. 553(d).
418 of the Dodd-Frank Act.
43 Section
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into account performance fee
arrangements that were permissible
when they were entered into.
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.
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
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
44 See
supra note 8 and accompanying text.
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.
45 As
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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.
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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-undermanagement 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 DoddFrank Act, and therefore we do not
attribute this cost to this rulemaking.
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
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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$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
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
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 https://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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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
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 https://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
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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
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 nonqualified clients to invest in other
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.
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.
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15:16 May 12, 2011
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investment opportunities that do not
entail performance fees, we expect that
the proposed rule would not have a
significant impact on capital
formation.54
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.
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.
VI. Regulatory Flexibility Act
Certification
Section 3(a) of the Regulatory
Flexibility Act of 1980 57 (‘‘RFA’’)
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.
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).
56 44 U.S.C. 3501–3521.
57 5 U.S.C. 603(a).
PO 00000
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Fmt 4702
Sfmt 4702
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
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 assetsunder-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-undermanagement 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
58 5
U.S.C. 605(b).
0–7(a).
59 Rule
E:\FR\FM\13MYP1.SGM
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Federal Register / Vol. 76, No. 93 / Friday, May 13, 2011 / Proposed Rules
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.
§ 275.205–3 Exemption from the
compensation prohibition of section
205(a)(1) for investment advisers.
WReier-Aviles on DSKGBLS3C1PROD with PROPOSALS
*
*
*
*
*
(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
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15:16 May 12, 2011
Jkt 223001
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. 80a2(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 yearend 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
PO 00000
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Sfmt 4702
27967
(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
DEPARTMENT OF HOMELAND
SECURITY
Coast Guard
33 CFR Part 165
[Docket No. USCG–2011–0303]
RIN 1625–AA00
Safety Zone; Shore Thing and
Independence Day Fireworks,
Chesapeake Bay, Norfolk, VA
Coast Guard, DHS.
Notice of proposed rulemaking.
AGENCY:
ACTION:
The Coast Guard proposes
establishing a temporary safety zone on
the Chesapeake Bay in the vicinity of
Ocean View Beach Park, Norfolk, VA in
support of the Shore Thing and
Independence Day Fireworks event.
This action is necessary to provide for
the safety of life on navigable waters
during the Shore Thing and
Independence Day Fireworks show.
This action is intended to restrict vessel
traffic movement on the Chesapeake Bay
to protect mariners from the hazards
associated with fireworks displays.
DATES: Comments and related material
must be received by the Coast Guard on
or before June 13, 2011.
ADDRESSES: You may submit comments
identified by docket number USCG–
2011–0303 using any one of the
following methods:
(1) Federal eRulemaking Portal:
https://www.regulations.gov.
(2) Fax: 202–493–2251.
(3) Mail: Docket Management Facility
(M–30), U.S. Department of
Transportation, West Building Ground
Floor, Room W12–140, 1200 New Jersey
Avenue, SE., Washington, DC 20590–
0001.
(4) Hand delivery: Same as mail
address above, between 9 a.m. and
5 p.m., Monday through Friday, except
Federal holidays. The telephone number
is 202–366–9329.
To avoid duplication, please use only
one of these four methods. See the
SUMMARY:
E:\FR\FM\13MYP1.SGM
13MYP1
]]>Agencies
[Federal Register Volume 76, Number 93 (Friday, May 13, 2011)]
[Proposed Rules]
[Pages 27959-27967]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2011-11801]
=======================================================================
-----------------------------------------------------------------------
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.
-----------------------------------------------------------------------
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 (https://www.sec.gov/rules/proposed.shtml); or
Send an e-mail to rule-comments@sec.gov. Please include
File Number S7-17-11 on the subject line; or
Use the Federal eRulemaking Portal (https://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 (https://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].
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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
https://www.bea.gov. See also https://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 https://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\
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\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.
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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
https://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
https://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.
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\56\ 44 U.S.C. 3501-3521.
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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
