On July 12, 2011 the U.S. Securities and Exchange Commission (“SEC”) issued an order that effectively raises two of the thresholds that determine whether an investment adviser can charge a performance fee. Under section 205(a)(1) of the Investment Advisers Act of 1940 (“Investment Advisers Act”) investment advisers are generally prohibited “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 (also known as “performance compensation” or “performance fees”).” Section 205(e) of the Investment Advisers Act authorizes the SEC to exempt any investment advisory contract from the performance fee prohibition if the contract is with a person the SEC determines does not need the protections of the prohibition.
SEC Rule 205-3 of the Investment Advisers Act exempts an investment adviser from the prohibition against charging performance fees in certain circumstances. SEC Rule 205-3 allows investment advisers to charge performance fees so long as a client meets certain criteria, including: the client must have at least $750,000 under management of an investment adviser immediately after entering into an advisory contract (“assets-under-management test”) or an investment adviser must have reasonable belief that the client has a net worth of more than $1.5 million at the time the contract is entered into (“net worth test”). These thresholds had not be revised since 1998.
The Dodd-Frank Wall Street Reform and Consumer Protection Act amended section 205(e) of the Investment Advisers Act to provide that, by July 21, 2011 and every five years after, the SEC shall adjust for inflation of the dollar amount thresholds in the rules under section 205(e). Under the July 12, 2011 SEC order, the client must have $1 million under management immediately after entering into an advisory contract with the investment adviser to satisfy the assets-under-management test or the investment adviser must reasonably believe that the client has a net worth of more than $2 million at the time the advisory contract is entered into to satisfy the net worth test.
This SEC order, carrying out a provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act, will be effective September 19, 2011. As required, the thresholds will be adjusted by the SEC for inflation every five years post this order.