2016-14450. Order Approving Adjustment for Inflation of the Dollar Amount Tests in Rule 205-3 Under the Investment Advisers Act of 1940

I. Background

Section 205(a)(1) of the Investment Advisers Act of 1940 (“Advisers Act”) generally prohibits an investment adviser from entering into, extending, renewing, or performing any investment advisory contract that provides for compensation to the adviser based on a share of capital gains on, or capital appreciation of, the funds of a client (also known as performance compensation or performance fees).^[1] Section 205(e) authorizes the Securities and Exchange Commission (“Commission”) to exempt any advisory contract from the performance fee prohibition if the contract is with persons who the Commission determines do not need the protections of the prohibition, on the basis of certain factors described in that section.^[2] Rule 205-3 under the Advisers Act exempts an investment adviser from the prohibition against charging a client performance fees in certain circumstances when the client is a “qualified client.” The rule allows an adviser to charge performance fees if the client has at least a certain dollar amount in assets under management (currently, $1,000,000) with the adviser immediately after entering into the advisory contract (“assets-under-management test”) or if the adviser reasonably believes, immediately prior to entering into the contract, that the client had a net worth of more than a certain dollar amount (currently, $2,000,000) (“net worth test”).^[3]

The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) ^[4] amended section 205(e) of the Advisers Act to provide that, by July 21, 2011 and every five years thereafter, the Commission shall adjust for inflation the dollar amount thresholds included in rules issued under section 205(e), rounded to the nearest $100,000.^[5] The Commission last issued an order to revise the dollar amount thresholds of the assets-under-management and net worth tests (to $1,000,000 and $2,000,000, respectively, as discussed above) on July 12, 2011.^[6] Rule 205-3 currently codifies the threshold amounts revised by the 2011 Order and states that the Commission will issue an order on or about May 1, 2016, and approximately every five years thereafter, adjusting for inflation the dollar amount thresholds of the rule's assets-under-management and net worth tests based on the Personal Consumption Expenditures Chain-Type Price Index (“PCE Index,” published by the United States Department of Commerce).^[7]

II. Adjustment of Dollar Amount Thresholds

On May 18, 2016, the Commission published a notice of intent to issue an order that would adjust for inflation, as appropriate, the dollar amount thresholds of the asset-under-management test and the net worth test.^[8] The Commission stated that, based on calculations that take into account the effects of inflation by reference to historic and current levels of the PCE Index, the dollar amount of the assets-under-management test would remain $1,000,000, and the dollar amount of the net worth test would increase from $2,000,000 to $2,100,000.^[9] These dollar amounts—which are rounded to the nearest $100,000 as required by section 205(e) of the Advisers Act—would reflect inflation from 2011 to the end of 2015.

The Commission's notice established a deadline of June 13, 2016 for submission of requests for a hearing. No requests for a hearing have been received by the Commission.

III. Effective Date of the Order

This Order is effective as of August 15, 2016. To the extent that contractual relationships are entered into prior to the Order's effective date, the dollar amount test adjustments in the Order would not generally apply retroactively to such contractual relationships, subject to the transition rules incorporated in rule 205-3.^[10]

IV. Conclusion

Accordingly, pursuant to section 205(e) of the Investment Advisers Act of 1940 and section 418 of the Dodd-Frank Act,

It is hereby ordered that, for purposes of rule 205-3(d)(1)(i) under the Investment Advisers Act of 1940 [17 CFR 275.205-3(d)(1)], a qualified client means 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; and

It is further ordered that, for purposes of rule 205-3(d)(1)(ii)(A) under the Investment Advisers Act of 1940 [17 CFR 275.205-3(d)(1)(ii)(A)], a qualified client means 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, has a net worth (together, in the case of a natural person, with assets held jointly with a spouse) of more than $2,100,000.

By the Commission.

Brent J. Fields,

Secretary.

Footnotes

1.  15 U.S.C. 80b-5(a)(1).

2.  Under section 205(e), 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].” 15 U.S.C. 80b-5(e).

3.  See rule 205-3(d)(1)(i)-(ii); see also infra note 6 and accompanying text.

4.  Public Law 111-203, 124 Stat. 1376 (2010).

5.  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).

6.  See text accompanying supra note 3; 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)] (“2011 Order”). The 2011 Order was effective as of September 19, 2011. It applies to contractual relationships entered into on or after the effective date and does not apply retroactively to contractual relationships previously in existence.

7.  See rule 205-3(e).

8.  See Investment Adviser Performance Compensation, Investment Advisers Act Release No. 4388 (May 18, 2016) [81 FR 32686 (May 24, 2016)]. While the dollar amount of the assets under-management test would not change, because the amount of the Commission's inflation adjustment calculation is smaller than the rounding amount specified under rule 205-3, the dollar amount of the net worth test would be adjusted as a result of Commission's inflation adjustment calculation effected pursuant to the rule.

9.  See id. at section II.A.

10.  See rule 205-3(c)(1) (“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.”); see also Investment Adviser Performance Compensation, Investment Advisers Act Release No. 3198 (May 10, 2011) [76 FR 27959 (May 13, 2011)], at section II.B.3.