Investment Adviser Performance Compensation, 10358-10368 [2012-4046]
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Federal Register / Vol. 77, No. 35 / Wednesday, February 22, 2012 / Rules and Regulations
Authority: 50 U.S.C. app. 2401 et seq.; 50
U.S.C. 1701 et seq.; 10 U.S.C. 7420; 10 U.S.C.
7430(e); 22 U.S.C. 287c; 22 U.S.C. 2151 note;
22 U.S.C. 3201 et seq.; 22 U.S.C. 6004; 30
U.S.C. 185(s), 185(u); 42 U.S.C. 2139a; 42
U.S.C. 6212; 43 U.S.C. 1354; 15 U.S.C. 1824a;
50 U.S.C. app. 5; 22 U.S.C. 7201 et seq.; 22
U.S.C. 7210; E.O. 11912, 41 FR 15825, 3 CFR,
1976 Comp., p. 114; E.O. 12002, 42 FR 35623,
3 CFR, 1977 Comp., p. 133; E.O. 12058, 43
FR 20947, 3 CFR, 1978 Comp., p. 179; E.O.
12214, 45 FR 29783, 3 CFR, 1980 Comp., p.
256; E.O. 12851, 58 FR 33181, 3 CFR, 1993
Comp., p. 608; E.O. 12854, 58 FR 36587, 3
CFR, 1993 Comp., p. 179; E.O. 12918, 59 FR
28205, 3 CFR, 1994 Comp., p. 899; E.O.
12938, 59 FR 59099, 3 CFR, 1994 Comp., p.
950; E.O. 12947, 60 FR 5079, 3 CFR, 1995
Comp., p. 356; E.O. 12981, 60 FR 62981, 3
CFR, 1995 Comp., p. 419; E.O. 13020, 61 FR
54079, 3 CFR, 1996 Comp., p. 219; E.O.
13026, 61 FR 58767, 3 CFR, 1996 Comp., p.
228; E.O. 13099, 63 FR 45167, 3 CFR, 1998
Comp., p. 208; E.O. 13222, 66 FR 44025, 3
CFR, 2001 Comp., p. 783; E.O. 13224, 66 FR
49079, 3 CFR, 2001 Comp., p. 786; E.O.
13338, 69 FR 26751, 3 CFR, 2004 Comp., p
168; Notice of August 12, 2011, 76 FR 50661
(August 16, 2011); Notice of September 21,
2011, 76 FR 59001 (September, 22, 2011);
Notice of November 9, 2011, 76 FR 70319
(November 10, 2011); Notice of January 19,
2012, 77 FR 3067 (January 20, 2012).
PART 744—[AMENDED]
2. The authority citation for 15 CFR
part 744 is revised to read as follows:
■
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Authority: 50 U.S.C. app. 2401 et seq.; 50
U.S.C. 1701 et seq.; 22 U.S.C. 3201 et seq.;
42 U.S.C. 2139a; 22 U.S.C. 7201 et seq.; 22
U.S.C. 7210; E.O. 12058, 43 FR 20947, 3 CFR,
1978 Comp., p. 179; E.O. 12851, 58 FR 33181,
3 CFR, 1993 Comp., p. 608; E.O. 12938, 59
FR 59099, 3 CFR, 1994 Comp., p. 950; E.O.
12947, 60 FR 5079, 3 CFR, 1995 Comp., p.
356; E.O. 13026, 61 FR 58767, 3 CFR, 1996
Comp., p. 228; E.O. 13099, 63 FR 45167, 3
CFR, 1998 Comp., p. 208; E.O. 13222, 66 FR
44025, 3 CFR, 2001 Comp., p. 783; E.O.
13224, 66 FR 49079, 3 CFR, 2001 Comp., p.
786; Notice of August 12, 2011, 76 FR 50661
(August 16, 2011); Notice of September 21,
2011, 76 FR 59001 (September, 22, 2011);
Notice of November 9, 2011, 76 FR 70319
(November 10, 2011); Notice of January 19,
2012, 77 FR 3067 (January 20, 2012).
Dated: February 14, 2012.
Kevin J. Wolf,
Assistant Secretary for Export
Administration.
[FR Doc. 2012–4062 Filed 2–21–12; 8:45 am]
BILLING CODE 3510–33–P
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CONSUMER PRODUCT SAFETY
COMMISSION
16 CFR Chapter II
Acceptance of ASTM F963–11 as a
Mandatory Consumer Product Safety
Standard
Consumer Product Safety
Commission.
ACTION: Acceptance of standard.
AGENCY:
The Consumer Product Safety
Commission (‘‘CPSC,’’ Commission,’’ or
‘‘we’’) is announcing that we have
accepted the revised ASTM F963–11
standard titled, Standard Consumer
Safety Specifications for Toy Safety.
Pursuant to section 106 of the Consumer
Product Safety Improvement Act of
2008, ASTM F963–11 will become a
mandatory consumer product safety
standard effective June 12, 2012.
DATES: ASTM F963–11 will become
effective on June 12, 2012.
FOR FURTHER INFORMATION CONTACT:
Jonathan Midgett, Ph.D., Office of
Hazard Identification and Reduction,
U.S. Consumer Product Safety
Commission, 4330 East West Highway,
Suite 600, Bethesda, MD 20814;
telephone (301) 504–7692; email
jmidgett@cpsc.gov.
SUPPLEMENTARY INFORMATION:
On February 10, 2009, section 106(a)
of the Consumer Product Safety
Improvement Act of 2008, (CPSIA),
Public Law 110–314, made the
provisions of ASTM F963–07, Standard
Consumer Safety Specifications for Toy
Safety (except for section 4.2 and Annex
4 or any provision that restates or
incorporates an existing mandatory
standard or ban promulgated by the
Commission or by statute) mandatory
consumer product safety standards
under section 9 of the Consumer
Product Safety Act (CPSA). On May 13,
2009, the Commission accepted ASTM
International (formerly the American
Society for Testing and Materials)
(ASTM) proposed revisions to the
standard, by accepting ASTM F963–08
(except for the removal of section 4.27
of ASTM F963–07, which covers toy
chests). The requirements of ASTM
F963–08 became effective on August 16,
2009, except for section 4.27 (toy chests)
of ASTM F963–07, which was already
in effect.
On December 15, 2011, ASTM
officially proposed revisions to the
existing standard for Commission
consideration, by submitting ASTM
F963–11, Standard Consumer Safety
Specifications for Toy Safety. ASTM
proposes replacing ASTM F963–08 with
the revised ASTM F963–11 version.
SUMMARY:
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Section 106(g) of the CPSIA provides
that, upon ASTM notifying the
Commission of proposed revisions to
ASTM F963, the Commission must
incorporate the revisions into the
consumer product safety rule, unless
within 90 days of receiving the notice,
the Commission notifies ASTM that it
has determined that the proposed
revisions do not improve the safety of
the consumer product(s) covered by the
standard. If the Commission so notifies
ASTM regarding a proposed revision of
the standard, the existing standard
remains in effect, regardless of the
proposed revision. If the Commission
does not object to the proposed
revisions, the revised standard becomes
effective 180 days after the date that
ASTM notifies the Commission of the
revision.
The Commission has determined that
the proposed revisions in ASTM F963–
11 improve the safety of the consumer
products covered by the standard.
Therefore, although the CPSIA does not
require us to issue a notice in the
Federal Register announcing our
decision, we are, through this notice,
announcing that the CPSC accepts the
revisions as mandatory consumer
product safety standards. ASTM F963–
11 will become effective as a mandatory
consumer product safety standard on
June 12, 2012. However, because ASTM
F963–11 does not reincorporate section
4.27 (toy chests) of ASTM F963–07, that
provision from ASTM F963–07
regarding toy chests remains in effect.
Dated: February 15, 2012.
Todd A. Stevenson,
Secretary, Consumer Product Safety
Commission.
[FR Doc. 2012–3990 Filed 2–21–12; 8:45 am]
BILLING CODE 6355–01–P
SECURITIES AND EXCHANGE
COMMISSION
17 CFR Part 275
[Release No. IA–3372; File No. S7–17–11]
RIN 3235–AK71
Investment Adviser Performance
Compensation
Securities and Exchange
Commission.
ACTION: Final rule.
AGENCY:
The Securities and Exchange
Commission (‘‘Commission’’ or ‘‘SEC’’)
is adopting amendments to the rule
under the Investment Advisers Act of
1940 that permits investment advisers to
charge performance based compensation
to ‘‘qualified clients.’’ The amendments
SUMMARY:
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Federal Register / Vol. 77, No. 35 / Wednesday, February 22, 2012 / Rules and Regulations
revise the dollar amount thresholds of
the rule’s tests that are used to
determine whether an individual or
company is a qualified client. These
rule amendments codify revisions that
the Commission recently issued by
order that adjust the dollar amount
thresholds to account for the effects of
inflation. In addition, the rule
amendments: provide that the
Commission will issue an order every
five years in the future adjusting the
dollar amount thresholds for inflation;
exclude the value of a person’s primary
residence and certain associated debt
from the test of whether a person has
sufficient net worth to be considered a
qualified client; and add certain
transition provisions to the rule.
DATES: Effective Date: The amendments
are effective on May 22, 2012.
FOR FURTHER INFORMATION CONTACT:
Daniel K. Chang, Senior Counsel, or C.
Hunter Jones, Assistant Director, at 202–
551–6792, Office of Regulatory Policy,
Division of Investment Management,
Securities and Exchange Commission,
100 F Street NE., Washington, DC
20549–8549.
SUPPLEMENTARY INFORMATION: The
Commission is adopting amendments to
rule 205–3 [17 CFR 275.205–3] under
the Investment Advisers Act of 1940
(‘‘Advisers Act’’ or ‘‘Act’’).1
Table of Contents
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I. Introduction
II. Discussion
A. Inflation Adjustment of Dollar Amount
Thresholds
B. Exclusion of the Value of Primary
Residence From Net Worth
Determination
C. Transition Provisions
D. Effective Date
III. Cost-Benefit Analysis
A. Benefits
B. Costs
IV. Paperwork Reduction Act
V. Regulatory Flexibility Act Certification
VI. Statutory Authority
Text of Rules
I. Introduction
Section 205(a)(1) of the Investment
Advisers Act generally restricts an
investment adviser from entering into,
extending, renewing, or performing any
investment advisory contract that
provides for compensation to the
adviser based on a share of capital gains
on, or capital appreciation of, the funds
of a client.2 Congress restricted these
1 15 U.S.C. 80b. Unless otherwise noted, all
references to statutory sections are to the
Investment Advisers Act, and all references to rules
under the Advisers Act, including rule 205–3, are
to Title 17, Part 275 of the Code of Federal
Regulations [17 CFR part 275].
2 15 U.S.C. 80b–5(a)(1).
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compensation arrangements (also
known as performance compensation or
performance fees) in 1940 to protect
advisory clients from arrangements it
believed might encourage advisers to
take undue risks with client funds to
increase advisory fees.3 Congress
subsequently authorized the
Commission to exempt any advisory
contract from the performance fee
restrictions if the contract is with
persons that the Commission
determines do not need the protections
of those restrictions.4
The Commission adopted rule 205–3
in 1985 to exempt an investment adviser
from the restrictions against charging a
client performance fees in certain
circumstances.5 The rule, when
adopted, allowed an adviser to charge
performance fees if the client had at
least $500,000 under management with
the adviser immediately after entering
into the advisory contract (‘‘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.6
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
3 H.R. Rep. No. 2639, 76th Cong., 3d Sess. 29
(1940). Performance fees were characterized as
‘‘heads I win, tails you lose’’ arrangements in which
the adviser had everything to gain if successful and
little, if anything, to lose if not. S. Rep No. 1775,
76th Cong., 3d Sess. 22 (1940).
4 Section 205(3) of the Advisers Act. Section
205(e) of the Advisers Act authorizes the
Commission to exempt conditionally or
unconditionally from the performance fee
prohibition advisory contracts with persons that the
Commission determines do not need its protections.
Section 205(e) provides that the Commission may
determine that persons do not need the protections
of section 205(a)(1) on the basis of such factors as
‘‘financial sophistication, net worth, knowledge of
an experience in financial matters, amount of assets
under management, relationship with a registered
investment adviser, and such other factors as the
Commission determines are consistent with [section
205].’’
5 Exemption To Allow Registered Investment
Advisers to Charge Fees Based Upon a Share of
Capital Gains Upon or Capital Appreciation of a
Client’s Account, Investment Advisers Act Release
No. 996 (Nov. 14, 1985) [50 FR 48556 (Nov. 26,
1985)] (‘‘1985 Adopting Release’’). The exemption
applies to the entrance into, performance, renewal,
and extension of advisory contracts. See rule 205–
3(a).
6 See 1985 Adopting Release, supra note 5, at
Sections I.C and II.B. The rule also imposed other
conditions, including specific disclosure
requirements and restrictions on calculation of
performance fees. See id. at Sections II.C–E.
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10359
since 1985.7 The Commission revised
the former from $500,000 to $750,000,
and the latter from $1 million to $1.5
million.8
The Dodd-Frank Wall Street Reform
and Consumer Protection Act (‘‘DoddFrank Act’’) 9 amended section 205(e) of
the Advisers Act to require that the
Commission adjust for inflation the
dollar amount thresholds in rules under
the section, rounded to the nearest
$100,000.10 Separately, the Dodd-Frank
Act also required that we adjust the net
worth standard for an ‘‘accredited
investor’’ in rules under the Securities
Act of 1933 (‘‘Securities Act’’),11 such as
Regulation D,12 to exclude the value of
a person’s primary residence.13
In May 2011, the Commission
published a notice of intent to issue an
order revising the dollar amount
thresholds of the assets-undermanagement and the net worth tests of
rule 205–3 to account for the effects of
inflation.14 Our release (‘‘Proposing
Release’’) also proposed to amend the
rule itself to reflect any inflation
adjustments to the dollar amount
thresholds that we might issue by
order.15 In addition, our proposed
amendments (i) stated that the
Commission would issue an order every
five years adjusting for inflation the
dollar amount thresholds, (ii) excluded
the value of a person’s primary
residence from the test of whether a
person has sufficient net worth to be
considered a ‘‘qualified client,’’ and (iii)
modified certain transition provisions of
the rule.
On July 12, 2011, we issued an order
revising the threshold of the assetsunder-management test to $1 million,
7 See Exemption To Allow Investment Advisers
To Charge Fees Based Upon a Share of Capital
Gains Upon or Capital Appreciation of a Client’s
Account, Investment Advisers Act Release No. 1731
(July 15, 1998) [63 FR 39022 (July 21, 1998)] (‘‘1998
Adopting Release’’).
8 See id. at Section II.B.1.
9 Public Law 111–203, 124 Stat. 1376 (2010).
10 See section 418 of the Dodd-Frank Act
(requiring the Commission to issue an order every
five years revising dollar amount thresholds in a
rule that exempts a person or transaction from
section 205(a)(1) of the Advisers Act if the dollar
amount threshold was a factor in the Commission’s
determination that the persons do not need the
protections of that section).
11 15 U.S.C. 77a–77z–3.
12 See 17 CFR 230.501–.508.
13 See section 413(a) of the Dodd-Frank Act.
14 See Investment Adviser Performance
Compensation, Investment Advisers Act Release
No. 3198 (May 10, 2011) [76 FR 27959 (May 13,
2011)] (‘‘Proposing Release’’). Rule 205–3 is the
only exemptive rule issued under section 205(e) of
the Advisers Act that includes dollar amount tests,
which are the assets-under-management and net
worth tests. See supra text accompanying note 10.
15 Id.
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Federal Register / Vol. 77, No. 35 / Wednesday, February 22, 2012 / Rules and Regulations
and of the net worth test to $2 million.16
We received approximately 50
comments on our proposed rule
amendments.17 Today we are adopting
amendments to rule 205–3 largely as we
proposed them, with modifications to
address issues raised by commenters, as
discussed further below.
II. Discussion
A. Inflation Adjustment of Dollar
Amount Thresholds
We are amending rule 205–3 in three
ways to carry out the required inflation
adjustment of the dollar amount
thresholds of the rule. First, we are
revising the dollar amount thresholds
that currently apply to investment
advisers, to codify the order we issued
on July 12, 2011. As amended,
paragraph (d) of rule 205–3 provides
that the assets-under-management
threshold is $1 million and that the net
worth threshold is $2 million, which are
the revised amounts we issued by
order.18 Although some commenters
objected to raising these dollar amount
thresholds,19 section 205(e) of the
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16 See
Order Approving Adjustment for Inflation
of the Dollar Amount Tests in Rule 205–3 under the
Investment Advisers Act of 1940, Investment
Advisers Act Release No. 3236 (July 12, 2011) [76
FR 41838 (July 15, 2011)] (‘‘Order’’). The Order is
effective as of September 19, 2011. Id. The order
applies to contractual relationships entered into on
or after the effective date, and does not apply
retroactively to contractual relationships previously
in existence.
17 The comment letters we received on the
Proposing Release are available on our Web site at
https://www.sec.gov/comments/s7-17-11/s71711.
shtml.
18 The calculation used to determine the revised
dollar amounts in the tests is described below. See
infra note 25. As we noted in the Proposing Release,
an investment adviser can include in determining
the amount of assets under management the assets
that a client is contractually obligated to invest in
private funds managed by the adviser. Only bona
fide contractual commitments may be included, i.e.,
those that the adviser has a reasonable belief that
the investor will be able to meet. See Proposing
Release, supra note 15, at n.17.
19 Some commenters maintained, for example,
that raising the dollar amount thresholds would
limit the investment options for those investors that
fall below the new thresholds, and would harm
smaller funds that rely on investments from
investors with more limited resources to operate.
See, e.g., Comment Letter of Crescat Portfolio
Management LLC (May 11, 2011) (‘‘Crescat Portfolio
Comment Letter’’); Comment Letter of Hyonmyong
Cho (June 8, 2011) (‘‘H. Cho Comment Letter’’);
Comment Letter of Harold Clyde (June 4, 2011) (‘‘H.
Clyde Comment Letter’’); Comment Letter of
Douglas Estadt (June 7, 2011) (‘‘D. Estadt Comment
Letter’’). Other commenters supported raising the
dollar amount thresholds, noting that this change
would ensure that the ‘‘qualified client’’ standard
is limited to clients who are financially experienced
and able to bear the risks of performance fee
arrangements. See, e.g., Comment Letter of Better
Markets, Inc. (July 11, 2011) (‘‘Better Markets
Comment Letter’’); Comment Letter of Certified
Financial Planner Board of Standards, Inc. (July 11,
2011) (‘‘CFP Board Comment Letter’’); Comment
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Advisers Act requires that we adjust the
amounts for inflation.20
Second, we are adding to rule 205–3,
as proposed, a new paragraph (e) that
states that the Commission will issue an
order every five years adjusting for
inflation the dollar amount thresholds
of the assets-under-management and net
worth tests of the rule.21 These periodic
adjustments are required by the
Advisers Act,22 and most commenters
supported this amendment to the rule.23
Amended rule 205–3(e) also specifies
the price index on which future
inflation adjustments will be based.24
The index is the Personal Consumption
Expenditures Chain-Type Price Index
(‘‘PCE Index’’),25 which is published by
the Department of Commerce.26 The
dollar amount tests we adopted in 1998
Letter of Managed Funds Association (July 8, 2011)
(‘‘MFA Comment Letter’’); Comment Letter of North
American Securities Administrators Association,
Inc. (July 11, 2011) (‘‘NASAA Comment Letter’’).
20 See supra note 10.
21 Rule 205–3(e) provides that the Commission
will issue an order on or about May 1, 2016 and
approximately every five years thereafter adjusting
the assets-under-management and net worth tests
for the effects of inflation. These adjusted amounts
will apply to contractual relationships entered into
on or after the effective date of the order, and will
not apply retroactively to contractual relationships
previously in existence. See supra note 16. The
proposed rule would have stated that the
Commission’s order would be effective on or about
May 1. We have deleted the word ‘‘effective’’ in the
final rule to reflect the fact that the effective date
will likely be later than May 1. See Order, supra
note 16 (setting effective date of the order
approximately 60 days after the order’s issuance).
22 See supra note 10.
23 See Comment Letter of Chris Barnard (May 31,
2011) (‘‘C. Barnard Comment Letter’’); Better
Markets Comment Letter; CFP Board Comment
Letter; Comment Letter of Investment Adviser
Association (July 11, 2011) (‘‘IAA Comment
Letter’’); MFA Comment Letter. One commenter
stated that the dollar amount tests should be
reevaluated more frequently. See NASAA Comment
Letter.
24 See rule 205–3(e)(1).
25 The revised dollar amounts in the tests reflect
inflation as of the end of 2010, and are rounded to
the nearest $100,000 as required by section 418 of
the Dodd-Frank Act. The 2010 PCE Index is
111.112, and the 1997 PCE Index is 85.433. These
values are slightly different from those provided in
the Proposing Release because of periodic
adjustments issued by the Department of
Commerce. See Proposing Release, supra note 15,
at n.19; see also infra note 26. Assets-undermanagement test calculation to adjust for the effects
of inflation: 111.112/85.433 × $750,000 = $975,431;
$975,431 rounded to the nearest multiple of
$100,000 = $1 million. Net worth test calculation
to adjust for the effects of inflation: 111.112/85.433
× $1.5 million = $1,950,862; $1,950,862 rounded to
the nearest multiple of $100,000 = $2 million.
26 The values of the PCE Index are available from
the Bureau of Economic Analysis, a bureau of the
Department of Commerce. See 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.
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will be the baseline for future
calculations.27 As we noted in the
Proposing Release, the use of the PCE
Index is appropriate because it is an
indicator of inflation in the personal
sector of the U.S. economy 28 and is
used in other provisions of the federal
securities laws.29 Commenters agreed
that the PCE Index is an appropriate
indicator of inflation 30 and that the
1998 dollar amounts are the proper
baseline for future inflation
adjustments.31
B. Exclusion of the Value of Primary
Residence From Net Worth
Determination
We also are amending the net worth
test in the definition of ‘‘qualified
client’’ in rule 205–3 to exclude the
value of a natural person’s primary
residence and certain debt secured by
the property.32 This change, although
not required by the Dodd-Frank Act, is
similar to the change that Act requires
the Commission to make to rules under
27 Rule 205–3(e) provides that the assets-undermanagement 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 yearend 2015 PCE Index by the year-end 1997 PCE
Index, (ii) multiply the quotient by $750,000 and
$1.5 million, and (iii) round each of the two
products to the nearest $100,000.
28 See Clinton P. McCully, Brian C. Moyer, and
Kenneth J. Stewart, ‘‘Comparing the Consumer Price
Index and the Personal Consumption Expenditures
Price Index,’’ Survey of Current Business (Nov.
2007) at 26 n.1 (available at https://www.bea.gov/
scb/pdf/2007/11%20november/1107_cpipce.pdf)
(PCE Index measures changes in ‘‘prices paid for
goods and services by the personal sector in the
U.S. national income and product accounts’’ and is
primarily used for macroeconomic analysis and
forecasting). See also Federal Reserve Board,
Monetary Policy Report to the Congress (Feb. 17,
2000) at n.1 (available at 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).
29 See Proposing Release, supra note 15, at n.22
and accompanying text.
30 See Better Markets Comment Letter; IAA
Comment Letter; Comment Letter of Georg Merkl
(July 11, 2011) (‘‘G. Merkl Comment Letter’’).
Although two commenters asserted that inflation is
not the proper unit of measure by which to adjust
net worth requirements, see Comment Letter of
David Hale (May 20, 2011) and Comment Letter of
Joseph V. Delaney (undated) (‘‘J. Delaney Comment
Letter’’), section 205(e) of the Advisers Act requires
that we adjust the dollar amount thresholds of rule
205–3 for inflation.
31 See C. Barnard Comment Letter; G. Merkl
Comment Letter.
32 Rule 205–3(d)(1)(ii)(A).
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the Securities Act, such as Regulation
D.33
We proposed to exclude the value of
a person’s primary residence and the
debt secured by the residence, up to the
fair market value of the residence, from
the calculation of a person’s net
worth.34 A number of commenters
supported the proposed exclusion.35
Many agreed with our statement in the
Proposing Release that the value of an
individual’s residence may have little
relevance to the person’s financial
experience and ability to bear the risks
of performance fee arrangements.36 The
Certified Financial Planner Board of
Standards noted in its comment letter
that the value of an individual’s equity
in a residence is more likely to be a
function of the length of time that the
investor has owned the home, than to be
a function of the investor’s experience
or sophistication. Commenters also
stated that excluding the value of the
residence would promote regulatory
consistency because it parallels the
treatment of a person’s primary
residence in determinations of net
worth under other securities rules.37
Many commenters objected to the
exclusion of the value of a person’s
primary residence from the calculation
of net worth. Commenters expressed
concern that the exclusion would limit
the investment options of less wealthy
investors and restrict their access to
advisory arrangements that include
33 See section 413(a) of the Dodd-Frank Act
(requiring the Commission to adjust any net worth
standard for an ‘‘accredited investor’’ as set forth in
Commission rules under the Securities Act to
exclude the value of a natural person’s primary
residence). The Dodd-Frank Act does not require
that the net worth standard for an accredited
investor be adjusted periodically for the effects of
inflation, although it does require the Commission
at least every four years to ‘‘undertake a review of
the definition, in its entirety, of the term ‘accredited
investor’ * * * [as defined in Commission rules] as
such term applies to natural persons, to determine
whether the requirements of the definition should
be adjusted or modified for the protection of
investors, in the public interest, and in light of the
economy.’’ See section 413(b)(2)(A) of the DoddFrank Act. In January 2011, we proposed rule
amendments to adjust the net worth standards for
accredited investors in our rules under the
Securities Act. See Net Worth Standard for
Accredited Investors, Securities Act Release No.
9177 (Jan. 25, 2011) [76 FR 5307 (Jan. 31, 2011)]
(‘‘Accredited Investor Proposing Release’’). We
recently adopted those amendments substantially as
proposed. See Net Worth Standard for Accredited
Investors, Securities Act Release No. 9287 (Dec. 21,
2011) [76 FR 81793 (Dec. 29, 2011)] (‘‘Accredited
Investor Adopting Release’’).
34 See Proposing Release, supra note 15, at n.28
and accompanying text.
35 See, e.g., C. Barnard Comment Letter; CFP
Board Comment Letter; MFA Comment Letter;
NASAA Comment Letter.
36 See, e.g., C. Barnard Comment Letter; CFP
Board Comment Letter; NASAA Comment Letter.
37 See, e.g., Better Markets Comment Letter; CFP
Board Comment Letter; NASAA Comment Letter.
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performance fees.38 Some argued that
excluding the value of a residence
would harm advisers to smaller funds
that rely on investments from less
wealthy investors.39 Others argued that
home ownership, compared to home
rental, may in fact evidence greater
rather than less financial experience on
the part of individuals.40
We continue to believe that the value
of a person’s residence generally has
little relevance to the individual’s
financial experience and ability to bear
the risks of performance fee
arrangements, and therefore little
relevance to the individual’s need for
the Act’s protections from performance
fee arrangements.41 Although the
process of purchasing and financing a
home can contribute to an individual’s
financial experience, the value of the
individual’s equity interest in the
residence reflects the prevailing market
values at the time and can be a function
of time in paying down the associated
debt rather than a function of deliberate
investment decision-making. In
addition, because of the generally
illiquid nature of residential assets, the
value of an individual’s home equity
may not help the investor to bear the
risks of loss that are inherent in
performance fee arrangements.
Our exclusion of the value of a
person’s primary residence from the net
worth calculation under the rule is
similar to the approach that the
Commission has taken in other rules to
determine the financial qualifications of
investors. For example, the Commission
excluded the value of a person’s
primary residence and associated
liabilities from the determination of
whether a person is a ‘‘high net worth
customer’’ in Regulation R under the
Securities Exchange Act of 1934.42 The
Commission also excluded the value of
a residence from the determination of
whether an individual has sufficient
investments to be considered a
‘‘qualified purchaser’’ under the
Investment Company Act of 1940
(‘‘Investment Company Act’’) who can
invest in certain private funds that are
not registered under that Act.43 As
discussed above, this approach is also
reflected in the Commission’s recent
amendments to the definition of
‘‘accredited investor’’ in rules under the
Securities Act, including Regulation D,
as required by the Dodd-Frank Act.44
Some commenters voiced particular
concern about the exclusion of the
residential value at the same time that
we adjust the dollar amount thresholds
for inflation, and argued that the two
changes together could cause too much
change at one time.45 We note that we
revised the dollar amount threshold of
the net worth test last July and that the
38 See, e.g., Comment Letter of Matthew Gee (June
14, 2011); Comment Letter of Gunderson Dettmer
Stough Villeneuve Franklin Hachigan LLP (July 8,
2011) (‘‘Gunderson Dettmer Comment Letter’’);
Comment Letter of Alvin Suvil (July 17, 2011) (‘‘A.
Suvil Comment Letter’’).
39 See, e.g., Comment Letter of Roger Alsop (June
16, 2011) (‘‘R. Alsop Comment Letter’’); J. Delaney
Comment Letter; Comment Letter of Molly
Huntsman (June 23, 2011) (‘‘M. Huntsman
Comment Letter’’); Comment Letter of Greg
Thornton (June 2, 2011); Comment Letter of Greg J.
Wimmer (June 3, 2011).
40 See M. Gee Comment Letter; Comment Letter
of Douglas Wood (June 13, 2011) (‘‘D. Wood
Comment Letter’’). Some commenters appeared to
object to excluding residence from net worth on
public policy grounds because the exclusion would
discourage home ownership. See, e.g., Comment
Letter of Ron Cuningham (June 25, 2011) (‘‘R.
Cuningham Comment Letter’’); D. Wood Comment
Letter.
41 For example, an individual who meets the net
worth test only by including the value of his
primary residence in the calculation is unlikely to
be as able to bear the risks of performance fee
arrangements as an individual who meets the test
without including the value of her primary
residence. We stated in 2006, when we proposed a
minimum net worth threshold for establishing
when an individual could invest in hedge funds
pursuant to the safe harbor of Regulation D, that the
value of an individual’s personal residence may
bear little or no relationship to that person’s
knowledge and financial sophistication. See
Prohibition of Fraud by Advisers to Certain Pooled
Investment Vehicles; Accredited Investors in
Certain Private Investment Vehicles, Investment
Advisers Act Release No. 2576 (Dec. 27, 2006) [72
FR 400 (Jan. 4, 2007)] at Section III.B.3.
42 See, e.g., Definition of Terms and Exemptions
Relating to the ‘‘Broker’’ Exceptions for Banks,
Securities Exchange Act Release No. 56501 (Sept.
24, 2007) [72 FR 56514 (Oct. 3, 2007)] at Section
II.C.1 (excluding primary residence and associated
liabilities from the fixed-dollar threshold for ‘‘high
net worth customers’’ under Rule 701 of Regulation
R, which permits a bank to pay an employee certain
fees for the referral of a high net worth customer
or institutional customer to a broker-dealer without
requiring registration of the bank as a brokerdealer).
43 Section 3(c)(7) of the Investment Company Act
provides an exclusion from the definition of
‘‘investment company’’ for any ‘‘issuer, the
outstanding securities of which are owned
exclusively by persons who, at the time of
acquisition of such securities, are qualified
purchasers, and which is not making and does not
at that time propose to make a public offering of
such securities.’’ A ‘‘qualified purchaser’’ under
section 2(a)(51) of the Investment Company Act [15
U.S.C. 80a–2(a)(51)] includes, among others, any
natural person who owns not less than $5 million
in investments, as defined by the Commission. Rule
2a51–1 under the Investment Company Act
includes within the meaning of ‘‘investments’’ real
estate held for investment purposes. 17 CFR
270.2a51–1(b)(2). A personal residence is not
considered an investment under rule 2a51–1,
although residential property may be treated as an
investment if it is not treated as a residence for tax
purposes. See Privately Offered Investment
Companies, Investment Company Act Release No.
22597 (Apr. 3, 1997) [62 FR 17512 (Apr. 9, 1997)]
at text accompanying and following n.48.
44 See supra note 33 and accompanying text.
45 See, e.g., R. Alsop Comment Letter; R.
Cuningham Comment Letter; M. Huntsman
Comment Letter; A. Suvil Comment Letter.
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revision was effective in September. Our
current amendment of the net worth test
to exclude the value of a residence,
which will be effective in May 2012,
will be effective approximately eight
months after the previous change to the
net worth test. Any further revisions of
the dollar amount thresholds of rule
205–3 to adjust for inflation are not
scheduled to occur until 2016.46
Some of the commenters who
disagreed with the proposal to raise the
dollar amount threshold of the net
worth standard or to exclude the value
of a residence from net worth, also
disagreed that a person’s net worth
should be used as a measure of
eligibility for the exemption from the
performance fee restrictions.47 These
commenters did not recommend an
alternative standard that is objective and
verifiable, and that would effectively
distinguish between those investors
who do, and those who do not, need the
protections of the Act’s performance fee
restrictions.48
Our amendment of the net worth
standard of rule 205–3 differs from the
proposed amendment in one respect.
The approach we are adopting today
will generally require any increase in
the amount of debt secured by the
primary residence in the 60 days before
the advisory contract is entered into to
be included as a liability. As discussed
below, this change will prevent debt
that is incurred shortly before entry into
an advisory contract from being
excluded from the calculation of net
worth merely because it is secured by
the individual’s home.
As proposed, the amended rule would
have excluded the value of a person’s
primary residence and the amount of all
debt secured by the property that is no
greater than the property’s current
market value.49 The proposed treatment
of debt secured by the primary
residence was the same as we proposed
for the calculation of net worth for
46 See
rule 205–3(e).
e.g., J. Delaney Comment Letter; Comment
Letter of David Hale (May 20, 2011); Comment
Letter of Tom Irvin (May 18, 2011).
48 One commenter suggested that a ‘‘qualified
client’’ include an individual with a bachelor’s
degree in a finance-related major or a master’s
degree in any area from an accredited U.S.
university. See Comment Letter of Troy Clark (June
23, 2011). Although the suggested finance-related
major requirement would help to determine
whether an individual is financially knowledgeable,
the suggested master’s degree requirement would
not, and neither requirement would establish
whether an investor has sufficient practical
experience in making investment decisions or is
capable of bearing the risks of loss associated with
performance fee arrangements.
49 Proposed rule 205–3(d)(1)(ii)(A).
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47 See,
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accredited investors in our rules under
the Securities Act.50
In the Proposing Release, we
requested comment on whether the
amendments to the rule should contain
a timing provision to prevent investors
from inflating their net worth by
borrowing against their homes,
effectively converting their home
equity—which is excluded from the net
worth calculation under the
amendments adopted today—into cash
or other assets that would be included
in the net worth calculation.51 In
particular, we indicated that the
amendments could provide that the net
worth calculation must be made as of a
date 30, 60, or 90 days prior to entry
into the investment advisory contract.52
This request for comment was similar to
the one we made when we proposed
amendments to the net worth standard
in rules under the Securities Act,
including Regulation D.53
As in the recently adopted accredited
investor rule amendments adjusting the
net worth standard,54 the rule
50 See Accredited Investor Proposing Release,
supra note 33, at text preceding n.28. One
commenter recommended that all debt secured by
the residence (not just debt up to the fair market
value of the residence) be excluded from the net
worth calculation. See G. Merkl Comment Letter.
The commenter argued that excluding the debt
secured by the residence up to the fair market value
of the residence would require an investor to obtain
a valuation of the residence from a real estate agent,
which would be burdensome and costly. We note
that the rule requires an estimate of the fair market
value, but does not require a third party opinion on
valuation for the primary residence. Furthermore,
many online services provide residence valuations
at no charge. In addition, if the amount of mortgage
debt exceeds the value of the primary residence,
excluding the entire debt would result in a higher
net worth than under a conventional calculation
that takes into account all assets and all liabilities.
The commenter also acknowledged that, although
he disagreed with the net worth test as a measure
of financial sophistication, for purposes of
calculating residence-related indebtedness a ‘‘close
proximity between the time of taking on new debt
and entering into the advisory contract could
work.’’ Cf. rule 205–3(d)(1)(ii)(A)(2) (requiring that
all residence-related indebtedness incurred within
60 days before the advisory contract is entered into,
other than as a result of the acquisition of the
primary residence, be subtracted from a client’s net
worth for purposes of determining whether the
client is a ‘‘qualified client’’).
51 See Proposing Release, supra note 15, at
Section II.B.2.
52 Id. Two commenters stated that the net worth
calculation should not be required to be made on
a specified date prior to the day the advisory
contract is entered into. See C. Barnard Comment
Letter; G. Merkl Comment Letter. Another
commenter stated that the net worth calculation
should be required to be made on a specified date
prior to the day the advisory contract is entered into
to assist in protecting against refinancing
transactions intended solely to inflate net worth.
See NASAA Comment Letter.
53 See Accredited Investor Proposing Release,
supra note 33, at Specific Request for Comment
Number 7 in Section II.A.
54 See Accredited Investor Adopting Release,
supra note 33, at text following n.34.
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amendments to the qualified client net
worth standard include a specific
provision addressing the treatment of
incremental debt secured by the primary
residence that is incurred in the 60 days
before the advisory contract is entered
into.55 Debt secured by the primary
residence generally will not be included
as a liability in the net worth calculation
under the rule, except to the extent it
exceeds the estimated value of the
primary residence. Under the final rule
amendments, however, any increase in
the amount of debt secured by the
primary residence in the 60 days before
the advisory contract is entered into
generally will be included as a liability,
even if the estimated value of the
primary residence exceeds the aggregate
amount of debt secured by such primary
residence.56 Net worth will be
calculated only once, at the time the
advisory contract is entered into. The
individual’s primary residence will be
excluded from assets and any
indebtedness secured by the primary
residence, up to the estimated value of
the primary residence at that time, will
be excluded from liabilities, except if
there is incremental debt secured by the
primary residence incurred in the 60
days before the advisory contract is
entered into. If any such incremental
debt is incurred, net worth will be
reduced by the amount of the
incremental debt. In other words, the
60-day look-back provision requires
investors to identify any increase in
mortgage debt over the 60-day period
prior to entering into an advisory
contract and count that debt as a
liability in calculating net worth.
This approach should significantly
reduce the incentive for persons to
induce potential clients to take on
incremental debt secured against their
homes to facilitate a near-term
investment. We believe a 60-day look55 See
rule 205–3(d)(1)(ii)(A)(2).
fair market value of the primary residence
is determined as of the time the advisory contract
is entered into, even if the investor has changed his
or her primary residence during the 60-day period.
The rule provides an exception to the 60-day lookback provision for increases in debt secured by a
primary residence where the debt results from the
acquisition of the primary residence. Without this
exception, an individual who acquires a new
primary residence in the 60-day period before the
advisory contract is entered into may have to
include the full amount of the mortgage incurred in
connection with the purchase of the primary
residence as a liability, while excluding the full
value of the primary residence, in a net worth
calculation. The 60-day look-back provision is
intended to address incremental debt secured
against a primary residence that is incurred for the
purpose of circumventing the net worth standard of
the rule. It is not intended to address debt secured
by a primary residence that is incurred in
connection with the acquisition of a primary
residence within the 60-day period.
56 The
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back period is long enough to decrease
the likelihood of circumvention of the
standard by taking on new debt and
waiting for the look-back period to
expire. The 60-day period also is
designed to be short enough to
accommodate investors who may have
increased their mortgage debt in the
ordinary course at some point prior to
entering into an advisory contract.
Another alternative to address the
possibility of parties attempting to
circumvent the standard would have
been to provide that any debt secured by
the primary residence that was incurred
after the original purchase date of the
primary residence would have been
counted as a liability, whether or not the
fair market value of the primary
residence exceeded the value of the total
amount of debt secured by the primary
residence. We believe that such a
standard would be overly restrictive and
not provide for ordinary course changes
to debt secured by a primary residence,
such as refinancing and drawings on
home equity lines. We believe that the
approach we are adopting here will
protect investors by addressing
circumstances in which they may have
been induced to incur new debt secured
by the primary residence for the
purpose of inflating net worth under the
rule, while still permitting ordinary
course changes to debt secured by the
primary residence. This approach is
similar to the approach the Commission
recently adopted for accredited investor
rule amendments adjusting the net
worth standard, and it responds to
commenters who urged the Commission
to promote regulatory consistency in the
treatment of primary residences in other
similar contexts in order to promote
fairness, facilitate enforcement, and
provide clarity for both industry and
regulators.57
C. Transition Provisions
We proposed two new transition
provisions that would allow an
investment adviser and its clients to
maintain existing performance fee
arrangements that were permissible
when the advisory contract was entered
into, even if the performance fees would
not be permissible under the contract if
it were entered into at a later date. We
are adopting the two transition rules
substantially as proposed, which
commenters supported.58 At the
suggestion of one commenter we also
57 See Accredited Investor Adopting Release,
supra note 33, at text following n.46; see, e.g., Better
Markets Comment Letter; NASAA Comment Letter.
58 Rule 205–3(c)(1); rule 205–3(c)(2). See, e.g., C.
Barnard Comment Letter; Gunderson Dettmer
Comment Letter; M. Huntsman Comment Letter;
IAA Comment Letter; MFA Comment Letter.
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are adopting an additional transition
provision to address certain transfers of
interest, as discussed below.59 The
amendments replace the current
transition rules section of rule 205–3.
Paragraphs (1) and (2) of rule 205–3(c)
are designed so that restrictions on
performance fees apply only to new
contractual arrangements and do not
apply to new investments by clients
(including equity owners of ‘‘private
investment companies’’) who met the
definition of ‘‘qualified client’’ when
they entered into the advisory contract,
even if they subsequently do not meet
the dollar amount thresholds of the
rule.60 This approach minimizes the
disruption of existing contractual
relationships that met applicable
requirements under the rule at the time
the parties entered into them.
Rule 205–3(c)(1)61 provides that, if a
registered investment adviser entered
into a contract and satisfied the
conditions of the rule that were in effect
when the contract was entered into, the
adviser will be considered to satisfy the
conditions of the rule.62 If, however, a
natural person or company that was not
a party to the contract becomes a party,
the conditions of the rule in effect at the
time they become a party will apply to
that person or company. This provision
means, for example, that if an
individual met the $1.5 million net
worth test in effect before the effective
date of our 2011 order and entered into
an advisory contract with a registered
investment adviser before that date, the
client could continue to maintain assets
59 See
rule 205–3(c)(3).
‘‘private investment company’’ is a company
that is excluded from the definition of an
‘‘investment company’’ under the Investment
Company Act by reason of section 3(c)(1) of that
Act. Rule 205–3(d)(3). Under rule 205–3(b), the
equity owner of a private investment company, or
of a registered investment company or business
development company, is considered a client of the
adviser for purposes of rule 205–3(a). We adopted
this provision in 1998, and the provision was not
affected by our subsequent rule amendments and
related litigation concerning the registration of
certain hedge fund advisers. See 1998 Adopting
Release, supra note 7; Goldstein v. Securities and
Exchange Commission, 451 F.3d 873 (DC Cir. 2006).
61 Rule 205–3(c)(1), as amended, modifies the
existing transition rule in rule 205–3(c)(1), which
permits advisers and their clients that entered into
a contract before August 20, 1998, and satisfied the
eligibility criteria in effect on the date the contract
was entered into, to maintain their existing
performance fee arrangements.
62 One commenter supported the provisions
allowing advisers to continue to provide advisory
services under performance fee arrangements that
were permitted at the time the contract was entered
into but stated that the rule should prohibit an
adviser from charging performance fees to investors
that are not qualified clients with respect to money
committed after the effective date for the rule
amendments. See G. Merkl Comment Letter. We
believe such an approach would be unnecessarily
disruptive to advisory relationships.
60 A
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(and invest additional assets) with the
adviser under that contract even though
the net worth test was subsequently
raised to $2 million and he or she no
longer met the new test. If, however,
another person becomes a party to that
contract, the current net worth
threshold will apply to the new party
when he or she becomes a party to the
contract.63
Rule 205–3(c)(2) provides that, if a
registered investment adviser previously
was not required to register with the
Commission pursuant to section 203 of
the Act and did not register, section
205(a)(1) of the Act will not apply to the
contractual arrangements into which the
registered adviser entered when it was
not registered with the Commission.64
This means, for example, that if an
investment adviser to a private
investment company with 50 individual
investors was exempt from registration
with the Commission in 2009, but then
subsequently registered with the
Commission because it was no longer
exempt from registration or because it
chose voluntarily to register, section
205(a)(1) will not apply to the
contractual arrangements the adviser
entered into before it registered,
including the accounts of the 50
individual investors with the private
investment company and any additional
investments they make in that company.
If, however, any other individuals
63 Rule 205–3(c)(1). Similarly, a person who
invests in a private investment company advised by
a registered investment adviser must satisfy the
rule’s conditions when he or she becomes an
investor in the company. See rule 205–3(b) (equity
owner of a private investment company is
considered a client of a registered investment
adviser for purposes of rule 205–3(a)).
64 Section 205(a)(1) will apply, however, to
contractual arrangements into which the adviser
enters after it is required to register with the
Commission. See rule 205–3(c)(2). The approach of
subsection (c)(2) is similar to the transition
provisions we adopted for the registration of
investment advisers to private funds. See
Registration Under the Advisers Act of Certain
Hedge Fund Advisers, Investment Advisers Act
Release No. 2333 (Dec. 2, 2004) [69 FR 72054 (Dec.
10, 2004)]. We are adopting the subsection
substantially as proposed, but have made minor
changes to clarify that the transition provision
applies only to contractual arrangements with
advisers that were not required to register and did
not register with the Commission. Our proposed
subsection would have applied to contractual
arrangements with any registered investment
adviser that previously was ‘‘exempt’’ from the
requirement to register with the Commission. The
revised language clarifies that the transition
provision applies to contractual arrangements with
advisers when they were not required to register
(even if they were not ‘‘exempt’’), and does not
apply to contractual arrangements entered into with
advisers when they were registered (even if they
were not required to register). Investment advisers
that previously registered already are subject to
section 205(a)(1) and rule 205–3, and therefore
would not need the transition relief of rule 205–
3(c)(2).
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become new investors in the private
investment company or if the original
investors became investors in a different
private investment company managed
by the adviser after the adviser registers
with the Commission, section 205(a)(1)
will apply to the adviser’s relationship
with the investors with regard to their
new investments.65
Finally, at the suggestion of one
commenter, we have revised the third
paragraph of rule 205–3(c), to allow for
limited transfers of interests from a
qualified client to a person that was not
a party to the contract and is not a
qualified client at the time of the
transfer.66 The approach we are taking
is similar to the approach we adopted in
rule 3c–6 under the Investment
Company Act. Rule 3c–6 provides that,
in the case of a transfer of ownership
interest in a private investment
company by gift or bequest, or pursuant
to an agreement relating to a legal
separation or divorce, the beneficial
owner of the interest will be considered
to be the person who transferred the
interest.67 We believe that, when those
types of transfers occur, the transferee
does not make a separate investment
decision to enter into an advisory
contract with the adviser, but is the
recipient, perhaps involuntarily, of the
benefits of a pre-existing contractual
relationship. Because of the
circumstances of these transfers, we
believe the transferee is not of the type
that needs the protections of the
performance fee restrictions. We are
65 One commenter recommended that we revise
the rule to accommodate fund-of-funds purchases
when the acquiring funds are private investment
companies. See MFA Comment Letter. The
commenter recommended that the rule ‘‘clarify’’
that an acquiring private investment company is
able to pay performance fees to the adviser of an
acquired private investment company even if some
of the investors in the acquiring private investment
company are not qualified clients at the time the
investment is made in the acquired private
investment company. We are not making the
suggested revision to the final rule, because it
would permit advisers to pool small client accounts
to circumvent the eligibility standards of rule 205–
3(d)(1) and would permit performance fee
arrangements that currently are not permissible
under rule 205–3(b). As we stated in 1998, rule
205–3(b) specifies that the requirement to look
through to each investor of a private investment
company applies to each tier of a funds-of-funds
structure. See 1998 Adopting Release, supra note 7,
at Section II.C. (‘‘Under [Rule 205–3(b)], each ‘tier’
of such entities must be examined in this manner.
Thus, if a private investment company seeking to
enter into a performance fee contract (first tier
company) is owned by another private investment
company (the second tier company), the look
through provision applies to the second (and any
other) level private investment company, and thus
the adviser must look to the ultimate client to
determine whether the arrangement satisfies the
requirements of the rule.’’).
66 See Gunderson Dettmer Comment Letter.
67 See rule 3c–6(b) under the Investment
Company Act [17 CFR 270.3c–6(b)].
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therefore amending paragraph (3) of rule
205–3(c) to provide that, if an owner of
an interest in a private investment
company transfers an interest by gift or
bequest, or pursuant to an agreement
related to a legal separation or divorce,
the transfer will not cause the transferee
to ‘‘become a party’’ to the contract and
will not cause section 205(a)(1) of the
Act to apply to such transferee. Thus,
transfers in these circumstances will not
cause the transferee to have to meet the
definition of a qualified client under
rule 205–3.68
D. Effective Date
The rule amendments we are adopting
today will be effective on May 22, 2012.
In addition, in order to minimize the
disruption of contractual relationships
that met applicable requirements at the
time the parties entered into them, the
Commission will not object if advisers
rely or relied upon the amended
transition provisions of rule 205–3(c)
before that date.69
III. Cost-Benefit Analysis
The Commission is sensitive to the
costs and benefits imposed by its rules.
In the Proposing Release, we analyzed
the costs and benefits of the proposed
rules and sought comment on all aspects
of the cost-benefit analysis, including
identification and assessment of any
costs and benefits not discussed in the
analysis. Only two commenters
addressed the cost-benefit analysis.70
These commenters focused on the costs
of the rule but did not provide any
empirical data.
As stated above, section 205(a)(1) of
the Advisers Act generally restricts an
investment adviser from entering into
an advisory contract that provides for
performance-based compensation.71
Congress restricted performance
compensation arrangements to protect
advisory clients from arrangements it
believed might encourage advisers to
take undue risks with client funds to
68 A gift transfer, however, would need to be a
bona fide gift and could not be used as a means to
avoid the protections of section 205 of the Act, for
example by transferring an interest in a private fund
supposedly as a gift but in reality in exchange for
payment.
69 As discussed above, some advisers may have
entered into contractual relationships with clients
who met the requirements of the rule at the time
the parties entered into them, but who no longer
meet the requirements of the amended rule. See
supra Section II.C. For example, some registered
investment advisers may have entered into advisory
contracts with clients who met the $1.5 million net
worth test when that test was applicable, but who
would not meet the $2 million net worth test of the
revised rule.
70 See Comment Letter of Phillip Goldstein (May
24, 2011) (‘‘P. Goldstein Comment Letter’’); G.
Merkl Comment Letter.
71 See supra Section I.
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increase advisory fees.72 Congress
subsequently authorized the
Commission in section 205(e) of the
Advisers Act to exempt any advisory
contract from the performance fee
restrictions if the contract is with
persons that the Commission
determines do not need the protections
of those restrictions. Section 205(e)
provides that the Commission may
determine that persons do not need the
protections of section 205(a)(1) on the
basis of such factors as ‘‘financial
sophistication, net worth, knowledge of
and experience in financial matters,
amount of assets under management,
relationship with a registered
investment adviser, and such other
factors as the Commission determines
are consistent with [section 205].’’
The Commission adopted rule 205–3
to exempt an investment adviser from
the restrictions against charging a client
performance fees where a client has a
specified net worth or amount of assets
under management. Section 418 of the
Dodd-Frank Act amended section 205(e)
to require that the Commission adjust
for inflation the dollar amount
thresholds in rules promulgated under
section 205(e) within one year of
enactment of the Dodd-Frank Act and
every five years thereafter. Generally an
inflation adjustment is designed to help
make the dollar amount thresholds in a
provision continue to serve the same
purposes over time. The amendments to
rule 205–3 providing that the
Commission will issue orders every five
years adjusting for inflation the dollar
amount thresholds of the rule will
codify the Dodd-Frank Act’s
amendment of section 205(e) of the
Advisers Act that requires the
Commission to issue these orders.73
Also, pursuant to section 418’s
requirements, the Commission issued an
order in July 2011 revising the threshold
of the assets-under-management test to
$1 million, and of the net worth test to
$2 million. The rule amendments will
codify in the rule the changes already
made to the dollar amount thresholds in
the July 2011 Order, and will have no
separate economic effect.
As proposed, we are amending rule
205–3 to exclude the value of a natural
person’s primary residence and certain
debt secured by the property from the
determination of whether a person has
sufficient net worth to be considered a
‘‘qualified client.’’ We are also
modifying the transition provisions of
the rule to take into account
performance fee arrangements that were
permissible when they were entered
72 Id.
73 Section
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into. We analyze the costs and benefits
of these provisions below.
A. Benefits
The exclusion of the value of an
individual’s primary residence will
benefit certain investors. As discussed
above, the Act’s restrictions on
performance fee arrangements are
designed to protect advisory clients
from arrangements that encourage
advisers to take undue risks with client
funds to increase advisory fees, while
rule 205–3 is designed to permit clients
who are financially experienced and
able to bear the risks of performance fee
arrangements to enter into those
arrangements.74 We believe that the
value of an individual’s primary
residence may bear little or no
relationship to that person’s financial
experience or ability to bear the risks of
performance fee arrangements. The
value of the individual’s equity interest
in the residence reflects the prevailing
market values at the time and can be a
function of time in paying down the
associated debt rather than a function of
deliberate investment decision-making.
In addition, because of the generally
illiquid nature of residential assets, the
value of an individual’s home equity
may not help the investor to bear the
risks of loss that are inherent in
performance fee arrangements.
Therefore, some of the clients who do
not meet the net worth test of rule 205–
3 without including the value of their
primary residence may not possess the
financial experience or ability to bear
the risks of performance fee
arrangements. We estimate that the
exclusion of the value of an individual’s
primary residence will result in up to
1.3 million households that no longer
qualify as ‘‘qualified clients’’ under the
revised net worth test and therefore will
now be protected by the performance
fee restrictions in section 205 of the
Advisers Act.75
As discussed above, the exclusion of
the value of an individual’s primary
residence from the calculation of net
worth under the rule is similar to
changes that Congress required the
74 See
supra notes 3 and 6.
infra notes 79–81. As discussed above, the
amendments to rule 205–3 also exclude from the
net worth test the amount of debt secured by the
primary residence that is no greater than the
property’s current market value. The exclusion of
the debt might limit these benefits in some
circumstances. For example, if a client meets the
net worth test as a result of the exclusion of debt
secured by the primary residence and the market
value of the primary residence were to decline to
the extent that the debt could not be satisfied by
the sale of the residence, the client might be less
able to bear the risks related to the performance fee
contract and the investments that the adviser might
make on behalf of the client.
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Commission to make to rules under the
Securities Act, including Regulation
D.76 As we noted when we recently
adopted those rule amendments, section
413(a) of the Dodd-Frank Act required
us to adjust the ‘‘accredited investor’’
net worth standards of certain rules
under the Securities Act that apply to
individuals, by ‘‘excluding the value of
the primary residence.’’ 77 The
amendment to rule 205–3 under the
Advisers Act we are adopting today, as
some commenters argued, will promote
regulatory consistency in the treatment
of primary residences between this rule
and other rules that the Commission has
adopted that distinguish high net worth
individuals from less wealthy
individuals.78
The amendments to the rule’s
transition provisions will allow
advisory clients and investment
advisers to avoid certain costs resulting
from the statutory mandate to adjust for
inflation and the Commission’s
resultant July 2011 Order. The
amendments allow an investment
adviser and its clients to maintain
existing performance fee arrangements
that were permissible when the advisory
contract was entered into, even if
performance fees would not be
permissible under the contract if it were
entered into at a later date. These
transition provisions are designed so
that the restrictions on the charging of
performance fees apply to new
contractual arrangements and do not
apply retroactively to existing
contractual arrangements, including
investments in private investment
companies. Otherwise, advisory clients
and investment advisers might have to
terminate contractual arrangements into
which they previously entered and enter
into new arrangements, which could be
costly to investors and advisers.
B. Costs
The amendments exclude the value of
a person’s primary residence and
generally exclude debt secured by the
property (if no greater than the current
market value of the residence) from the
calculation of a person’s net worth.79
Based on data from the Federal Reserve
Board, approximately 5.5 million
households have a net worth of more
than $2 million including the equity in
76 See
supra note 33.
Accredited Investor Adopting Release,
supra note 33, at n.18 and accompanying text.
78 See supra notes 42–44 and 57 and
accompanying text.
79 As discussed above, any increase in the amount
of debt secured by the primary residence in the 60
days before the securities are purchased will be
included in the net worth calculation as a liability,
regardless of the estimated value of the residence.
See supra Section II.B; rule 205–3(d)(1)(ii)(A)(2).
77 See
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the primary residence (i.e., value minus
debt secured by the property), and
approximately 4.2 million households
have a net worth of more than $2
million excluding the equity in the
primary residence.80 Therefore,
approximately 1.3 million households
will not meet a $2 million net worth test
under the revised test, and will
therefore not be considered ‘‘qualified
clients,’’ when the value of the primary
residence is excluded from the test.81
Excluding the value of the primary
residence (and debt secured by the
property up to the current market value
of the residence) means that 1.3 million
households that would have met the net
worth threshold if the value of the
residence were included, as is currently
permitted, will no longer be ‘‘qualified
clients’’ under the revised net worth test
and therefore will be unable to enter
into performance fee contracts unless
they meet another test of rule 205–3.82
For purposes of this cost-benefit
analysis, Commission staff assumes that
25 percent of the 1.3 million households
would have entered into new advisory
contracts that contained performance
fee arrangements after the compliance
date of the amendments, and therefore
approximately 325,000 clients will not
meet the revised net worth test.83
80 These figures are derived from the 2007 Federal
Reserve Board Survey of Consumer Finances. These
figures represent the net worth of households rather
than individual persons who might be clients. More
information regarding the survey may be obtained
at https://www.federalreserve.gov/pubs/oss/oss2/
scfindex.html.
81 Although some of these 1.3 million households
may be grandfathered by the transition provisions
of the rule, we assume for the purposes of our
analysis that none of these households will be
grandfathered. This assumption may therefore
result in an overestimation of the costs of the rule
amendments.
82 This estimate, as described in the Proposing
Release, was not premised on the notion that
investors would borrow against the equity in their
primary residence shortly before the calculation of
net worth. See Proposing Release, supra note 15, at
nn. 47–48 and accompanying text. The 60-day lookback provision in rule 205–3 that we are adopting
today, because it reduces the incentives to incur
debt secured by residences in order to boost net
worth under the rule, strengthens the accuracy of
our estimate. See supra notes 55–57 and
accompanying text.
83 The assumption that 25% of these investors
would have entered into new performance fee
arrangements is based on data compiled in a 2008
report sponsored by the Commission. See Angela A.
Hung et al., Investor and Industry Perspectives on
Investment Advisers and Broker-Dealers 130 (Table
C.1) (2008) (available at https://www.sec.gov/news/
press/2008/2008-1_randiabdreport.pdf). That report
indicated that 20% of investment advisers charge
performance fees. Id. at 105 (Table 6.13).
Commission staff assumes the percentage of
investment advisers charging performance fees
reflects investor demand for these advisory
arrangements. Although the report indicates that
20% of investment advisers charge performance
fees, the use of a 25% assumption is intended to
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Commission staff estimates that about
40 percent of those 325,000 potential
clients (i.e., 130,000) will separately
meet the ‘‘qualified client’’ definition
under the assets-under-management
test, and therefore will be able to enter
into performance fee arrangements.84
The remaining 60 percent (195,000
households) will have access only to
those investment advisers (directly or
through the private investment
companies they manage) that charge
advisory fees other than performance
fees.85 Some of these investors may be
negatively affected by their inability to
enter into performance-based
compensation arrangements with
investment advisers (which
arrangements in some ways align the
advisers’ interests with the clients’
interests). These investors also may
experience differences in their
investment options and returns, changes
in advisory service, and the cost of
being unable to enter into advisory
contracts with their preferred advisers.
For purposes of this cost-benefit
analysis, Commission staff assumes that
approximately 80 percent of the 195,000
households (i.e., 156,000 households)
will enter into non-performance fee
arrangements, and that the other 20
percent (i.e., 39,000 households) will
decide not to invest their assets with an
adviser.86 Commission staff anticipates
that the non-performance fee
arrangements into which these clients
will enter may contain management fees
that yield advisers approximately the
same amount of fees that clients would
have paid under performance fee
arrangements. Under these nonperformance fee arrangements, if the
adviser’s performance is not positive or
does not reach the level at which it
would have accrued performance fees
overestimate rather than underestimate costs,
especially given the inherent uncertainty
surrounding hypothetical events. It is also notable
that an average of only 37% of investors indicated
they would seek investment advisory services in the
next five years. The estimate concerning 1.3 million
households is derived from the 2007 Federal
Reserve Board Survey of Consumer Finances. See
supra note 80 and accompanying and following
text.
84 This estimate is based on data filed by
registered investment advisers on Form ADV.
85 Commission staff estimates that less than one
percent of registered investment advisers are
compensated solely by performance fees, based on
data from filings by registered investment advisers
on Form ADV.
86 This assumption is based on the idea that a
substantial majority of investment advisers that
typically charge performance fees and that in the
future would calculate a potential client’s net worth
and determine that it does not meet the $2 million
threshold, will offer alternate compensation
arrangements in order to offer their services. As
noted above, Commission staff estimates that less
than one percent of registered advisers charge
performance fees exclusively. See supra note 85.
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(i.e., the ‘‘hurdle rate’’ of return), a client
might end up paying higher overall fees
than if he had paid performance fees.87
Commission staff estimates that the
remaining 39,000 households that
would have entered into advisory
contracts, if the value of the client’s
primary residence were not excluded
from the calculation of a person’s net
worth, will not enter into advisory
contracts. Some of these households
will likely seek other investment
opportunities. Other households may
forego professional investment
management altogether because of the
higher value they place on the
alignment of advisers’ interests with
their own interests associated with the
use of performance fee arrangements.
We recognize that the exclusion of the
value of a person’s primary residence
from the calculation of a person’s net
worth will reduce the pool of potential
qualified clients for advisers. This, in
turn, might result in a reduction in the
total fees collected by investment
advisers. In order to replace those
clients and lost revenue, some advisers
may choose to market their services to
more potential clients, which may result
in increased marketing and
administrative costs.88
Although some commenters asserted
that these amendments would harm
small advisers or less wealthy clients,
commenters did not provide any
quantitative data to support their
statements.89 As discussed above,
advisers may charge advisory fees other
than performance fees in order to obtain
revenue from clients who do not meet
the definition of ‘‘qualified clients.’’ In
addition, clients who no longer meet the
net worth test as a result of the
exclusion of their primary residence
likely would have invested a smaller
amount of assets than other clients who
continue to meet the test. As a result,
the revenue loss to investment advisers
from the exclusion of these clients from
the performance fee exemption may be
mitigated. Moreover, as mentioned
above, less wealthy clients can enter
into non-performance based
compensation arrangements and seek
87 Performance fee arrangements typically include
a ‘‘hurdle rate,’’ which is a minimum rate of return
that must be exceeded before the performance fee
can be charged. See, e.g., Tamar Frankel, The
Regulation of Money Managers § 12.03[F] (2d ed.
Supp. 2009).
88 Although advisers that charge performance fees
typically require investment minimums of $10,000
or more, one of the steps that advisers may take to
market their services to a larger number of potential
clients is to reduce their investment minimums.
This may result in slightly higher administrative
costs for investment advisers that choose to take
such action.
89 See supra notes 38–39 and accompanying text.
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other investment opportunities.
Therefore, for the reasons discussed
above, we believe that the amendments
are unlikely to impose a significant net
cost on most advisers and clients.
One commenter asserted that because
liabilities in excess of the value of the
primary residence would be included in
the net worth calculation the
Commission should include in its
analysis the cost to clients of obtaining
valuations from real estate agents.90
First, currently investors may include
the value of their primary residence in
the calculation of their net worth and,
as such, those investors that choose to
do so must be estimating the value of
the primary residence in order to
calculate their net worth. Second, the
rule requires an estimate, but does not
require a third party opinion on
valuation either for the primary
residence or for any other assets or
liabilities. Third, as we noted
previously, many online services
provide residence valuations at no
charge.91
Some commenters argued that
excluding the value of an investor’s
primary residence from the net worth
test of the rule at the same time as
adjusting the rule’s dollar amount
thresholds for inflation would cause too
much change at one time.92 Although
we attribute the costs of inflationadjusting the dollar amount thresholds
of the rule to the Dodd-Frank Act and
the order we issued thereunder, we have
considered the relative magnitude of
each of these changes to the net worth
standard in determining the significance
of making these changes at the same
time. Based on data from the Federal
Reserve Board, approximately 7 million
households have a net worth of more
than $1.5 million (the previous net
worth threshold, including primary
residence), and approximately 5.5
million households have a net worth of
more than $2 million (the revised net
worth threshold we established by order
in July 2011, including primary
residence).93 Therefore, inflationadjusting the dollar amount threshold of
the net worth test from $1.5 to $2
million will have caused about 1.5
million households to no longer meet
the net worth test of the rule. Therefore
the numerical effect of the inflation
adjustment of the net worth test’s dollar
amount threshold (1.5 million
households) is slightly greater than the
exclusion of primary residence from the
net worth test (1.3 million
90 See
G. Merkl Comment Letter.
supra note 50.
92 See supra note 45 and accompanying text.
93 See supra note 80.
91 See
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households).94 As discussed above, we
are not making these two changes to the
rule at the same time.95 We revised the
dollar amount threshold of the net
worth test for inflation in July 2011 (as
required by statute), and the revision
was effective in September 2011. Our
current amendment of the net worth test
to exclude the value of a primary
residence, which will be effective in
May 2012, will be effective
approximately eight months after the
previous change to the net worth test.96
We believe that what has turned out to
be a two-step process (adjustment for
inflation followed by exclusion of
primary residence), with roughly equal
results on the numbers of ‘‘qualified
clients,’’ will help to ameliorate the
economic impact of the two rule
revisions on investment advisers. In
addition, we are concerned that
delaying beyond 90 days the effective
date of excluding primary residence
from the net worth standard might
encourage some advisers to focus their
efforts on entering into performance fee
arrangements with clients who will not
meet the rule’s net worth standards after
the effective date.
The amendments to the rule’s
transition provisions are not likely to
impose any new costs on advisory
clients or investment advisers. As
discussed above, the amendments allow
an investment adviser and its clients to
maintain existing performance fee
arrangements that were permissible
when the advisory contract was entered
into, even if performance fees would not
be permissible under the contract if it
were entered into at a later date. The
amendments also allow for the transfer
of an ownership interest in a private
investment company by gift or bequest,
or pursuant to an agreement relating to
a legal separation or divorce to a party
that is not a qualified client.97
We do not expect that adjustment of
the dollar amount thresholds in rule
205–3, which codifies the adjustments
that the Commission effected in its July
2011 order, will impose new costs on
advisory clients or investment advisers.
94 See
supra text accompanying note 81.
supra note 46 and preceding text.
96 Any further revisions of the dollar amount
thresholds of rule 205–3 to adjust for inflation are
not scheduled to occur until 2016. See rule 205–
3(e).
97 Rule 205–3(c)(3). The rule provides that for
purposes of paragraphs 205–3(c)(1) (transition rule
for registered investment advisers) and 205–3(c)(2)
(transition rule for registered investment advisers
that were previously not registered) the transfer of
an equity ownership interest in a private
investment company by gift or bequest, or pursuant
to an agreement related to a legal separation or
divorce, will not cause the transferee to become a
party to the contract and will not cause section
205(a)(1) of the Act to apply to such transferee.
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The adjustments will have no effect on
existing contractual relationships that
met applicable requirements under the
rule at the time the parties entered into
them, because those relationships may
continue under the transition provisions
of the rule. Although an investment
adviser could be prohibited from
charging performance fees to new
clients to whom it could have charged
performance fees if the advisory
contract had been entered into before
the adjustment of the dollar thresholds,
we attribute this effect to the DoddFrank Act rather than to this
rulemaking. One commenter stated that
rather than addressing the contention
that the adjustment to the dollar amount
thresholds is unfair to small investors,
the Commission ‘‘passed the buck’’ back
to Congress.98 The Commission,
however, is required to adjust the dollar
amount thresholds for the effects of
inflation. Exempting less wealthy
investors from the limits would be
contrary to the purpose of the dollar
amount thresholds, which is to limit the
availability of the exemption to clients
who are financially experienced and
able to bear the risks of performance fee
arrangements.
Section 418 of the Dodd-Frank Act
does not specify how the Commission
should measure inflation in adjusting
the dollar amount thresholds. We
proposed, and are adopting, the PCE
Index because it is widely used as a
broad indicator of inflation in the
economy and because the Commission
has used the PCE Index in other
contexts. It is possible that the use of the
PCE Index to measure inflation might
result in a larger or smaller dollar
amount for the two thresholds than the
use of a different index, but the
rounding required by the Dodd-Frank
Act (to the nearest $100,000) likely
negates any difference between indexes.
IV. Paperwork Reduction Act
The amendments to rule 205–3 under
the Investment Advisers Act do not
contain any ‘‘collection of information’’
requirements as defined by the
Paperwork Reduction Act of 1995, as
amended (‘‘PRA’’).99 Accordingly, the
PRA is not applicable. We received no
comments on any PRA issues.
V. Regulatory Flexibility Act
Certification
The Commission certified in the
Proposing Release, pursuant to section
605(b) of the Regulatory Flexibility Act
of 1980 (‘‘RFA’’),100 that the proposed
98 See
P. Goldstein Comment Letter.
U.S.C. 3501–3520.
100 5 U.S.C. 605(b).
99 44
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10367
rule amendments would not, if adopted,
have a significant impact on a
substantial number of small entities.101
As we explained in the Proposing
Release, under Commission rules, for
the purposes of the Advisers Act and
the RFA, an investment adviser
generally is a small entity if it: (i) Has
assets under management having a total
value of less than $25 million; (ii) did
not have total assets of $5 million or
more on the last day of its most recent
fiscal year; and (iii) does not control, is
not controlled by, and is not under
common control with another
investment adviser that has assets under
management of $25 million or more, or
any person (other than a natural person)
that had total assets of $5 million or
more on the last day of its most recent
fiscal year (‘‘small adviser’’).102
Based on information in filings
submitted to the Commission, 617 of the
approximately 11,888 investment
advisers registered with the Commission
are small entities. Only approximately
20 percent of the 617 registered
investment advisers that are small
entities (about 122 advisers) charge any
of their clients performance fees. In
addition, 24 of the 122 advisers required
at the time of the Proposing Release an
initial investment from their clients that
would meet the then current assetsunder-management threshold
($750,000), which advisory contracts
will be grandfathered into the
exemption provided by rule 205–3
under the amendments. Therefore, if
these advisers in the future raise those
minimum investment levels to the
revised level that we issued by order
($1 million), those advisers could charge
their clients performance fees because
the clients would meet the assets-undermanagement test, even if they would not
meet the revised net worth test that
excludes the value of the client’s
primary residence. For these reasons,
the Commission believes that the
amendments to rule 205–3 will not have
a significant economic impact on a
substantial number of small entities.
The Commission requested written
comments regarding the certification.
One commenter stated that the
Proposing Release includes
‘‘suspicious’’ quantified data to support
the claim as to how few advisers will be
affected by the required review every
five years.103 The commenter provided
no further detail about why the
quantified data was suspicious, or any
101 See Proposing Release, supra note 15, at
Section VI.
102 Rule 0–7(a).
103 See Comment Letter of David Flatray (May 29,
2011).
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alternative empirical data, and did not
address the number of small advisers
that would be affected.104
VI. Statutory Authority
The Commission is adopting
amendments to rule 205–3 pursuant to
the authority set forth in section 205(e)
of the Investment Advisers Act of 1940
[15 U.S.C. 80b–5(e)].
List of Subjects in 17 CFR Part 275
Reporting and recordkeeping
requirements, Securities.
Text of Rules
For the reasons set out in the
preamble, Title 17, Chapter II of the
Code of Federal Regulations is amended
as follows:
■
PART 275—RULES AND
REGULATIONS, INVESTMENT
ADVISERS ACT OF 1940
1. The general authority citation for
Part 275 continues to read as follows:
■
Authority: 15 U.S.C. 80b–2(a)(11)(G), 80b–
2(a)(11)(H), 80b–2(a)(17), 80b–3, 80b–4, 80b–
4a, 80b–6(4), 80b–6a, 80b–11, unless
otherwise noted.
*
*
*
*
*
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.
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*
*
*
*
*
(c) Transition rules—(1) Registered
investment advisers. If a registered
investment adviser entered into a
contract and satisfied the conditions of
this section that were in effect when the
contract was entered into, the adviser
will be considered to satisfy the
conditions of this section; Provided,
however, that if a natural person or
company who was not a party to the
contract becomes a party (including an
equity owner of a private investment
company advised by the adviser), the
conditions of this section in effect at
that time will apply with regard to that
person or company.
(2) Registered investment advisers
that were previously not registered. If an
investment adviser was not required to
register with the Commission pursuant
to section 203 of the Act (15 U.S.C. 80b–
3) and was not registered, section
205(a)(1) of the Act will not apply to an
advisory contract entered into when the
104 Id.
VerDate Mar<15>2010
14:56 Feb 21, 2012
Jkt 226001
adviser was not required to register and
was not registered, or to an account of
an equity owner of a private investment
company advised by the adviser if the
account was established when the
adviser was not required to register and
was not registered; Provided, however,
that section 205(a)(1) of the Act will
apply with regard to a natural person or
company who was not a party to the
contract and becomes a party (including
an equity owner of a private investment
company advised by the adviser) when
the adviser is required to register.
(3) Certain transfers of interests.
Solely for purposes of paragraphs (c)(1)
and (c)(2) of this section, a transfer of an
equity ownership interest in a private
investment company by gift or bequest,
or pursuant to an agreement related to
a legal separation or divorce, will not
cause the transferee to ‘‘become a party’’
to the contract and will not cause
section 205(a)(1) of the Act to apply to
such transferee.
(d) * * *
(1) * * *
(i) A natural person who, or a
company that, immediately after
entering into the contract has at least
$1,000,000 under the management of
the investment adviser;
(ii) A natural person who, or a
company that, the investment adviser
entering into the contract (and any
person acting on his behalf) reasonably
believes, immediately prior to entering
into the contract, either:
(A) Has a net worth (together, in the
case of a natural person, with assets
held jointly with a spouse) of more than
$2,000,000. For purposes of calculating
a natural person’s net worth:
(1) The person’s primary residence
must not be included as an asset;
(2) Indebtedness secured by the
person’s primary residence, up to the
estimated fair market value of the
primary residence at the time the
investment advisory contract is entered
into may not be included as a liability
(except that if the amount of such
indebtedness outstanding at the time of
calculation exceeds the amount
outstanding 60 days before such time,
other than as a result of the acquisition
of the primary residence, the amount of
such excess must be included as a
liability); and
(3) Indebtedness that is secured by the
person’s primary residence in excess of
the estimated fair market value of the
residence must be included as a
liability; or
(B) Is a qualified purchaser as defined
in section 2(a)(51)(A) of the Investment
Company Act of 1940 (15 U.S.C. 80a–
PO 00000
Frm 00018
Fmt 4700
Sfmt 4700
2(a)(51)(A)) at the time the contract is
entered into; or
*
*
*
*
*
(e) Inflation adjustments. Pursuant to
section 205(e) of the Act, the dollar
amounts specified in paragraphs
(d)(1)(i) and (d)(1)(ii)(A) of this section
shall be adjusted by order of the
Commission, on or about May 1, 2016
and issued approximately every five
years thereafter. The adjusted dollar
amounts established in such orders
shall be computed by:
(1) Dividing the year-end value of the
Personal Consumption Expenditures
Chain-Type Price Index (or any
successor index thereto), as published
by the United States Department of
Commerce, for the calendar year
preceding the calendar year in which
the order is being issued, by the 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
(3) For the dollar amount in paragraph
(d)(1)(ii)(A) of this section, multiplying
$1,500,000 times the quotient obtained
in paragraph (e)(1) of this section and
rounding the product to the nearest
multiple of $100,000.
Dated: February 15, 2012.
By the Commission.
Elizabeth M. Murphy,
Secretary.
[FR Doc. 2012–4046 Filed 2–21–12; 8:45 am]
BILLING CODE 8011–01–P
DEPARTMENT OF HOMELAND
SECURITY
U.S. Customs and Border Protection
DEPARTMENT OF THE TREASURY
19 CFR Parts 10 and 163
[CBP Dec. 12–02; USCBP–2011–0030]
RIN 1515–AD75
Duty-Free Treatment of Certain Visual
and Auditory Materials
U.S. Customs and Border
Protection, Department of Homeland
Security; Department of the Treasury.
ACTION: Final rule.
AGENCY:
This document adopts as a
final rule, without change, the proposed
amendments to the U.S. Customs and
Border Protection (CBP) regulations to
permit an applicant to file the
SUMMARY:
E:\FR\FM\22FER1.SGM
22FER1
]]>Agencies
[Federal Register Volume 77, Number 35 (Wednesday, February 22, 2012)]
[Rules and Regulations]
[Pages 10358-10368]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2012-4046]
=======================================================================
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 275
[Release No. IA-3372; File No. S7-17-11]
RIN 3235-AK71
Investment Adviser Performance Compensation
AGENCY: Securities and Exchange Commission.
ACTION: Final rule.
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SUMMARY: The Securities and Exchange Commission (``Commission'' or
``SEC'') is adopting amendments to the rule under the Investment
Advisers Act of 1940 that permits investment advisers to charge
performance based compensation to ``qualified clients.'' The amendments
[[Page 10359]]
revise the dollar amount thresholds of the rule's tests that are used
to determine whether an individual or company is a qualified client.
These rule amendments codify revisions that the Commission recently
issued by order that adjust the dollar amount thresholds to account for
the effects of inflation. In addition, the rule amendments: provide
that the Commission will issue an order every five years in the future
adjusting the dollar amount thresholds for inflation; exclude the value
of a person's primary residence and certain associated debt from the
test of whether a person has sufficient net worth to be considered a
qualified client; and add certain transition provisions to the rule.
DATES: Effective Date: The amendments are effective on May 22, 2012.
FOR FURTHER INFORMATION CONTACT: Daniel K. Chang, Senior Counsel, or C.
Hunter Jones, Assistant Director, at 202-551-6792, Office of Regulatory
Policy, Division of Investment Management, Securities and Exchange
Commission, 100 F Street NE., Washington, DC 20549-8549.
SUPPLEMENTARY INFORMATION: The Commission is adopting amendments to
rule 205-3 [17 CFR 275.205-3] under the Investment Advisers Act of 1940
(``Advisers Act'' or ``Act'').\1\
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\1\ 15 U.S.C. 80b. Unless otherwise noted, all references to
statutory sections are to the Investment Advisers Act, and all
references to rules under the Advisers Act, including rule 205-3,
are to Title 17, Part 275 of the Code of Federal Regulations [17 CFR
part 275].
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Table of Contents
I. Introduction
II. Discussion
A. Inflation Adjustment of Dollar Amount Thresholds
B. Exclusion of the Value of Primary Residence From Net Worth
Determination
C. Transition Provisions
D. Effective Date
III. Cost-Benefit Analysis
A. Benefits
B. Costs
IV. Paperwork Reduction Act
V. Regulatory Flexibility Act Certification
VI. Statutory Authority
Text of Rules
I. Introduction
Section 205(a)(1) of the Investment Advisers Act generally
restricts an investment adviser from entering into, extending,
renewing, or performing any investment advisory contract that provides
for compensation to the adviser based on a share of capital gains on,
or capital appreciation of, the funds of a client.\2\ Congress
restricted these compensation arrangements (also known as performance
compensation or performance fees) in 1940 to protect advisory clients
from arrangements it believed might encourage advisers to take undue
risks with client funds to increase advisory fees.\3\ Congress
subsequently authorized the Commission to exempt any advisory contract
from the performance fee restrictions if the contract is with persons
that the Commission determines do not need the protections of those
restrictions.\4\
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\2\ 15 U.S.C. 80b-5(a)(1).
\3\ H.R. Rep. No. 2639, 76th Cong., 3d Sess. 29 (1940).
Performance fees were characterized as ``heads I win, tails you
lose'' arrangements in which the adviser had everything to gain if
successful and little, if anything, to lose if not. S. Rep No. 1775,
76th Cong., 3d Sess. 22 (1940).
\4\ Section 205(3) of the Advisers Act. Section 205(e) of the
Advisers Act authorizes the Commission to exempt conditionally or
unconditionally from the performance fee prohibition advisory
contracts with persons that the Commission determines do not need
its protections. Section 205(e) provides that the Commission may
determine that persons do not need the protections of section
205(a)(1) on the basis of such factors as ``financial
sophistication, net worth, knowledge of an experience in financial
matters, amount of assets under management, relationship with a
registered investment adviser, and such other factors as the
Commission determines are consistent with [section 205].''
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The Commission adopted rule 205-3 in 1985 to exempt an investment
adviser from the restrictions against charging a client performance
fees in certain circumstances.\5\ The rule, when adopted, allowed an
adviser to charge performance fees if the client had at least $500,000
under management with the adviser immediately after entering into the
advisory contract (``assets-under-management test'') or if the adviser
reasonably believed the client had a net worth of more than $1 million
at the time the contract was entered into (``net worth test''). The
Commission stated that these standards would limit the availability of
the exemption to clients who are financially experienced and able to
bear the risks of performance fee arrangements.\6\
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\5\ Exemption To Allow Registered Investment Advisers to Charge
Fees Based Upon a Share of Capital Gains Upon or Capital
Appreciation of a Client's Account, Investment Advisers Act Release
No. 996 (Nov. 14, 1985) [50 FR 48556 (Nov. 26, 1985)] (``1985
Adopting Release''). The exemption applies to the entrance into,
performance, renewal, and extension of advisory contracts. See rule
205-3(a).
\6\ See 1985 Adopting Release, supra note 5, at Sections I.C and
II.B. The rule also imposed other conditions, including specific
disclosure requirements and restrictions on calculation of
performance fees. See id. at Sections II.C-E.
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In 1998, the Commission amended rule 205-3 to, among other things,
change the dollar amounts of the assets-under-management test and net
worth test to adjust for the effects of inflation since 1985.\7\ The
Commission revised the former from $500,000 to $750,000, and the latter
from $1 million to $1.5 million.\8\
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\7\ See Exemption To Allow Investment Advisers To Charge Fees
Based Upon a Share of Capital Gains Upon or Capital Appreciation of
a Client's Account, Investment Advisers Act Release No. 1731 (July
15, 1998) [63 FR 39022 (July 21, 1998)] (``1998 Adopting Release'').
\8\ See id. at Section II.B.1.
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The Dodd-Frank Wall Street Reform and Consumer Protection Act
(``Dodd-Frank Act'') \9\ amended section 205(e) of the Advisers Act to
require that the Commission adjust for inflation the dollar amount
thresholds in rules under the section, rounded to the nearest
$100,000.\10\ Separately, the Dodd-Frank Act also required that we
adjust the net worth standard for an ``accredited investor'' in rules
under the Securities Act of 1933 (``Securities Act''),\11\ such as
Regulation D,\12\ to exclude the value of a person's primary
residence.\13\
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\9\ Public Law 111-203, 124 Stat. 1376 (2010).
\10\ See section 418 of the Dodd-Frank Act (requiring the
Commission to issue an order every five years revising dollar amount
thresholds in a rule that exempts a person or transaction from
section 205(a)(1) of the Advisers Act if the dollar amount threshold
was a factor in the Commission's determination that the persons do
not need the protections of that section).
\11\ 15 U.S.C. 77a-77z-3.
\12\ See 17 CFR 230.501-.508.
\13\ See section 413(a) of the Dodd-Frank Act.
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In May 2011, the Commission published a notice of intent to issue
an order revising the dollar amount thresholds of the assets-under-
management and the net worth tests of rule 205-3 to account for the
effects of inflation.\14\ Our release (``Proposing Release'') also
proposed to amend the rule itself to reflect any inflation adjustments
to the dollar amount thresholds that we might issue by order.\15\ In
addition, our proposed amendments (i) stated that the Commission would
issue an order every five years adjusting for inflation the dollar
amount thresholds, (ii) excluded the value of a person's primary
residence from the test of whether a person has sufficient net worth to
be considered a ``qualified client,'' and (iii) modified certain
transition provisions of the rule.
---------------------------------------------------------------------------
\14\ See Investment Adviser Performance Compensation, Investment
Advisers Act Release No. 3198 (May 10, 2011) [76 FR 27959 (May 13,
2011)] (``Proposing Release''). Rule 205-3 is the only exemptive
rule issued under section 205(e) of the Advisers Act that includes
dollar amount tests, which are the assets-under-management and net
worth tests. See supra text accompanying note 10.
\15\ Id.
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On July 12, 2011, we issued an order revising the threshold of the
assets-under-management test to $1 million,
[[Page 10360]]
and of the net worth test to $2 million.\16\ We received approximately
50 comments on our proposed rule amendments.\17\ Today we are adopting
amendments to rule 205-3 largely as we proposed them, with
modifications to address issues raised by commenters, as discussed
further below.
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\16\ See Order Approving Adjustment for Inflation of the Dollar
Amount Tests in Rule 205-3 under the Investment Advisers Act of
1940, Investment Advisers Act Release No. 3236 (July 12, 2011) [76
FR 41838 (July 15, 2011)] (``Order''). The Order is effective as of
September 19, 2011. Id. The order applies to contractual
relationships entered into on or after the effective date, and does
not apply retroactively to contractual relationships previously in
existence.
\17\ The comment letters we received on the Proposing Release
are available on our Web site at https://www.sec.gov/comments/s7-17-11/s71711.shtml.
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II. Discussion
A. Inflation Adjustment of Dollar Amount Thresholds
We are amending rule 205-3 in three ways to carry out the required
inflation adjustment of the dollar amount thresholds of the rule.
First, we are revising the dollar amount thresholds that currently
apply to investment advisers, to codify the order we issued on July 12,
2011. As amended, paragraph (d) of rule 205-3 provides that the assets-
under-management threshold is $1 million and that the net worth
threshold is $2 million, which are the revised amounts we issued by
order.\18\ Although some commenters objected to raising these dollar
amount thresholds,\19\ section 205(e) of the Advisers Act requires that
we adjust the amounts for inflation.\20\
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\18\ The calculation used to determine the revised dollar
amounts in the tests is described below. See infra note 25. As we
noted in the Proposing Release, an investment adviser can include in
determining the amount of assets under management the assets that a
client is contractually obligated to invest in private funds managed
by the adviser. Only bona fide contractual commitments may be
included, i.e., those that the adviser has a reasonable belief that
the investor will be able to meet. See Proposing Release, supra note
15, at n.17.
\19\ Some commenters maintained, for example, that raising the
dollar amount thresholds would limit the investment options for
those investors that fall below the new thresholds, and would harm
smaller funds that rely on investments from investors with more
limited resources to operate. See, e.g., Comment Letter of Crescat
Portfolio Management LLC (May 11, 2011) (``Crescat Portfolio Comment
Letter''); Comment Letter of Hyonmyong Cho (June 8, 2011) (``H. Cho
Comment Letter''); Comment Letter of Harold Clyde (June 4, 2011)
(``H. Clyde Comment Letter''); Comment Letter of Douglas Estadt
(June 7, 2011) (``D. Estadt Comment Letter''). Other commenters
supported raising the dollar amount thresholds, noting that this
change would ensure that the ``qualified client'' standard is
limited to clients who are financially experienced and able to bear
the risks of performance fee arrangements. See, e.g., Comment Letter
of Better Markets, Inc. (July 11, 2011) (``Better Markets Comment
Letter''); Comment Letter of Certified Financial Planner Board of
Standards, Inc. (July 11, 2011) (``CFP Board Comment Letter'');
Comment Letter of Managed Funds Association (July 8, 2011) (``MFA
Comment Letter''); Comment Letter of North American Securities
Administrators Association, Inc. (July 11, 2011) (``NASAA Comment
Letter'').
\20\ See supra note 10.
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Second, we are adding to rule 205-3, as proposed, a new paragraph
(e) that states that the Commission will issue an order every five
years adjusting for inflation the dollar amount thresholds of the
assets-under-management and net worth tests of the rule.\21\ These
periodic adjustments are required by the Advisers Act,\22\ and most
commenters supported this amendment to the rule.\23\
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\21\ Rule 205-3(e) provides that the Commission will issue an
order on or about May 1, 2016 and approximately every five years
thereafter adjusting the assets-under-management and net worth tests
for the effects of inflation. These adjusted amounts will apply to
contractual relationships entered into on or after the effective
date of the order, and will not apply retroactively to contractual
relationships previously in existence. See supra note 16. The
proposed rule would have stated that the Commission's order would be
effective on or about May 1. We have deleted the word ``effective''
in the final rule to reflect the fact that the effective date will
likely be later than May 1. See Order, supra note 16 (setting
effective date of the order approximately 60 days after the order's
issuance).
\22\ See supra note 10.
\23\ See Comment Letter of Chris Barnard (May 31, 2011) (``C.
Barnard Comment Letter''); Better Markets Comment Letter; CFP Board
Comment Letter; Comment Letter of Investment Adviser Association
(July 11, 2011) (``IAA Comment Letter''); MFA Comment Letter. One
commenter stated that the dollar amount tests should be reevaluated
more frequently. See NASAA Comment Letter.
---------------------------------------------------------------------------
Amended rule 205-3(e) also specifies the price index on which
future inflation adjustments will be based.\24\ The index is the
Personal Consumption Expenditures Chain-Type Price Index (``PCE
Index''),\25\ which is published by the Department of Commerce.\26\ The
dollar amount tests we adopted in 1998 will be the baseline for future
calculations.\27\ As we noted in the Proposing Release, the use of the
PCE Index is appropriate because it is an indicator of inflation in the
personal sector of the U.S. economy \28\ and is used in other
provisions of the federal securities laws.\29\ Commenters agreed that
the PCE Index is an appropriate indicator of inflation \30\ and that
the 1998 dollar amounts are the proper baseline for future inflation
adjustments.\31\
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\24\ See rule 205-3(e)(1).
\25\ The revised dollar amounts in the tests reflect inflation
as of the end of 2010, and are rounded to the nearest $100,000 as
required by section 418 of the Dodd-Frank Act. The 2010 PCE Index is
111.112, and the 1997 PCE Index is 85.433. These values are slightly
different from those provided in the Proposing Release because of
periodic adjustments issued by the Department of Commerce. See
Proposing Release, supra note 15, at n.19; see also infra note 26.
Assets-under-management test calculation to adjust for the effects
of inflation: 111.112/85.433 x $750,000 = $975,431; $975,431 rounded
to the nearest multiple of $100,000 = $1 million. Net worth test
calculation to adjust for the effects of inflation: 111.112/85.433 x
$1.5 million = $1,950,862; $1,950,862 rounded to the nearest
multiple of $100,000 = $2 million.
\26\ The values of the PCE Index are available from the Bureau
of Economic Analysis, a bureau of the Department of Commerce. See
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.
\27\ Rule 205-3(e) provides that the assets-under-management and
net worth tests will be adjusted for inflation by (i) dividing the
year-end value of the PCE Index for the calendar year preceding the
calendar year in which the order is being issued, by the year-end
value of the PCE Index for the calendar year 1997, (ii) multiplying
the threshold amounts adopted in 1998 ($750,000 and $1.5 million) by
that quotient, and (iii) rounding each product to the nearest
multiple of $100,000. For example, for the order the Commission
would issue in 2016, the Commission would (i) divide the year-end
2015 PCE Index by the year-end 1997 PCE Index, (ii) multiply the
quotient by $750,000 and $1.5 million, and (iii) round each of the
two products to the nearest $100,000.
\28\ See Clinton P. McCully, Brian C. Moyer, and Kenneth J.
Stewart, ``Comparing the Consumer Price Index and the Personal
Consumption Expenditures Price Index,'' Survey of Current Business
(Nov. 2007) at 26 n.1 (available at https://www.bea.gov/scb/pdf/2007/11%20november/1107_cpipce.pdf) (PCE Index measures changes in
``prices paid for goods and services by the personal sector in the
U.S. national income and product accounts'' and is primarily used
for macroeconomic analysis and forecasting). See also Federal
Reserve Board, Monetary Policy Report to the Congress (Feb. 17,
2000) at n.1 (available at 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).
\29\ See Proposing Release, supra note 15, at n.22 and
accompanying text.
\30\ See Better Markets Comment Letter; IAA Comment Letter;
Comment Letter of Georg Merkl (July 11, 2011) (``G. Merkl Comment
Letter''). Although two commenters asserted that inflation is not
the proper unit of measure by which to adjust net worth
requirements, see Comment Letter of David Hale (May 20, 2011) and
Comment Letter of Joseph V. Delaney (undated) (``J. Delaney Comment
Letter''), section 205(e) of the Advisers Act requires that we
adjust the dollar amount thresholds of rule 205-3 for inflation.
\31\ See C. Barnard Comment Letter; G. Merkl Comment Letter.
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B. Exclusion of the Value of Primary Residence From Net Worth
Determination
We also are amending the net worth test in the definition of
``qualified client'' in rule 205-3 to exclude the value of a natural
person's primary residence and certain debt secured by the
property.\32\ This change, although not required by the Dodd-Frank Act,
is similar to the change that Act requires the Commission to make to
rules under
[[Page 10361]]
the Securities Act, such as Regulation D.\33\
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\32\ Rule 205-3(d)(1)(ii)(A).
\33\ See section 413(a) of the Dodd-Frank Act (requiring the
Commission to adjust any net worth standard for an ``accredited
investor'' as set forth in Commission rules under the Securities Act
to exclude the value of a natural person's primary residence). The
Dodd-Frank Act does not require that the net worth standard for an
accredited investor be adjusted periodically for the effects of
inflation, although it does require the Commission at least every
four years to ``undertake a review of the definition, in its
entirety, of the term `accredited investor' * * * [as defined in
Commission rules] as such term applies to natural persons, to
determine whether the requirements of the definition should be
adjusted or modified for the protection of investors, in the public
interest, and in light of the economy.'' See section 413(b)(2)(A) of
the Dodd-Frank Act. In January 2011, we proposed rule amendments to
adjust the net worth standards for accredited investors in our rules
under the Securities Act. See Net Worth Standard for Accredited
Investors, Securities Act Release No. 9177 (Jan. 25, 2011) [76 FR
5307 (Jan. 31, 2011)] (``Accredited Investor Proposing Release'').
We recently adopted those amendments substantially as proposed. See
Net Worth Standard for Accredited Investors, Securities Act Release
No. 9287 (Dec. 21, 2011) [76 FR 81793 (Dec. 29, 2011)] (``Accredited
Investor Adopting Release'').
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We proposed to exclude the value of a person's primary residence
and the debt secured by the residence, up to the fair market value of
the residence, from the calculation of a person's net worth.\34\ A
number of commenters supported the proposed exclusion.\35\ Many agreed
with our statement in the Proposing Release that the value of an
individual's residence may have little relevance to the person's
financial experience and ability to bear the risks of performance fee
arrangements.\36\ The Certified Financial Planner Board of Standards
noted in its comment letter that the value of an individual's equity in
a residence is more likely to be a function of the length of time that
the investor has owned the home, than to be a function of the
investor's experience or sophistication. Commenters also stated that
excluding the value of the residence would promote regulatory
consistency because it parallels the treatment of a person's primary
residence in determinations of net worth under other securities
rules.\37\
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\34\ See Proposing Release, supra note 15, at n.28 and
accompanying text.
\35\ See, e.g., C. Barnard Comment Letter; CFP Board Comment
Letter; MFA Comment Letter; NASAA Comment Letter.
\36\ See, e.g., C. Barnard Comment Letter; CFP Board Comment
Letter; NASAA Comment Letter.
\37\ See, e.g., Better Markets Comment Letter; CFP Board Comment
Letter; NASAA Comment Letter.
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Many commenters objected to the exclusion of the value of a
person's primary residence from the calculation of net worth.
Commenters expressed concern that the exclusion would limit the
investment options of less wealthy investors and restrict their access
to advisory arrangements that include performance fees.\38\ Some argued
that excluding the value of a residence would harm advisers to smaller
funds that rely on investments from less wealthy investors.\39\ Others
argued that home ownership, compared to home rental, may in fact
evidence greater rather than less financial experience on the part of
individuals.\40\
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\38\ See, e.g., Comment Letter of Matthew Gee (June 14, 2011);
Comment Letter of Gunderson Dettmer Stough Villeneuve Franklin
Hachigan LLP (July 8, 2011) (``Gunderson Dettmer Comment Letter'');
Comment Letter of Alvin Suvil (July 17, 2011) (``A. Suvil Comment
Letter'').
\39\ See, e.g., Comment Letter of Roger Alsop (June 16, 2011)
(``R. Alsop Comment Letter''); J. Delaney Comment Letter; Comment
Letter of Molly Huntsman (June 23, 2011) (``M. Huntsman Comment
Letter''); Comment Letter of Greg Thornton (June 2, 2011); Comment
Letter of Greg J. Wimmer (June 3, 2011).
\40\ See M. Gee Comment Letter; Comment Letter of Douglas Wood
(June 13, 2011) (``D. Wood Comment Letter''). Some commenters
appeared to object to excluding residence from net worth on public
policy grounds because the exclusion would discourage home
ownership. See, e.g., Comment Letter of Ron Cuningham (June 25,
2011) (``R. Cuningham Comment Letter''); D. Wood Comment Letter.
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We continue to believe that the value of a person's residence
generally has little relevance to the individual's financial experience
and ability to bear the risks of performance fee arrangements, and
therefore little relevance to the individual's need for the Act's
protections from performance fee arrangements.\41\ Although the process
of purchasing and financing a home can contribute to an individual's
financial experience, the value of the individual's equity interest in
the residence reflects the prevailing market values at the time and can
be a function of time in paying down the associated debt rather than a
function of deliberate investment decision-making. In addition, because
of the generally illiquid nature of residential assets, the value of an
individual's home equity may not help the investor to bear the risks of
loss that are inherent in performance fee arrangements.
---------------------------------------------------------------------------
\41\ For example, an individual who meets the net worth test
only by including the value of his primary residence in the
calculation is unlikely to be as able to bear the risks of
performance fee arrangements as an individual who meets the test
without including the value of her primary residence. We stated in
2006, when we proposed a minimum net worth threshold for
establishing when an individual could invest in hedge funds pursuant
to the safe harbor of Regulation D, that the value of an
individual's personal residence may bear little or no relationship
to that person's knowledge and financial sophistication. See
Prohibition of Fraud by Advisers to Certain Pooled Investment
Vehicles; Accredited Investors in Certain Private Investment
Vehicles, Investment Advisers Act Release No. 2576 (Dec. 27, 2006)
[72 FR 400 (Jan. 4, 2007)] at Section III.B.3.
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Our exclusion of the value of a person's primary residence from the
net worth calculation under the rule is similar to the approach that
the Commission has taken in other rules to determine the financial
qualifications of investors. For example, the Commission excluded the
value of a person's primary residence and associated liabilities from
the determination of whether a person is a ``high net worth customer''
in Regulation R under the Securities Exchange Act of 1934.\42\ The
Commission also excluded the value of a residence from the
determination of whether an individual has sufficient investments to be
considered a ``qualified purchaser'' under the Investment Company Act
of 1940 (``Investment Company Act'') who can invest in certain private
funds that are not registered under that Act.\43\ As discussed above,
this approach is also reflected in the Commission's recent amendments
to the definition of ``accredited investor'' in rules under the
Securities Act, including Regulation D, as required by the Dodd-Frank
Act.\44\
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\42\ See, e.g., Definition of Terms and Exemptions Relating to
the ``Broker'' Exceptions for Banks, Securities Exchange Act Release
No. 56501 (Sept. 24, 2007) [72 FR 56514 (Oct. 3, 2007)] at Section
II.C.1 (excluding primary residence and associated liabilities from
the fixed-dollar threshold for ``high net worth customers'' under
Rule 701 of Regulation R, which permits a bank to pay an employee
certain fees for the referral of a high net worth customer or
institutional customer to a broker-dealer without requiring
registration of the bank as a broker-dealer).
\43\ Section 3(c)(7) of the Investment Company Act provides an
exclusion from the definition of ``investment company'' for any
``issuer, the outstanding securities of which are owned exclusively
by persons who, at the time of acquisition of such securities, are
qualified purchasers, and which is not making and does not at that
time propose to make a public offering of such securities.'' A
``qualified purchaser'' under section 2(a)(51) of the Investment
Company Act [15 U.S.C. 80a-2(a)(51)] includes, among others, any
natural person who owns not less than $5 million in investments, as
defined by the Commission. Rule 2a51-1 under the Investment Company
Act includes within the meaning of ``investments'' real estate held
for investment purposes. 17 CFR 270.2a51-1(b)(2). A personal
residence is not considered an investment under rule 2a51-1,
although residential property may be treated as an investment if it
is not treated as a residence for tax purposes. See Privately
Offered Investment Companies, Investment Company Act Release No.
22597 (Apr. 3, 1997) [62 FR 17512 (Apr. 9, 1997)] at text
accompanying and following n.48.
\44\ See supra note 33 and accompanying text.
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Some commenters voiced particular concern about the exclusion of
the residential value at the same time that we adjust the dollar amount
thresholds for inflation, and argued that the two changes together
could cause too much change at one time.\45\ We note that we revised
the dollar amount threshold of the net worth test last July and that
the
[[Page 10362]]
revision was effective in September. Our current amendment of the net
worth test to exclude the value of a residence, which will be effective
in May 2012, will be effective approximately eight months after the
previous change to the net worth test. Any further revisions of the
dollar amount thresholds of rule 205-3 to adjust for inflation are not
scheduled to occur until 2016.\46\
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\45\ See, e.g., R. Alsop Comment Letter; R. Cuningham Comment
Letter; M. Huntsman Comment Letter; A. Suvil Comment Letter.
\46\ See rule 205-3(e).
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Some of the commenters who disagreed with the proposal to raise the
dollar amount threshold of the net worth standard or to exclude the
value of a residence from net worth, also disagreed that a person's net
worth should be used as a measure of eligibility for the exemption from
the performance fee restrictions.\47\ These commenters did not
recommend an alternative standard that is objective and verifiable, and
that would effectively distinguish between those investors who do, and
those who do not, need the protections of the Act's performance fee
restrictions.\48\
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\47\ See, e.g., J. Delaney Comment Letter; Comment Letter of
David Hale (May 20, 2011); Comment Letter of Tom Irvin (May 18,
2011).
\48\ One commenter suggested that a ``qualified client'' include
an individual with a bachelor's degree in a finance-related major or
a master's degree in any area from an accredited U.S. university.
See Comment Letter of Troy Clark (June 23, 2011). Although the
suggested finance-related major requirement would help to determine
whether an individual is financially knowledgeable, the suggested
master's degree requirement would not, and neither requirement would
establish whether an investor has sufficient practical experience in
making investment decisions or is capable of bearing the risks of
loss associated with performance fee arrangements.
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Our amendment of the net worth standard of rule 205-3 differs from
the proposed amendment in one respect. The approach we are adopting
today will generally require any increase in the amount of debt secured
by the primary residence in the 60 days before the advisory contract is
entered into to be included as a liability. As discussed below, this
change will prevent debt that is incurred shortly before entry into an
advisory contract from being excluded from the calculation of net worth
merely because it is secured by the individual's home.
As proposed, the amended rule would have excluded the value of a
person's primary residence and the amount of all debt secured by the
property that is no greater than the property's current market
value.\49\ The proposed treatment of debt secured by the primary
residence was the same as we proposed for the calculation of net worth
for accredited investors in our rules under the Securities Act.\50\
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\49\ Proposed rule 205-3(d)(1)(ii)(A).
\50\ See Accredited Investor Proposing Release, supra note 33,
at text preceding n.28. One commenter recommended that all debt
secured by the residence (not just debt up to the fair market value
of the residence) be excluded from the net worth calculation. See G.
Merkl Comment Letter. The commenter argued that excluding the debt
secured by the residence up to the fair market value of the
residence would require an investor to obtain a valuation of the
residence from a real estate agent, which would be burdensome and
costly. We note that the rule requires an estimate of the fair
market value, but does not require a third party opinion on
valuation for the primary residence. Furthermore, many online
services provide residence valuations at no charge. In addition, if
the amount of mortgage debt exceeds the value of the primary
residence, excluding the entire debt would result in a higher net
worth than under a conventional calculation that takes into account
all assets and all liabilities. The commenter also acknowledged
that, although he disagreed with the net worth test as a measure of
financial sophistication, for purposes of calculating residence-
related indebtedness a ``close proximity between the time of taking
on new debt and entering into the advisory contract could work.''
Cf. rule 205-3(d)(1)(ii)(A)(2) (requiring that all residence-related
indebtedness incurred within 60 days before the advisory contract is
entered into, other than as a result of the acquisition of the
primary residence, be subtracted from a client's net worth for
purposes of determining whether the client is a ``qualified
client'').
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In the Proposing Release, we requested comment on whether the
amendments to the rule should contain a timing provision to prevent
investors from inflating their net worth by borrowing against their
homes, effectively converting their home equity--which is excluded from
the net worth calculation under the amendments adopted today--into cash
or other assets that would be included in the net worth
calculation.\51\ In particular, we indicated that the amendments could
provide that the net worth calculation must be made as of a date 30,
60, or 90 days prior to entry into the investment advisory
contract.\52\ This request for comment was similar to the one we made
when we proposed amendments to the net worth standard in rules under
the Securities Act, including Regulation D.\53\
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\51\ See Proposing Release, supra note 15, at Section II.B.2.
\52\ Id. Two commenters stated that the net worth calculation
should not be required to be made on a specified date prior to the
day the advisory contract is entered into. See C. Barnard Comment
Letter; G. Merkl Comment Letter. Another commenter stated that the
net worth calculation should be required to be made on a specified
date prior to the day the advisory contract is entered into to
assist in protecting against refinancing transactions intended
solely to inflate net worth. See NASAA Comment Letter.
\53\ See Accredited Investor Proposing Release, supra note 33,
at Specific Request for Comment Number 7 in Section II.A.
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As in the recently adopted accredited investor rule amendments
adjusting the net worth standard,\54\ the rule amendments to the
qualified client net worth standard include a specific provision
addressing the treatment of incremental debt secured by the primary
residence that is incurred in the 60 days before the advisory contract
is entered into.\55\ Debt secured by the primary residence generally
will not be included as a liability in the net worth calculation under
the rule, except to the extent it exceeds the estimated value of the
primary residence. Under the final rule amendments, however, any
increase in the amount of debt secured by the primary residence in the
60 days before the advisory contract is entered into generally will be
included as a liability, even if the estimated value of the primary
residence exceeds the aggregate amount of debt secured by such primary
residence.\56\ Net worth will be calculated only once, at the time the
advisory contract is entered into. The individual's primary residence
will be excluded from assets and any indebtedness secured by the
primary residence, up to the estimated value of the primary residence
at that time, will be excluded from liabilities, except if there is
incremental debt secured by the primary residence incurred in the 60
days before the advisory contract is entered into. If any such
incremental debt is incurred, net worth will be reduced by the amount
of the incremental debt. In other words, the 60-day look-back provision
requires investors to identify any increase in mortgage debt over the
60-day period prior to entering into an advisory contract and count
that debt as a liability in calculating net worth.
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\54\ See Accredited Investor Adopting Release, supra note 33, at
text following n.34.
\55\ See rule 205-3(d)(1)(ii)(A)(2).
\56\ The fair market value of the primary residence is
determined as of the time the advisory contract is entered into,
even if the investor has changed his or her primary residence during
the 60-day period. The rule provides an exception to the 60-day
look-back provision for increases in debt secured by a primary
residence where the debt results from the acquisition of the primary
residence. Without this exception, an individual who acquires a new
primary residence in the 60-day period before the advisory contract
is entered into may have to include the full amount of the mortgage
incurred in connection with the purchase of the primary residence as
a liability, while excluding the full value of the primary
residence, in a net worth calculation. The 60-day look-back
provision is intended to address incremental debt secured against a
primary residence that is incurred for the purpose of circumventing
the net worth standard of the rule. It is not intended to address
debt secured by a primary residence that is incurred in connection
with the acquisition of a primary residence within the 60-day
period.
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This approach should significantly reduce the incentive for persons
to induce potential clients to take on incremental debt secured against
their homes to facilitate a near-term investment. We believe a 60-day
look-
[[Page 10363]]
back period is long enough to decrease the likelihood of circumvention
of the standard by taking on new debt and waiting for the look-back
period to expire. The 60-day period also is designed to be short enough
to accommodate investors who may have increased their mortgage debt in
the ordinary course at some point prior to entering into an advisory
contract.
Another alternative to address the possibility of parties
attempting to circumvent the standard would have been to provide that
any debt secured by the primary residence that was incurred after the
original purchase date of the primary residence would have been counted
as a liability, whether or not the fair market value of the primary
residence exceeded the value of the total amount of debt secured by the
primary residence. We believe that such a standard would be overly
restrictive and not provide for ordinary course changes to debt secured
by a primary residence, such as refinancing and drawings on home equity
lines. We believe that the approach we are adopting here will protect
investors by addressing circumstances in which they may have been
induced to incur new debt secured by the primary residence for the
purpose of inflating net worth under the rule, while still permitting
ordinary course changes to debt secured by the primary residence. This
approach is similar to the approach the Commission recently adopted for
accredited investor rule amendments adjusting the net worth standard,
and it responds to commenters who urged the Commission to promote
regulatory consistency in the treatment of primary residences in other
similar contexts in order to promote fairness, facilitate enforcement,
and provide clarity for both industry and regulators.\57\
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\57\ See Accredited Investor Adopting Release, supra note 33, at
text following n.46; see, e.g., Better Markets Comment Letter; NASAA
Comment Letter.
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C. Transition Provisions
We proposed two new transition provisions that would allow an
investment adviser and its clients to maintain existing performance fee
arrangements that were permissible when the advisory contract was
entered into, even if the performance fees would not be permissible
under the contract if it were entered into at a later date. We are
adopting the two transition rules substantially as proposed, which
commenters supported.\58\ At the suggestion of one commenter we also
are adopting an additional transition provision to address certain
transfers of interest, as discussed below.\59\ The amendments replace
the current transition rules section of rule 205-3.
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\58\ Rule 205-3(c)(1); rule 205-3(c)(2). See, e.g., C. Barnard
Comment Letter; Gunderson Dettmer Comment Letter; M. Huntsman
Comment Letter; IAA Comment Letter; MFA Comment Letter.
\59\ See rule 205-3(c)(3).
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Paragraphs (1) and (2) of rule 205-3(c) are designed so that
restrictions on performance fees apply only to new contractual
arrangements and do not apply to new investments by clients (including
equity owners of ``private investment companies'') who met the
definition of ``qualified client'' when they entered into the advisory
contract, even if they subsequently do not meet the dollar amount
thresholds of the rule.\60\ This approach minimizes the disruption of
existing contractual relationships that met applicable requirements
under the rule at the time the parties entered into them.
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\60\ A ``private investment company'' is a company that is
excluded from the definition of an ``investment company'' under the
Investment Company Act by reason of section 3(c)(1) of that Act.
Rule 205-3(d)(3). Under rule 205-3(b), the equity owner of a private
investment company, or of a registered investment company or
business development company, is considered a client of the adviser
for purposes of rule 205-3(a). We adopted this provision in 1998,
and the provision was not affected by our subsequent rule amendments
and related litigation concerning the registration of certain hedge
fund advisers. See 1998 Adopting Release, supra note 7; Goldstein v.
Securities and Exchange Commission, 451 F.3d 873 (DC Cir. 2006).
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Rule 205-3(c)(1)\61\ provides that, if a registered investment
adviser entered into a contract and satisfied the conditions of the
rule that were in effect when the contract was entered into, the
adviser will be considered to satisfy the conditions of the rule.\62\
If, however, a natural person or company that was not a party to the
contract becomes a party, the conditions of the rule in effect at the
time they become a party will apply to that person or company. This
provision means, for example, that if an individual met the $1.5
million net worth test in effect before the effective date of our 2011
order and entered into an advisory contract with a registered
investment adviser before that date, the client could continue to
maintain assets (and invest additional assets) with the adviser under
that contract even though the net worth test was subsequently raised to
$2 million and he or she no longer met the new test. If, however,
another person becomes a party to that contract, the current net worth
threshold will apply to the new party when he or she becomes a party to
the contract.\63\
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\61\ Rule 205-3(c)(1), as amended, modifies the existing
transition rule in rule 205-3(c)(1), which permits advisers and
their clients that entered into a contract before August 20, 1998,
and satisfied the eligibility criteria in effect on the date the
contract was entered into, to maintain their existing performance
fee arrangements.
\62\ One commenter supported the provisions allowing advisers to
continue to provide advisory services under performance fee
arrangements that were permitted at the time the contract was
entered into but stated that the rule should prohibit an adviser
from charging performance fees to investors that are not qualified
clients with respect to money committed after the effective date for
the rule amendments. See G. Merkl Comment Letter. We believe such an
approach would be unnecessarily disruptive to advisory
relationships.
\63\ Rule 205-3(c)(1). Similarly, a person who invests in a
private investment company advised by a registered investment
adviser must satisfy the rule's conditions when he or she becomes an
investor in the company. See rule 205-3(b) (equity owner of a
private investment company is considered a client of a registered
investment adviser for purposes of rule 205-3(a)).
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Rule 205-3(c)(2) provides that, if a registered investment adviser
previously was not required to register with the Commission pursuant to
section 203 of the Act and did not register, section 205(a)(1) of the
Act will not apply to the contractual arrangements into which the
registered adviser entered when it was not registered with the
Commission.\64\ This means, for example, that if an investment adviser
to a private investment company with 50 individual investors was exempt
from registration with the Commission in 2009, but then subsequently
registered with the Commission because it was no longer exempt from
registration or because it chose voluntarily to register, section
205(a)(1) will not apply to the contractual arrangements the adviser
entered into before it registered, including the accounts of the 50
individual investors with the private investment company and any
additional investments they make in that company. If, however, any
other individuals
[[Page 10364]]
become new investors in the private investment company or if the
original investors became investors in a different private investment
company managed by the adviser after the adviser registers with the
Commission, section 205(a)(1) will apply to the adviser's relationship
with the investors with regard to their new investments.\65\
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\64\ Section 205(a)(1) will apply, however, to contractual
arrangements into which the adviser enters after it is required to
register with the Commission. See rule 205-3(c)(2). The approach of
subsection (c)(2) is similar to the transition provisions we adopted
for the registration of investment advisers to private funds. See
Registration Under the Advisers Act of Certain Hedge Fund Advisers,
Investment Advisers Act Release No. 2333 (Dec. 2, 2004) [69 FR 72054
(Dec. 10, 2004)]. We are adopting the subsection substantially as
proposed, but have made minor changes to clarify that the transition
provision applies only to contractual arrangements with advisers
that were not required to register and did not register with the
Commission. Our proposed subsection would have applied to
contractual arrangements with any registered investment adviser that
previously was ``exempt'' from the requirement to register with the
Commission. The revised language clarifies that the transition
provision applies to contractual arrangements with advisers when
they were not required to register (even if they were not
``exempt''), and does not apply to contractual arrangements entered
into with advisers when they were registered (even if they were not
required to register). Investment advisers that previously
registered already are subject to section 205(a)(1) and rule 205-3,
and therefore would not need the transition relief of rule 205-
3(c)(2).
\65\ One commenter recommended that we revise the rule to
accommodate fund-of-funds purchases when the acquiring funds are
private investment companies. See MFA Comment Letter. The commenter
recommended that the rule ``clarify'' that an acquiring private
investment company is able to pay performance fees to the adviser of
an acquired private investment company even if some of the investors
in the acquiring private investment company are not qualified
clients at the time the investment is made in the acquired private
investment company. We are not making the suggested revision to the
final rule, because it would permit advisers to pool small client
accounts to circumvent the eligibility standards of rule 205-3(d)(1)
and would permit performance fee arrangements that currently are not
permissible under rule 205-3(b). As we stated in 1998, rule 205-3(b)
specifies that the requirement to look through to each investor of a
private investment company applies to each tier of a funds-of-funds
structure. See 1998 Adopting Release, supra note 7, at Section II.C.
(``Under [Rule 205-3(b)], each `tier' of such entities must be
examined in this manner. Thus, if a private investment company
seeking to enter into a performance fee contract (first tier
company) is owned by another private investment company (the second
tier company), the look through provision applies to the second (and
any other) level private investment company, and thus the adviser
must look to the ultimate client to determine whether the
arrangement satisfies the requirements of the rule.'').
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Finally, at the suggestion of one commenter, we have revised the
third paragraph of rule 205-3(c), to allow for limited transfers of
interests from a qualified client to a person that was not a party to
the contract and is not a qualified client at the time of the
transfer.\66\ The approach we are taking is similar to the approach we
adopted in rule 3c-6 under the Investment Company Act. Rule 3c-6
provides that, in the case of a transfer of ownership interest in a
private investment company by gift or bequest, or pursuant to an
agreement relating to a legal separation or divorce, the beneficial
owner of the interest will be considered to be the person who
transferred the interest.\67\ We believe that, when those types of
transfers occur, the transferee does not make a separate investment
decision to enter into an advisory contract with the adviser, but is
the recipient, perhaps involuntarily, of the benefits of a pre-existing
contractual relationship. Because of the circumstances of these
transfers, we believe the transferee is not of the type that needs the
protections of the performance fee restrictions. We are therefore
amending paragraph (3) of rule 205-3(c) to provide that, if an owner of
an interest in a private investment company transfers an interest by
gift or bequest, or pursuant to an agreement related to a legal
separation or divorce, the transfer will not cause the transferee to
``become a party'' to the contract and will not cause section 205(a)(1)
of the Act to apply to such transferee. Thus, transfers in these
circumstances will not cause the transferee to have to meet the
definition of a qualified client under rule 205-3.\68\
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\66\ See Gunderson Dettmer Comment Letter.
\67\ See rule 3c-6(b) under the Investment Company Act [17 CFR
270.3c-6(b)].
\68\ A gift transfer, however, would need to be a bona fide gift
and could not be used as a means to avoid the protections of section
205 of the Act, for example by transferring an interest in a private
fund supposedly as a gift but in reality in exchange for payment.
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D. Effective Date
The rule amendments we are adopting today will be effective on May
22, 2012. In addition, in order to minimize the disruption of
contractual relationships that met applicable requirements at the time
the parties entered into them, the Commission will not object if
advisers rely or relied upon the amended transition provisions of rule
205-3(c) before that date.\69\
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\69\ As discussed above, some advisers may have entered into
contractual relationships with clients who met the requirements of
the rule at the time the parties entered into them, but who no
longer meet the requirements of the amended rule. See supra Section
II.C. For example, some registered investment advisers may have
entered into advisory contracts with clients who met the $1.5
million net worth test when that test was applicable, but who would
not meet the $2 million net worth test of the revised rule.
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III. Cost-Benefit Analysis
The Commission is sensitive to the costs and benefits imposed by
its rules. In the Proposing Release, we analyzed the costs and benefits
of the proposed rules and sought comment on all aspects of the cost-
benefit analysis, including identification and assessment of any costs
and benefits not discussed in the analysis. Only two commenters
addressed the cost-benefit analysis.\70\ These commenters focused on
the costs of the rule but did not provide any empirical data.
---------------------------------------------------------------------------
\70\ See Comment Letter of Phillip Goldstein (May 24, 2011)
(``P. Goldstein Comment Letter''); G. Merkl Comment Letter.
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As stated above, section 205(a)(1) of the Advisers Act generally
restricts an investment adviser from entering into an advisory contract
that provides for performance-based compensation.\71\ Congress
restricted performance compensation arrangements to protect advisory
clients from arrangements it believed might encourage advisers to take
undue risks with client funds to increase advisory fees.\72\ Congress
subsequently authorized the Commission in section 205(e) of the
Advisers Act to exempt any advisory contract from the performance fee
restrictions if the contract is with persons that the Commission
determines do not need the protections of those restrictions. Section
205(e) provides that the Commission may determine that persons do not
need the protections of section 205(a)(1) on the basis of such factors
as ``financial sophistication, net worth, knowledge of and experience
in financial matters, amount of assets under management, relationship
with a registered investment adviser, and such other factors as the
Commission determines are consistent with [section 205].''
---------------------------------------------------------------------------
\71\ See supra Section I.
\72\ Id.
---------------------------------------------------------------------------
The Commission adopted rule 205-3 to exempt an investment adviser
from the restrictions against charging a client performance fees where
a client has a specified net worth or amount of assets under
management. Section 418 of the Dodd-Frank Act amended section 205(e) to
require that the Commission adjust for inflation the dollar amount
thresholds in rules promulgated under section 205(e) within one year of
enactment of the Dodd-Frank Act and every five years thereafter.
Generally an inflation adjustment is designed to help make the dollar
amount thresholds in a provision continue to serve the same purposes
over time. The amendments to rule 205-3 providing that the Commission
will issue orders every five years adjusting for inflation the dollar
amount thresholds of the rule will codify the Dodd-Frank Act's
amendment of section 205(e) of the Advisers Act that requires the
Commission to issue these orders.\73\ Also, pursuant to section 418's
requirements, the Commission issued an order in July 2011 revising the
threshold of the assets-under-management test to $1 million, and of the
net worth test to $2 million. The rule amendments will codify in the
rule the changes already made to the dollar amount thresholds in the
July 2011 Order, and will have no separate economic effect.
---------------------------------------------------------------------------
\73\ Section 418 of the Dodd-Frank Act.
---------------------------------------------------------------------------
As proposed, we are amending rule 205-3 to exclude the value of a
natural person's primary residence and certain debt secured by the
property from the determination of whether a person has sufficient net
worth to be considered a ``qualified client.'' We are also modifying
the transition provisions of the rule to take into account performance
fee arrangements that were permissible when they were entered
[[Page 10365]]
into. We analyze the costs and benefits of these provisions below.
A. Benefits
The exclusion of the value of an individual's primary residence
will benefit certain investors. As discussed above, the Act's
restrictions on performance fee arrangements are designed to protect
advisory clients from arrangements that encourage advisers to take
undue risks with client funds to increase advisory fees, while rule
205-3 is designed to permit clients who are financially experienced and
able to bear the risks of performance fee arrangements to enter into
those arrangements.\74\ We believe that the value of an individual's
primary residence may bear little or no relationship to that person's
financial experience or ability to bear the risks of performance fee
arrangements. The value of the individual's equity interest in the
residence reflects the prevailing market values at the time and can be
a function of time in paying down the associated debt rather than a
function of deliberate investment decision-making. In addition, because
of the generally illiquid nature of residential assets, the value of an
individual's home equity may not help the investor to bear the risks of
loss that are inherent in performance fee arrangements. Therefore, some
of the clients who do not meet the net worth test of rule 205-3 without
including the value of their primary residence may not possess the
financial experience or ability to bear the risks of performance fee
arrangements. We estimate that the exclusion of the value of an
individual's primary residence will result in up to 1.3 million
households that no longer qualify as ``qualified clients'' under the
revised net worth test and therefore will now be protected by the
performance fee restrictions in section 205 of the Advisers Act.\75\
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\74\ See supra notes 3 and 6.
\75\ See infra notes 79-81. As discussed above, the amendments
to rule 205-3 also exclude from the net worth test the amount of
debt secured by the primary residence that is no greater than the
property's current market value. The exclusion of the debt might
limit these benefits in some circumstances. For example, if a client
meets the net worth test as a result of the exclusion of debt
secured by the primary residence and the market value of the primary
residence were to decline to the extent that the debt could not be
satisfied by the sale of the residence, the client might be less
able to bear the risks related to the performance fee contract and
the investments that the adviser might make on behalf of the client.
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As discussed above, the exclusion of the value of an individual's
primary residence from the calculation of net worth under the rule is
similar to changes that Congress required the Commission to make to
rules under the Securities Act, including Regulation D.\76\ As we noted
when we recently adopted those rule amendments, section 413(a) of the
Dodd-Frank Act required us to adjust the ``accredited investor'' net
worth standards of certain rules under the Securities Act that apply to
individuals, by ``excluding the value of the primary residence.'' \77\
The amendment to rule 205-3 under the Advisers Act we are adopting
today, as some commenters argued, will promote regulatory consistency
in the treatment of primary residences between this rule and other
rules that the Commission has adopted that distinguish high net worth
individuals from less wealthy individuals.\78\
---------------------------------------------------------------------------
\76\ See supra note 33.
\77\ See Accredited Investor Adopting Release, supra note 33, at
n.18 and accompanying text.
\78\ See supra notes 42-44 and 57 and accompanying text.
---------------------------------------------------------------------------
The amendments to the rule's transition provisions will allow
advisory clients and investment advisers to avoid certain costs
resulting from the statutory mandate to adjust for inflation and the
Commission's resultant July 2011 Order. The amendments allow an
investment adviser and its clients to maintain existing performance fee
arrangements that were permissible when the advisory contract was
entered into, even if performance fees would not be permissible under
the contract if it were entered into at a later date. These transition
provisions are designed so that the restrictions on the charging of
performance fees apply to new contractual arrangements and do not apply
retroactively to existing contractual arrangements, including
investments in private investment companies. Otherwise, advisory
clients and investment advisers might have to terminate contractual
arrangements into which they previously entered and enter into new
arrangements, which could be costly to investors and advisers.
B. Costs
The amendments exclude the value of a person's primary residence
and generally exclude debt secured by the property (if no greater than
the current market value of the residence) from the calculation of a
person's net worth.\79\ Based on data from the Federal Reserve Board,
approximately 5.5 million households have a net worth of more than $2
million including the equity in the primary residence (i.e., value
minus debt secured by the property), and approximately 4.2 million
households have a net worth of more than $2 million excluding the
equity in the primary residence.\80\ Therefore, approximately 1.3
million households will not meet a $2 million net worth test under the
revised test, and will therefore not be considered ``qualified
clients,'' when the value of the primary residence is excluded from the
test.\81\ Excluding the value of the primary residence (and debt
secured by the property up to the current market value of the
residence) means that 1.3 million households that would have met the
net worth threshold if the value of the residence were included, as is
currently permitted, will no longer be ``qualified clients'' under the
revised net worth test and therefore will be unable to enter into
performance fee contracts unless they meet another test of rule 205-
3.\82\
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\79\ As discussed above, any increase in the amount of debt
secured by the primary residence in the 60 days before the
securities are purchased will be included in the net worth
calculation as a liability, regardless of the estimated value of the
residence. See supra Section II.B; rule 205-3(d)(1)(ii)(A)(2).
\80\ These figures are derived from the 2007 Federal Reserve
Board Survey of Consumer Finances. These figures represent the net
worth of households rather than individual persons who might be
clients. More information regarding the survey may be obtained at
https://www.federalreserve.gov/pubs/oss/oss2/scfindex.html.
\81\ Although some of these 1.3 million households may be
grandfathered by the transition provisions of the rule, we assume
for the purposes of our analysis that none of these households will
be grandfathered. This assumption may therefore result in an
overestimation of the costs of the rule amendments.
\82\ This estimate, as described in the Proposing Release, was
not premised on the notion that investors would borrow against the
equity in their primary residence shortly before the calculation of
net worth. See Proposing Release, supra note 15, at nn. 47-48 and
accompanying text. The 60-day look-back provision in rule 205-3 that
we are adopting today, because it reduces the incentives to incur
debt secured by residences in order to boost net worth under the
rule, strengthens the accuracy of our estimate. See supra notes 55-
57 and accompanying text.
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For purposes of this cost-benefit analysis, Commission staff
assumes that 25 percent of the 1.3 million households would have
entered into new advisory contracts that contained performance fee
arrangements after the compliance date of the amendments, and therefore
approximately 325,000 clients will not meet the revised net worth
test.\83\
[[Page 10366]]
Commission staff estimates that about 40 percent of those 325,000
potential clients (i.e., 130,000) will separately meet the ``qualified
client'' definition under the assets-under-management test, and
therefore will be able to enter into performance fee arrangements.\84\
The remaining 60 percent (195,000 households) will have access only to
those investment advisers (directly or through the private investment
companies they manage) that charge advisory fees other than performance
fees.\85\ Some of these investors may be negatively affected by their
inability to enter into performance-based compensation arrangements
with investment advisers (which arrangements in some ways align the
advisers' interests with the clients' interests). These investors also
may experience differences in their investment options and returns,
changes in advisory service, and the cost of being unable to enter into
advisory contracts with their preferred advisers. For purposes of this
cost-benefit analysis, Commission staff assumes that approximately 80
percent of the 195,000 households (i.e., 156,000 households) will enter
into non-performance fee arrangements, and that the other 20 percent
(i.e., 39,000 households) will decide not to invest their assets with
an adviser.\86\ Commission staff anticipates that the non-performance
fee arrangements into which these clients will enter may contain
management fees that yield advisers approximately the same amount of
fees that clients would have paid under performance fee arrangements.
Under these non-performance fee arrangements, if the adviser's
performance is not positive or does not reach the level at which it
would have accrued performance fees (i.e., the ``hurdle rate'' of
return), a client might end up paying higher overall fees than if he
had paid performance fees.\87\
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\83\ The assumption that 25% of these investors would have
entered into new performance fee arrangements is based on data
compiled in a 2008 report sponsored by the Commission. See Angela A.
Hung et al., Investor and Industry Perspectives on Investment
Advisers and Broker-Dealers 130 (Table C.1) (2008) (available at
https://www.sec.gov/news/press/2008/2008-1_randiabdreport.pdf). That
report indicated that 20% of investment advisers charge performance
fees. Id. at 105 (Table 6.13). Commission staff assumes the
percentage of investment advisers charging performance fees reflects
investor demand for these advisory arrangements. Although the report
indicates that 20% of investment advisers charge performance fees,
the use of a 25% assumption is intended to overestimate rather than
underestimate costs, especially given the inherent uncertainty
surrounding hypothetical events. It is also notable that an average
of only 37% of investors indicated they would seek investment
advisory services in the next five years. The estimate concerning
1.3 million households is derived from the 2007 Federal Reserve
Board Survey of Consumer Finances. See supra note 80 and
accompanying and following text.
\84\ This estimate is based on data filed by registered
investment advisers on Form ADV.
\85\ Commission staff estimates that less than one percent of
registered investment advisers are compensated solely by performance
fees, based on data from filings by registered investment advisers
on Form ADV.
\86\ This assumption is based on the idea that a substantial
majority of investment advisers that typically charge performance
fees and that in the future would calculate a potential client's net
worth and determine that it does not meet the $2 million threshold,
will offer alternate compensation arrangements in order to offer
their services. As noted above, Commission staff estimates that less
than one percent of registered advisers charge performance fees
exclusively. See supra note 85.
\87\ Performance fee arrangements typically include a ``hurdle
rate,'' which is a minimum rate of return that must be exceeded
before the performance fee can be charged. See, e.g., Tamar Frankel,
The Regulation of Money Managers Sec. 12.03[F] (2d ed. Supp. 2009).
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Commission staff estimates that the remaining 39,000 households
that would have entered into advisory contracts, if the value of the
client's primary residence were not excluded from the calculation of a
person's net worth, will not enter into advisory contracts. Some of
these households will likely seek other investment opportunities. Other
households may forego professional investment management altogether
because of the higher value they place on the alignment of advisers'
interests with their own interests associated with the use of
performance fee arrangements.
We recognize that the exclusion of the value of a person's primary
residence from the calculation of a person's net worth will reduce the
pool of potential qualified clients for advisers. This, in turn, might
result in a reduction in the total fees collected by investment
advisers. In order to replace those clients and lost revenue, some
advisers may choose to market their services to more potential clients,
which may result in increased marketing and administrative costs.\88\
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\88\ Although advisers that charge performance fees typically
require investment minimums of $10,000 or more, one of the steps
that advisers may take to market their services to a larger number
of potential clients is to reduce their investment minimums. This
may result in slightly higher administrative costs for investment
advisers that choose to take such action.
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Although some commenters asserted that these amendments would harm
small advisers or less wealthy clients, commenters did not provide any
quantitative data to support their statements.\89\ As discussed above,
advisers may charge advisory fees other than performance fees in order
to obtain revenue from clients who do not meet the definition of
``qualified clients.'' In addition, clients who no longer meet the net
worth test as a result of the exclusion of their primary residence
likely would have invested a smaller amount of assets than other
clients who continue to meet the test. As a result, the revenue loss to
investment advisers from the exclusion of these clients from the
performance fee exemption may be mitigated. Moreover, as mentioned
above, less wealthy clients can enter into non-performance based
compensation arrangements and seek other investment opportunities.
Therefore, for the reasons discussed above, we believe that the
amendments are unlikely to impose a significant net cost on most
advisers and clients.
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\89\ See supra notes 38-39 and accompanying text.
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One commenter asserted that because liabilities in excess of the
value of the primary residence would be included in the net worth
calculation the Commission should include in its analysis the cost to
clients of obtaining valuations from real estate agents.\90\ First,
currently investors may include the value of their primary residence in
the calculation of their net worth and, as such, those investors that
choose to do so must be estimating the value of the primary residence
in order to calculate their net worth. Second, the rule requires an
estimate, but does not require a third party opinion on valuation
either for the primary residence or for any other assets or
liabilities. Third, as we noted previously, many online services
provide residence valuations at no charge.\91\
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\90\ See G. Merkl Comment Letter.
\91\ See supra note 50.
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Some commenters argued that excluding the value of an investor's
primary residence from the net worth test of the rule at the same time
as adjusting the rule's dollar amount thresholds for inflation would
cause too much change at one time.\92\ Although we attribute the costs
of inflation-adjusting the dollar amount thresholds of the rule to the
Dodd-Frank Act and the order we issued thereunder, we have considered
the relative magnitude of each of these changes to the net worth
standard in determining the significance of making these changes at the
same time. Based on data from the Federal Reserve Board, approximately
7 million households have a net worth of more than $1.5 million (the
previous net worth threshold, including primary residence), and
approximately 5.5 million households have a net worth of more than $2
million (the revised net worth threshold we established by order in
July 2011, including primary residence).\93\ Therefore, inflation-
adjusting the dollar amount threshold of the net worth test from $1.5
to $2 million will have caused about 1.5 million households to no
longer meet the net worth test of the rule. Therefore the numerical
effect of the inflation adjustment of the net worth test's dollar
amount threshold (1.5 million households) is slightly greater than the
exclusion of primary residence from the net worth test (1.3 million
[[Page 10367]]
households).\94\ As discussed above, we are not making these two
changes to the rule at the same time.\95\ We revised the dollar amount
threshold of the net worth test for inflation in July 2011 (as required
by statute), and the revision was effective in September 2011. Our
current amendment of the net worth test to exclude the value of a
primary residence, which will be effective in May 2012, will be
effective approximately eight months after the previous change to the
net worth test.\96\ We believe that what has turned out to be a two-
step process (adjustment for inflation followed by exclusion of primary
residence), with roughly equal results on the numbers of ``qualified
clients,'' will help to ameliorate the economic impact of the two rule
revisions on investment advisers. In addition, we are concerned that
delaying beyond 90 days the effective date of excluding primary
residence from the net worth standard might encourage some advisers to
focus their efforts on entering into performance fee arrangements with
clients who will not meet the rule's net worth standards after the
effective date.
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\92\ See supra note 45 and accompanying text.
\93\ See supra note 80.
\94\ See supra text accompanying note 81.
\95\ See supra note 46 and preceding text.
\96\ Any further revisions of the dollar amount thresholds of
rule 205-3 to adjust for inflation are not scheduled to occur until
2016. See rule 205-3(e).
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The amendments to the rule's transition provisions are not likely
to impose any new costs on advisory clients or investment advisers. As
discussed above, the amendments allow an investment adviser and its
clients to maintain existing performance fee arrangements that were
permissible when the advisory contract was entered into, even if
performance fees would not be permissible under the contract if it were
entered into at a later date. The amendments also allow for the
transfer of an ownership interest in a private investment company by
gift or bequest, or pursuant to an agreement relating to a legal
separation or divorce to a party that is not a qualified client.\97\
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\97\ Rule 205-3(c)(3). The rule provides that for purposes of
paragraphs 205-3(c)(1) (transition rule for registered investment
advisers) and 205-3(c)(2) (transition rule for registered investment
advisers that were previously not registered) the transfer of an
equity ownership interest in a private investment company by gift or
bequest, or pursuant to an agreement related to a legal separation
or divorce, will not cause the transferee to become a party to the
contract and will not cause section 205(a)(1) of the Act to apply to
such transferee.
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We do not expect that adjustment of the dollar amount thresholds in
rule 205-3, which codifies the adjustments that the Commission effected
in its July 2011 order, will impose new costs on advisory clients or
investment advisers. The adjustments will have no effect on existing
contractual relationships that met applicable requirements under the
rule at the time the parties entered into them, because those
relationships may continue under the transition provisions of the rule.
Although an investment adviser could be prohibited from charging
performance fees to new clients to whom it could have charged
performance fees if the advisory contract had been entered into before
the adjustment of the dollar thresholds, we attribute this effect to
the Dodd-Frank Act rather than to this rulemaking. One commenter stated
that rather than addressing the contention that the adjustment to the
dollar amount thresholds is unfair to small investors, the Commission
``passed the buck'' back to Congress.\98\ The Commission, however, is
required to adjust the dollar amount thresholds for the effects of
inflation. Exempting less wealthy investors from the limits would be
contrary to the purpose of the dollar amount thresholds, which is to
limit the availability of the exemption to clients who are financially
experienced and able to bear the risks of performance fee arrangements.
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\98\ See P. Goldstein Comment Letter.
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Section 418 of the Dodd-Frank Act does not specify how the
Commission should measure inflation in adjusting the dollar amount
thresholds. We proposed, and are adopting, the PCE Index because it is
widely used as a broad indicator of inflation in the economy and
because the Commission has used the PCE Index in other contexts. It is
possible that the use of the PCE Index to measure inflation might
result in a larger or smaller dollar amount for the two thresholds than
the use of a different index, but the rounding required by the Dodd-
Frank Act (to the nearest $100,000) likely negates any difference
between indexes.
IV. Paperwork Reduction Act
The amendments to rule 205-3 under the Investment Advisers Act do
not contain any ``collection of information'' requirements as defined
by the Paperwork Reduction Act of 1995, as amended (``PRA'').\99\
Accordingly, the PRA is not applicable. We received no comments on any
PRA issues.
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\99\ 44 U.S.C. 3501-3520.
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V. Regulatory Flexibility Act Certification
The Commission certified in the Proposing Release, pursuant to
section 605(b) of the Regulatory Flexibility Act of 1980
(``RFA''),\100\ that the proposed rule amendments would not, if
adopted, have a significant impact on a substantial number of small
entities.\101\ As we explained in the Proposing Release, under
Commission rules, for the purposes of the Advisers Act and the RFA, an
investment adviser generally is a small entity if it: (i) Has assets
under management having a total value of less than $25 million; (ii)
did not have total assets of $5 million or more on the last day of its
most recent fiscal year; and (iii) does not control, is not controlled
by, and is not under common control with another investment adviser
that has assets under management of $25 million or more, or any person
(other than a natural person) that had total assets of $5 million or
more on the last day of its most recent fiscal year (``small
adviser'').\102\
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\100\ 5 U.S.C. 605(b).
\101\ See Proposing Release, supra note 15, at Section VI.
\102\ Rule 0-7(a).
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Based on information in filings submitted to the Commission, 617 of
the approximately 11,888 investment advisers registered with the
Commission are small entities. Only approximately 20 percent of the 617
registered investment advisers that are small entities (about 122
advisers) charge any of their clients performance fees. In addition, 24
of the 122 advisers required at the time of the Proposing Release an
initial investment from their clients that would meet the then current
assets-under-management threshold ($750,000), which advisory contracts
will be grandfathered into the exemption provided by rule 205-3 under
the amendments. Therefore, if these advisers in the future raise those
minimum investment levels to the revised level that we issued by order
($1 million), those advisers could charge their clients performance
fees because the clients would meet the assets-under-management test,
even if they would not meet the revised net worth test that excludes
the value of the client's primary residence. For these reasons, the
Commission believes that the amendments to rule 205-3 will not have a
significant economic impact on a substantial number of small entities.
The Commission requested written comments regarding the certification.
One commenter stated that the Proposing Release includes ``suspicious''
quantified data to support the claim as to how few advisers will be
affected by the required review every five years.\103\ The commenter
provided no further detail about why the quantified data was
suspicious, or any
[[Page 10368]]
alternative empirical data, and did not address the number of small
advisers that would be affected.\104\
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\103\ See Comment Letter of David Flatray (May 29, 2011).
\104\ Id.
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VI. Statutory Authority
The Commission is adopting amendments to rule 205-3 pursuant to the
authority set forth in section 205(e) of the Investment Advisers Act of
1940 [15 U.S.C. 80b-5(e)].
List of Subjects in 17 CFR Part 275
Reporting and recordkeeping requirements, Securities.
Text of Rules
0
For the reasons set out in the preamble, Title 17, Chapter II of the
Code of Federal Regulations is amended as follows:
PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940
0
1. The general authority citation for Part 275 continues to read as
follows:
Authority: 15 U.S.C. 80b-2(a)(11)(G), 80b-2(a)(11)(H), 80b-
2(a)(17), 80b-3, 80b-4, 80b-4a, 80b-6(4), 80b-6a, 80b-11, unless
otherwise noted.
* * * * *
0
2. Section 275.205-3 is amended by:
0
a. Revising paragraph (c);
0
b. Revising paragraphs (d)(1)(i) and (ii); and
0
c. Adding paragraph (e).
The revisions and addition read as follows:
Sec. 275.205-3 Exemption from the compensation prohibition of section
205(a)(1) for investment advisers.
* * * * *
(c) Transition rules--(1) Registered investment advisers. If a
registered investment adviser entered into a contract and satisfied the
conditions of this section that were in effect when the contract was
entered into, the adviser will be considered to satisfy the conditions
of this section; Provided, however, that if a natural person or company
who was not a party to the contract becomes a party (including an
equity owner of a private investment company advised by the adviser),
the conditions of this section in effect at that time will apply with
regard to that person or company.
(2) Registered investment advisers that were previously not
registered. If an investment adviser was not required to register with
the Commission pursuant to section 203 of the Act (15 U.S.C. 80b-3) and
was not registered, section 205(a)(1) of the Act will not apply to an
advisory contract entered into when the adviser was not required to
register and was not registered, or to an account of an equity owner of
a private investment company advised by the adviser if the account was
established when the adviser was not required to register and was not
registered; Provided, however, that section 205(a)(1) of the Act will
apply with regard to a natural person or company who was not a party to
the contract and becomes a party (including an equity owner of a
private investment company advised by the adviser) when the adviser is
required to register.
(3) Certain transfers of interests. Solely for purposes of
paragraphs (c)(1) and (c)(2) of this section, a transfer of an equity
ownership interest in a private investment company by gift or bequest,
or pursuant to an agreement related to a legal separation or divorce,
will not cause the transferee to ``become a party'' to the contract and
will not cause section 205(a)(1) of the Act to apply to such
transferee.
(d) * * *
(1) * * *
(i) A natural person who, or a company that, immediately after
entering into the contract has at least $1,000,000 under the management
of the investment adviser;
(ii) A natural person who, or a company that, the investment
adviser entering into the contract (and any person acting on his
behalf) reasonably believes, immediately prior to entering into the
contract, either:
(A) Has a net worth (together, in the case of a natural person,
with assets held jointly with a spouse) of more than $2,000,000. For
purposes of calculating a natural person's net worth:
(1) The person's primary residence must not be included as an
asset;
(2) Indebtedness secured by the person's primary residence, up to
the estimated fair market value of the primary residence at the time
the investment advisory contract is entered into may not be included as
a liability (except that if the amount of such indebtedness outstanding
at the time of calculation exceeds the amount outstanding 60 days
before such time, other than as a result of the acquisition of the
primary residence, the amount of such excess must be included as a
liability); and
(3) Indebtedness that is secured by the person's primary residence
in excess of the estimated fair market value of the residence must be
included as a liability; or
(B) Is a qualified purchaser as defined in section 2(a)(51)(A) of
the Investment Company Act of 1940 (15 U.S.C. 80a-2(a)(51)(A)) at the
time the contract is entered into; or
* * * * *
(e) Inflation adjustments. Pursuant to section 205(e) of the Act,
the dollar amounts specified in paragraphs (d)(1)(i) and (d)(1)(ii)(A)
of this section shall be adjusted by order of the Commission, on or
about May 1, 2016 and issued approximately every five years thereafter.
The adjusted dollar amounts established in such orders shall be
computed by:
(1) Dividing the year-end value of the Personal Consumption
Expenditures Chain-Type Price Index (or any successor index thereto),
as published by the United States Department of Commerce, for the
calendar year preceding the calendar year in which the order is being
issued, by the year-end value of such index (or successor) for the
calendar year 1997;
(2) For the dollar amount in paragraph (d)(1)(i) of this section,
multiplying $750,000 times the quotient obtained in paragraph (e)(1) of
this section and rounding the product to the nearest multiple of
$100,000; and
(3) For the dollar amount in paragraph (d)(1)(ii)(A) of this
section, multiplying $1,500,000 times the quotient obtained in
paragraph (e)(1) of this section and rounding the product to the
nearest multiple of $100,000.
Dated: February 15, 2012.
By the Commission.
Elizabeth M. Murphy,
Secretary.
[FR Doc. 2012-4046 Filed 2-21-12; 8:45 am]
BILLING CODE 8011-01-P
