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SEC Adopts Changes to the Definition of “Qualified Client” Under the Investment Advisers Act of 1940

July 21, 2011


Action.  On July 12, 2011, the U. S. Securities and Exchange Commission (the “SEC”) issued an order1 which raises the financial thresholds necessary for a client to be considered as a “qualified client” as defined in Rule 205-3(d) (1) under the Investment Advisers Act of 1940 (the “Investment Advisers Act”).  This change could impact investment advisers who charge their clients performance fees.

This change is effective September 19, 2011.

In originally proposing these changes,2 the SEC also proposed rule amendments, not yet adopted, that would “grandfather” existing performance fee arrangements so that the new thresholds effective after September 19, 2011 would not apply to current client arrangements.  Although the SEC’s order did not address these grandfathering proposals, we believe that the new “qualified client” definition only applies to:  (i) new clients in your hedge funds, private equity funds and/or separately managed accounts; and (ii) existing clients in your hedge funds or private equity funds that make an additional capital contribution.  In addition, with respect to private equity funds, if a client has already made a capital commitment to the fund, we do not believe that subsequent draw-downs of capital by the fund from such client will require you to re-certify such client to meet the new definition of “qualified client.”

Background.  The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was signed into law by President Obama on July 21, 2010, and became effective one day later.  The Dodd-Frank Act requires in part that the SEC adjust the “qualified client” standard contained in Rule 205-3(d) (1) under the Investment Advisers Act for inflation by July 22, 2011, and every 5 years thereafter.  This order is being issued to comply with that requirement.

Section 205(a) (1) of the Investment Advisers Act generally prohibits an investment adviser from entering into, extending, renewing, or performing any investment advisory contract that provides for compensation to the investment 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 this performance fee prohibition if the contract is with persons that the SEC determines do not need the protections of the prohibition, on the basis of certain factors, such as the financial sophistication, net worth, knowledge of and experience in financial matters, amount of assets under management and the relationship with a registered investment adviser.

Rule 205-3 under the Investment Advisers Act currently exempts an investment adviser from the prohibition against charging a client performance fees in certain circumstances, including when the client is a “qualified client.”  The rule allows an investment adviser to charge performance fees if the client has at least $750,000 under the management of an investment adviser immediately after entering into the advisory contract (the “assets-under-management test”) or if the investment adviser reasonably believes that the client has a net worth of more than $1,500,000 at the time the contract is entered into (the “net worth test”).  The SEC last revised the level of these dollar amount thresholds to account for the effects of inflation in 1998.

In the order, the SEC has adjusted the amounts contained in the assets under management test and the net worth test so that effective September 19, 2011, a “qualified client” under Rule 205-3 will be any client that has at least $1,000,000 under the management of the investment adviser immediately after entering into the advisory contract or if the investment adviser reasonably believes that the client has a net worth of more than $2,000,000 at the time the contract is entered into.

If the proposed rule amendments are adopted, a client may no longer include the value of his or her primary residence in calculating whether or not he or she meets the $2,000,000 net worth test.


1   Investment Advisers Act Release No. 3236 (July 12, 2011)
2   Investment Advisers Act Release No. 3198 (May 10, 2011)