[Federal Register Volume 63, Number 139 (Tuesday, July 21, 1998)]
[Rules and Regulations]
[Pages 39022-39028]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-19373]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 275
[Release No. IA-1731, File No. S7-29-97]
RIN 3235-AH25
Exemption To Allow Investment Advisers To Charge Fees Based Upon
a Share of Capital Gains Upon or Capital Appreciation of a Client's
Account
AGENCY: Securities and Exchange Commission.
ACTION: Final rule.
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SUMMARY: The Commission is adopting amendments to the rule under the
Investment Advisers Act of 1940 that permits investment advisers to
charge certain clients performance or incentive fees. The amendments
modify the rule's criteria for clients eligible to enter into a
contract under which a performance fee is charged and eliminate
provisions specifying required contract terms and disclosures. The
amendments provide investment advisers greater flexibility in
structuring performance fee arrangements with clients who are
financially sophisticated or have the resources to obtain sophisticated
financial advice regarding the terms of these arrangements.
EFFECTIVE DATE: The rule amendments will become effective August 20,
1998.
FOR FURTHER INFORMATION CONTACT: Kathy D. Ireland, Attorney, or
Jennifer S. Choi, Special Counsel, at (202) 942-0716, Task Force on
Investment Adviser Regulation, Division of Investment Management, U.S.
Securities and Exchange Commission, 450 Fifth Street, N.W., Mail Stop
5-6, Washington, D.C. 20549.
SUPPLEMENTARY INFORMATION: The Commission today is adopting amendments
to rule 205-3 [17 CFR 275.205-3] under the Investment Advisers Act of
1940 [15 U.S.C. 80b] (``Advisers Act'').
Table of Contents
Executive Summary
I. Background
A. Introduction
B. Proposed Amendments to Rule 205-3
II. Discussion
A. Elimination of Specific Contractual and Disclosure
Requirements
B. Qualified Clients
1. Numerical Thresholds
2. Qualified Purchasers
3. Knowledgeable Employees
C. Identification of the Client
D. Transition Rule
III. Cost-Benefit Analysis
IV. Summary of Regulatory Flexibility Analysis
V. Statutory Authority
Text of Rule
Executive Summary
Rule 205-3 under the Advisers Act permits investment advisers to
charge performance fees to clients with at least $500,000 under the
adviser's management or with a net worth of more than $1,000,000. The
rule requires certain terms to be included in contracts providing for
performance fees and specific disclosures to be made to clients
entering into these contracts. The Commission is adopting rule
amendments to eliminate the provisions of the rule that prescribe
contractual terms and require specific disclosures. In addition, the
amendments change the client eligibility criteria to permit the
following clients to enter into performance fee arrangements with their
investment advisers: (1) clients with at least $750,000 under
management with the adviser or more than $1,500,000 of net worth; (2)
clients who are ``qualified purchasers'' under section 2(a)(51)(A) of
the Investment Company Act of 1940
[[Page 39023]]
(``Investment Company Act''); \1\ and (3) knowledgeable employees of
the investment adviser.
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\1\ 15 U.S.C. 80a-2(a)(51)(A).
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I. Background
A. Introduction
Section 205(a)(1) of the 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 or any portion of the funds of the
client.\2\ In 1970, Congress provided an exception from the prohibition
in section 205(a)(1) for advisory contracts relating to the investment
of assets in excess of $1,000,000,\3\ so long as an appropriate
``fulcrum fee'' is used.\4\ This statutory exception was the only
provision under which advisers could enter into performance fee
contracts with so-called ``high net worth'' clients until 1985 when the
Commission adopted rule 205-3.\5\
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\2\ 15 U.S.C. 80b-5(a)(1).
\3\ 15 U.S.C. 80b-5(b)(2). Trusts, governmental plans,
collective trust funds, and separate accounts referred to in section
3(c)(11) of the Investment Company Act [15 U.S.C. 80a-3(c)(11)] are
not eligible for this exception from the performance fee prohibition
under section 205(b)(2)(B) of the Advisers Act [15 U.S.C. 80b-
5(b)(2)(B)].
\4\ 15 U.S.C. 80b-5(b)(2). See discussion of fulcrum fees in
Proposing Release, infra note 11, at n.5.
In 1980, Congress added an exception for contracts involving
business development companies under conditions set forth in section
205(b)(3) of the Advisers Act [15 U.S.C. 80b-5(b)(3)].
\5\ Rule 205-3 was adopted under section 206A of the Advisers
Act [15 U.S.C. 80b-6a], which grants the Commission general
exemptive authority. In providing this authority, Congress noted
that the Commission would be able to ``exempt persons . . . from the
bar on performance-based advisory compensation'' in appropriate
cases. H.R. Rep. No. 1382, 91st Cong., 2d Sess. 42 (1970); S. Rep.
No. 184, 91st Cong., 1st Sess. 46 (1969).
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Under current rule 205-3, an adviser may charge performance fees to
a client who has at least $500,000 under management with the adviser or
has a net worth of more than $1,000,000. The Commission presumed that
these clients, because of their wealth, financial knowledge, and
experience, are less dependent on the protections provided by the
Advisers Act's restrictions on performance fee arrangements.\6\ The
rule, however, imposes several conditions on advisers entering into
performance fee contracts in addition to those related to the
eligibility of clients.
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\6\ 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)].
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In 1992, the Commission's Division of Investment Management issued
a report recommending, among other things, that Congress enact
legislation clarifying the authority of the Commission to provide
exemptions from the performance fee prohibition for advisory contracts
with any persons whom the Commission determined did not need the
protections of the prohibition.\7\ Four years later, Congress included
in the National Securities Markets Improvement Act of 1996 (``1996
Act'') \8\ two additional statutory exceptions from the performance fee
prohibition \9\ and new section 205(e) of the Advisers Act, which
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.\10\
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\7\ See Division of Investment Management, U.S. Securities and
Exchange Commission, Protecting Investors: A Half Century of
Investment Company Regulation 245, 247-48 (1992) (``Protecting
Investors'').
\8\ Pub. L. No. 104-290, 110 Stat. 3416 (1996) (codified in
scattered sections of the U.S. Code).
\9\ Section 210 of the 1996 Act added to section 205 of the
Advisers Act exceptions for contracts with companies excepted from
the definition of investment company by section 3(c)(7) of the
Investment Company Act [15 U.S.C. 80a-3(c)(7)] and contracts with
persons who are not residents of the United States. The definition
of ``person'' under section 202 of the Advisers Act includes
companies, which in turn includes corporations, partnerships,
associations, joint-stock companies, trusts and organized groups of
persons [15 U.S.C. 80b-2(a)(5), (16)]; therefore, the exception for
foreign residents includes foreign investment companies.
\10\ 15 U.S.C. 80b-5(e). Section 205(e) provides that the
Commission may determine that persons may not need the protections
of section 205(a)(1) on the basis of such factors as ``financial
sophistication, net worth, knowledge of and experience in financial
matters, amount of assets under management, relationship with a
registered investment adviser, and such other factors as the
Commission determines are consistent with [section 205].''
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B. Proposed Amendments to Rule 205-3
On November 13, 1997, the Commission issued a release proposing
amendments to rule 205-3 (``Proposing Release'').\11\ The proposed
amendments were intended to provide increased flexibility to investment
advisers and their clients in entering into performance fee
arrangements and to revise the client eligibility criteria under the
rule.
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\11\ 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. 1682 (Nov. 13,
1997) [62 FR 61882 (Nov. 19, 1997)].
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The Commission received 22 comment letters on the proposed
amendments to rule 205-3. Commenters supported the proposed amendments;
many urged the Commission to expand further the types of clients
eligible to enter into such arrangements. The Commission is adopting
amendments to rule 205-3 with one change from the amendments as
proposed, in view of the issues raised by commenters. As suggested by
commenters, the Commission is adding certain knowledgeable employees of
investment advisers as another category of clients eligible to enter
into performance fee arrangements under rule 205-3.
II. Discussion
A. Elimination of Specific Contractual and Disclosure Requirements
Current rule 205-3 imposes a number of required provisions on
performance fee contracts, obligates the adviser to provide certain
disclosures to clients, and requires that the adviser reasonably
believe that the contract represents an arm's length arrangement and
that the client (or its independent agent) understands the method of
compensation and its risks. In the Proposing Release, the Commission
explained that, although these conditions were intended to protect
clients, they have inhibited the flexibility of advisers and their
clients in establishing performance fee arrangements beneficial to both
parties.\12\ In light of the other protections provided by the Advisers
Act, the Commission believed that these clients may not need the
protections of the rule. Therefore, the Commission proposed, pursuant
to its exemptive authority under new section 205(e) of the Advisers
Act, to eliminate all of the contractual and disclosure provisions in
rule 205-3 other than the client eligibility tests. All but one of the
commenters supported these proposed amendments, which the Commission is
adopting as proposed.
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\12\ See Proposing Release, supra note 11, at 8.
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The Commission emphasizes that the elimination of the contractual
and disclosure provisions from rule 205-3 does not alter the obligation
of an adviser, as a fiduciary, to deal fairly with its clients and to
make full and fair disclosure of its compensation arrangements.\13\
This obligation includes full client disclosure of all material
information regarding a proposed performance fee arrangement
[[Page 39024]]
as well as any material conflicts posed by the arrangement.\14\
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\13\ See SEC v. Capital Gains Research Bureau, 375 U.S. 180, 194
(1963). In addition, advisers registered with the Commission are
required to provide their clients with a brochure describing their
fee arrangements. See Part II of Form ADV.
\14\ The disclosure obligation flows from the Advisers Act's
prohibitions against fraud in section 206 of the Advisers Act [15
U.S.C. 80b-6]. The amendments also eliminate paragraph (h) of the
current rule, which states that ``[a]n investment adviser entering
into or performing an investment advisory contract under this rule
is not relieved of any obligations under section 206 of the Advisers
Act or of any other applicable provisions of the federal securities
laws.'' The Commission believes that rule 205-3 by its terms
provides an exemption only from section 205(a)(1), and that separate
reference to section 206 and other provisions of the federal
securities laws in the rule is unnecessary. By eliminating this
reference, the Commission does not intend in any way to suggest that
compliance with the amended rule would relieve advisers of any
obligations under section 206 of the Advisers Act or any other
applicable provisions of the federal securities laws.
The Commission further notes that advisers entering into
performance fee arrangements with employee benefit plans covered by
the Employee Retirement Income Security Act of 1974 (``ERISA'') are
subject to the fiduciary responsibility and prohibited transaction
provisions of ERISA. 29 U.S.C. 1001-1461. The amendments to rule
205-3 do not affect an adviser's obligation to comply with ERISA.
Issues involving performance fee arrangements under ERISA are within
the jurisdiction of the Department of Labor, which is responsible
for administering ERISA's fiduciary provisions and has addressed
performance fee arrangements in a number of advisory opinions under
ERISA. U.S. Department of Labor Advisory Opinion No. 89-28A (Sept.
25, 1989); U.S. Department of Labor Advisory Opinion 86-21A (Aug.
29, 1986); U.S. Department of Labor Advisory Opinion 86-20A (Aug.
29, 1986).
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B. Qualified Clients
Currently, rule 205-3 permits investment advisers to charge
performance fees to clients with at least $500,000 under the adviser's
management or with a net worth of more than $1,000,000. As noted above,
in adopting rule 205-3 in 1985, the Commission concluded that clients
who satisfy these criteria do not need the full protections provided by
the Advisers Act's restrictions on performance fee arrangements.\15\
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\15\ See supra note 6 and accompanying text.
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The Commission proposed to raise the net worth and assets-under-
management threshold levels and to add a third category of eligible
clients, ``qualified purchasers'' under section 2(a)(51)(A) of the
Investment Company Act. Under the proposed amendments, clients who
satisfied the new eligibility criteria contained in rule 205-3 would be
referred to as ``qualified clients.'' The Commission is adopting
amendments to the criteria for determining the eligibility of clients
with one modification to the proposal in response to suggestions by
commenters, as discussed below.\16\
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\16\ One commenter requested that the Commission clarify whether
a trust, governmental plan, collective trust fund, or separate
account referred to in section 3(c)(11) of the Investment Company
Act may be charged a fulcrum fee (or any other kind of performance
fee) under rule 205-3. The Commission believes that a trust,
governmental plan, collective trust fund, or separate account that
satisfies all the conditions of rule 205-3 may enter into a
performance fee (including a fulcrum fee) arrangement under the
rule.
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1. Numerical Thresholds
As discussed in the Proposing Release, the Commission recognized
that, since 1985, the net worth and assets-under-management thresholds
have been affected by inflation: $1,000,000 in 1985 dollars is now
worth approximately $1,500,000; and $500,000 in 1985 dollars is now
worth approximately $750,000.\17\ The Commission therefore proposed to
increase the amounts of the net worth and assets-under-management tests
from $1,000,000 and $500,000 to $1,500,000 and $750,000, respectively.
Five commenters supported the increased net worth and assets-under-
management thresholds. One commenter noted that increasing the
thresholds to reflect inflation would ensure that unsophisticated
retail clients continue to receive the protections of the performance
fee prohibition.\18\
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\17\ See Proposing Release, supra note 11, at 10.
\18\ One commenter went further and recommended a substantial
increase in the thresholds beyond those set forth in the proposal.
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Nine commenters opposed increasing the thresholds as unnecessary to
ensure adequate client sophistication, often citing the lack of a
history of abuse and the costs and inconvenience of incorporating new
thresholds into existing agreements.\19\ None of the commenters,
however, suggested any alternative criteria to the objective
thresholds, as requested by the Commission in the Proposing Release.
Moreover, responding to the Commission's request for comment, the
commenters opposed any indexing of the thresholds to take into account
automatically the effects of inflation. The Commission has decided to
adopt the amendments to the threshold levels as proposed. In light of
the expansion of the performance fee exemption and the effects of
inflation on the threshold levels, the Commission believes that, in
order to continue to determine that clients who satisfy the numerical
thresholds do not need the protections of the performance fee
prohibition, it should increase the thresholds.
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\19\ Although the proposed transition rule would ``grandfather''
existing arrangements with existing clients, the new thresholds
would apply to new clients to existing arrangements. See infra
Section II.D.
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2. Qualified Purchasers
The Commission also proposed to permit advisers to enter into
performance fee contracts with clients who are ``qualified
purchaser[s]'' under section 2(a)(51)(A) of the Investment Company
Act.\20\ New section 3(c)(7) of the Investment Company Act, as added by
the 1996 Act, exempts from regulation under the Investment Company Act
certain investment pools whose interests are not offered to the public
and whose shareholders consist primarily of ``qualified purchasers,''
including individuals with at least $5,000,000 of investments.\21\
Although, in most cases, persons who would be qualified purchasers
under section 2(a)(51)(A) would satisfy the assets-under-management or
net worth criterion under rule 205-3, even as amended, in some cases,
such persons would not.\22\ Therefore, the Commission proposed to add
``qualified purchasers'' as eligible clients under the rule so that an
investor who meets the eligibility requirements to invest in a section
3(c)(7) company also could enter into a performance fee arrangement
outside the context of a section 3(c)(7) company.\23\ The commenters
supported this provision, which the Commission is adopting as proposed.
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\20\ See supra note 1.
\21\ 15 U.S.C. 80a-3(c)(7).
\22\ For example, in determining the amount of investments for
purposes of the definition of qualified purchaser, only outstanding
indebtedness incurred to acquire the investments must be deducted.
Rule 2a51-1(e) under the Investment Company Act [17 CFR 270.2a51-
1(e)]. See also Privately Offered Investment Companies, Investment
Company Act Release No. 22597 (Apr. 3, 1997) [62 FR 17512 (Apr. 9,
1997)]. Thus, a person with less than $750,000 in assets under
management could have more than $5,000,000 of investments, but a net
worth of less than $1,500,000 because of other debt. Under the rule
amendments, such a person would be eligible to enter into a
performance fee contract under rule 205-3.
\23\ Under section 205(b)(4) of the Advisers Act [15 U.S.C. 80b-
5(b)(4)], section 3(c)(7) companies may enter into performance fee
contracts without relying on rule 205-3. Each investor in a section
3(c)(7) company need not satisfy the eligibility criteria of rule
205-3 for an adviser to charge performance fees to the section
3(c)(7) company.
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3. Knowledgeable Employees
The Proposing Release requested comment on whether the Commission
should exempt from the performance fee prohibition arrangements between
advisers and clients who have certain pre-existing relationships. These
relationships would be of a type that suggests that the abuses Congress
sought to prevent by prohibiting performance fee arrangements are
unlikely to occur. Section 205(e) permits the Commission to consider,
in addition to criteria such as financial sophistication and knowledge
and experience in financial matters, whether a client may not need the
protections of the performance fee
[[Page 39025]]
prohibition by virtue of the client's relationship with the
adviser.\24\
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\24\ See supra note 10.
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Many commenters recommended that the Commission add to the list of
qualified clients certain ``knowledgeable employees,'' consistent with
the concept of ``knowledgeable employees'' eligible to invest in
section 3(c)(1) \25\ and section 3(c)(7) companies in accordance with
rule 3c-5 under the Investment Company Act.\26\ Under rule 3c-5,
knowledgeable employees include executive officers, directors,
trustees, general partners, and advisory board members of a section
3(c)(1) or a section 3(c)(7) company, and those who serve in similar
capacities. The rule also includes certain other employees of the fund
or its management affiliate who participate in investment activities
and have performed such functions for at least 12 months.
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\25\ 15 U.S.C. 80a-3(c)(1).
\26\ Rule 3c-5 [17 CFR 270.3c-5].
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One commenter asserted that such employees are inherently
sophisticated because of their knowledge of the day-to-day investment
activities of the adviser and are in the best position to evaluate the
risks of performance fees and protect themselves from overreaching on
the part of the adviser. Another commenter noted that inclusion of
knowledgeable employees as qualified clients would allow such employees
to invest in section 3(c)(1) companies that enter into performance fee
arrangements as well as section 3(c)(7) companies, which are excepted
from the performance fee prohibition pursuant to section 205(b)(4) of
the Advisers Act.\27\
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\27\ 15 U.S.C. 80b-5(b)(4).
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The Commission agrees that employees who actively participate in
the investment activities of the adviser are likely to be sophisticated
financially and do not need the protections of the performance fee
prohibition. Therefore, the Commission is adding certain knowledgeable
employees of the investment adviser as another criterion for
``qualified clients'' under the rule. The new category is similar to
the definition of knowledgeable employee in rule 3c-5 under the
Investment Company Act, and would include an executive officer,
director, trustee, general partner, or person serving in a similar
capacity, of the investment adviser, as well as certain other employees
of the adviser who participate in investment activities and have
performed such functions for at least 12 months.
C. Identification of the Client \28\
Rule 205-3 provides that with respect to certain clients entering
into performance fee contracts with an adviser--private investment
companies, registered investment companies, and business development
companies--the adviser must ``look through'' the legal entity to
determine whether each equity owner of the company would be a qualified
client.\29\ Under this provision, 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 (the 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.\30\
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\28\ The following discussion of the identity of the ``client''
is relevant only for purposes of this rule and not for purposes of
section 206 of the Advisers Act [15 U.S.C. 80b-6].
\29\ Rule 205-3(b)(2) [17 CFR 275.205-3(b)(2)].
\30\ Conditional 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. 961 at n.21 (March 15, 1985) [50 FR 11718 (March 25,
1985)].
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The Commission proposed to retain the ``look through'' provision
and to clarify that any ``equity owners'' that are not charged a
performance fee would not be required to meet the qualified client
test.\31\ The Commission is adopting this provision as proposed.
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\31\ Amended rule 205-3(b) [17 CFR 275.205-3(b)]. The Commission
notes that an adviser charging a performance fee to only certain
clients in this context should provide appropriate disclosure
concerning the existence of the performance fee to those clients who
do not pay a performance fee. In addition, the amendments retain the
provision in rule 205-3 that an equity owner who is the investment
adviser entering into the performance fee contract need not be a
qualified client. Furthermore, as stated in the Proposing Release,
the look through provision does not apply to section 3(c)(7)
companies, which are excepted from the performance fee prohibition
by section 205(b)(4) of the Advisers Act.
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Some commenters urged the Commission to eliminate the look through
provision with respect to certain entities, such as private investment
companies. Others opposed such changes, arguing that it would permit
circumvention of the client eligibility requirements of the rule and
result in performance fees being charged to groups of unsophisticated
investors. The Commission has decided not to eliminate the look through
provision of the rule at this time.\32\
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\32\ One commenter urged that the look through provision not
apply if the first tier company and the second tier company are
independent of each other. This commenter reasoned that where a
second tier section 3(c)(1) company is truly independent of the
first tier section 3(c)(1) company, the adviser receiving the
performance fee could not seek to circumvent the purpose of the look
through provision and pool clients to avoid the qualified client
requirement. Another commenter urged that the look through provision
not apply if the first tier company and the second tier company are
section 3(c)(1) companies, unless the adviser to the first tier
company also is the adviser to the second tier company. This
commenter reasoned that the financial sophistication of the managers
of the second tier company would protect the interests of their
investors in negotiating a performance fee at arm's length, which is
consistent with the rule 205-3 exemption from the performance fee
prohibition. The Commission has decided not to amend the rule; it,
however, will entertain requests for relief from the application of
the look through provision in circumstances where the policies and
purposes of section 205 of the Advisers Act would not be served by
its application.
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D. Transition Rule
The Commission is adopting, as proposed, a transition rule
permitting investment advisers and their clients to maintain their
existing performance fee arrangements notwithstanding the clients'
failure to meet the eligibility criteria after the thresholds increase
to $750,000 and $1,500,000.\33\ Such arrangements could continue under
the transition rule if they were entered into before the effective date
of the amendments to the rule and they satisfy the requirements of the
rule as in effect on the date that they were entered into. A new party
to an existing arrangement, however, would be required to satisfy the
new qualified client test.
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\33\ Amended rule 205-3(c) [17 CFR 275.205-3(c)].
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III. Cost-Benefit Analysis
The Commission is sensitive to the costs and benefits imposed by
its rules. The Commission notes that the rule amendments are pursuant
to new authority granted to it by Congress in the 1996 Act.
As discussed below, although costs and benefits of the rule
amendments are difficult to quantify, the Commission believes that
these amendments will benefit investment advisers and their clients
without imposing any measurable costs.
The rule amendments will likely alter the total number of
investment advisers that rely on the performance fee exemption.\34\ The
number of performance fee contracts may increase
[[Page 39026]]
because the performance fee arrangement will no longer be subject to
prescribed contract terms. Moreover, the rule amendments will add two
new categories of clients eligible to enter into performance fee
arrangements--qualified purchasers and knowledgeable employees who may
not have been eligible under the numerical thresholds. On the other
hand, the increase in the net worth and assets-under-management
thresholds for determining eligibility under the rule may reduce the
number of eligible clients \35\ and, as a result, the total number of
performance fee arrangements. Overall, however, the Commission believes
it is reasonable to estimate that the amendments to the performance fee
rule will increase the number of performance fee arrangements.
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\34\ The Commission knows of no information concerning the
incidence of performance fee arrangements in the United States.
Performance fee arrangements, however, appear to be accepted
practices in many other countries. See International Survey of
Investment Adviser Regulation 15 (Marcia L. MacHarg & Roberta R. W.
Kameda eds., 1994) (noting that performance fees generally are
permitted in Australia, Brazil, Canada (Ontario, with client's
written consent), France, Germany, Italy, Japan, Spain, Switzerland
(up to 20% of net capital gain), the United Kingdom and Venezuela).
\35\ According to data from the 1995 Survey of Consumer Finances
conducted by the Federal Reserve Board, approximately 1,100,000
households have net worth between $1,000,000 and $1,500,000. This
figure, however, represents the net worth of households and not the
individual persons who might be clients. Furthermore, the survey
results do not address clients that are not natural persons.
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To the extent that the rule amendments increase the number of
performance fee arrangements, advisers and clients may benefit
overall.\36\ For example, proponents of performance fees have argued
that these arrangements may benefit both parties to the advisory
contract because linking advisory compensation to performance may
result in a closer alignment of the goals of the adviser and the
client.\37\ Proponents also claim that performance fees may encourage
better performance by rewarding good performance rather than linking
compensation and assets under management as in more traditional
arrangements.\38\ In addition, advocates of the increased use of
performance fees assert that they may encourage the establishment of
new advisory firms\39\ and may result in greater competition and
produce a wider array of investment advisers and services and lower
overall advisory costs.
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\36\ The Division discussed the advantages and disadvantages of
performance fees in more detail in its 1992 study. Protecting
Investors, supra note 7, at 239-40.
\37\ Richard Grinold & Andrew Rudd, Incentive Fees: Who Wins?
Who Loses?, 43 Fin. Analysts J. 27, 37 (Jan.-Feb. 1987); Harvey E.
Bines, The Law of Investment Management para. 5.03[2][b], at 5-43
(1978 & Supp. 1986) (observing that the principal justification for
performance fees is that they permit the uncertainty in the quality
of the product--the management of the portfolio--to be shared
between the adviser and the client).
\38\ See, e.g., Stephen Lofthouse, A Fair Day's Wages for a Fair
Day's Work, 4 Journal of Investing 74, 76 (Winter 1995); Grinold &
Rudd, supra note 37; at 37; Bines, supra note 37, at 5-36 to 5-37.
\39\ Julie Roher, The Great Debate Over Performance Fees, 17
Institutional Investor 123, 124 (Nov. 1983) (stating that new firms
can begin generating profits before attracting a large asset base).
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The increased use of performance fees, however, also may produce
some costs to advisory clients and the economy in general. Opponents of
advisory fees have cited the potential for the adviser under a
performance fee arrangement to engage in excessive risk taking with
respect to the client's account.\40\ In addition, some detractors have
expressed concern that performance fees might result in discrimination
against clients that do not pay performance fees.\41\
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\40\ Lofthouse, supra note 38, at 77; Roher, supra note 39, at
127.
\41\ See In re McKenzie Walker Investment Management, Inc.,
Investment Advisers Act Release No. 1571 (July 16, 1996) (investment
adviser favoring its performance-fee clients in the allocation of
hot initial public offerings).
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The arguments for and against performance fee arrangements provide
no definitive answers concerning their effect on advisers, clients and
the markets. The costs and benefits of performance fee arrangements in
general are difficult to quantify because of their theoretical nature.
Although the Commission requested comment in the Proposing Release on
whether the benefits and costs could be quantified, no commenters
responded to this request.
Similarly, it is difficult to quantify the effect of the rule
amendments on advisers, their clients, or the economy. The Commission
has no data from which to measure the total effect of these amendments.
For example, the Commission knows of no information concerning the
number of advisers that have performance fee contracts or the average
number of performance fee contracts per adviser. The Commission
requested the submission of data concerning incidence of performance
fees in the Proposing Release, but no commenters responded to this
request. In addition, the Commission has no information concerning
either the number of clients who would no longer qualify under the new
criteria or the number of clients who would qualify only under the new
criteria.
Although the Commission cannot quantify the effects of the rule
amendments, the Commission believes that the amendments will benefit
advisers and their qualified clients by providing them with more
flexibility in structuring performance fee arrangements that may
benefit both parties. The amendments eliminate all the prescribed
compensation calculations and other required contract terms, which have
raised a number of interpretative issues and technical concerns over
the years.\42\ Thus, the amendments allow investment advisers and their
clients who are financially sophisticated or have the resources to
obtain sophisticated financial advice to negotiate the terms of their
performance fee contracts. Moreover, the Commission believes that these
amendments should reduce the costs of establishing and monitoring
compliance with the current rule, and thus benefit both investment
advisers and their clients who wish to enter into performance fee
arrangements.
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\42\ See, e.g., Valuemark Capital Management, Inc. (pub. avail.
June 4, 1997) (limited partners purchasing or redeeming mid-year
immaterial if performance fee based on performance of partnership
over a period of at least one year); Securities Industry Association
(pub. avail. Nov. 18, 1986) (use of rolling one-year periods after
initial one-year period); P.E. Becker, Inc. (pub. avail. July 21,
1986) (individual limited partners may be considered the ``client''
for purposes of the ``arm's-length'' negotiation requirement).
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IV. Summary of Regulatory Flexibility Analysis
A summary of the Initial Regulatory Flexibility Analysis (''IRFA'')
was published in the Proposing Release. No comments were received on
the IRFA. The Commission has prepared a Final Regulatory Flexibility
Analysis (``FRFA'') in accordance with 5 U.S.C. 604 regarding
amendments to rule 205-3 under the Advisers Act. The following
summarizes the FRFA.
As set forth in greater detail in the FRFA, the 1996 Act added
section 205(e) to the Advisers Act, which authorizes the Commission to
exempt conditionally or unconditionally from the performance fee
prohibition contained in section 205(a)(1) of the Advisers Act advisory
contracts with persons that the Commission determines do not need the
protections of the prohibition. The FRFA states that the rule
amendments will liberalize rule 205-3, which permits performance fees
to be charged to sophisticated clients, by eliminating required
contract terms and disclosures, update the current criteria for
determining eligible clients to reflect the effects of inflation on the
current assets-under-management and net worth tests, and add new
categories of eligible clients--``qualified purchasers'' under section
2(a)(51)(A) of the Investment Company Act, and ``knowledgeable
employees'' of the investment adviser.
The FRFA also discusses the effect of the rule amendments on small
entities. For the purposes of the Advisers Act and the Regulatory
Flexibility Act, an investment adviser generally is a small entity (i)
if it manages assets of $50
[[Page 39027]]
million or less, in discretionary or non-discretionary accounts, as of
the end of its most recent fiscal year or (ii) if it renders other
advisory services, has $50,000 or less in assets related to its
advisory business.\43\ The Commission estimates that approximately
17,650 investment advisers are small entities.\44\
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\43\ Rule 275.0-7 [17 CFR 275.0-7]. The Commission has revised
the definition of ``small entity,'' effective July 30, 1998. See
Definitions of ``Small Business'' or ``Small Organization'' Under
the Investment Company Act of 1940, the Investment Advisers Act of
1940, the Securities Exchange Act of 1934, and the Securities Act of
1933, Release Nos. 33-7548, 34-40122, IC-23272, and IA-1727 (June
24, 1998) [63 FR 35508 (June 30, 1998)]. Because the IRFA concerning
the proposed amendments to rule 205-3 was prepared under the old
definition, that definition applies to the Commission's preparation
of the FRFA concerning these amendments. Id. at n.32.
\44\ This estimate of the number of small entities was made for
purposes of the Final Regulatory Flexibility Analysis for the rules
implementing Title III of the 1996 Act, the Investment Advisers
Supervision Coordination Act (the ``Coordination Act''). See Rules
Implementing Amendments to the Investment Advisers Act of 1940,
Investment Advisers Act Release No. 1633 (May 15, 1997) [62 FR 28112
(May 22, 1997)] at nn.189-190 and accompanying text.
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The Commission does not have information from which to estimate the
number of advisers managing assets of $50 million or less whose clients
will be able to meet the eligibility tests under the amended rule and
thereby will qualify to enter into a performance fee arrangement under
the rule. However, the Commission believes that the number may be
substantial. The Commission also believes that it would be reasonable
to estimate that the overall effect of the amendments to the rule would
be to increase the use of the exemption by small entities, and that the
economic effect on small entities may be significant.
The FRFA states that the rule amendments will not impose any new
reporting, recordkeeping or compliance requirements. The FRFA also
discusses the various alternatives considered by the Commission in
connection with the rule amendments that might minimize the effect on
small entities, including (a) the establishment of differing compliance
or reporting requirements or timetables that take into account the
resources of small entities; (b) the clarification, consolidation or
simplification of compliance and reporting requirements under the rule
amendments for small entities; (c) the use of performance rather than
design standards; and (d) an exemption from coverage of the rule or any
portion of the rule, for small entities. As discussed in more detail in
the FRFA, the amended rule will reduce the regulatory burden on all
investment advisers, impose no new compliance or reporting
requirements, and include a transition rule allowing existing
arrangements to continue. The Commission therefore believes that it
would be inappropriate to establish a different timetable for small
entities, to further clarify, consolidate or simplify the rule's
requirements for small entities, or to provide an even broader
exemption for small entities.
The FRFA is available for public inspection in File No. S7-29-87,
and a copy may be obtained by contacting Kathy D. Ireland, Securities
and Exchange Commission, 450 5th Street, N.W., Mail Stop 5-6,
Washington, D.C. 20549.
V. 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 Rule
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 authority citation for Part 275 is revised to read as
follows:
Authority: 15 U.S.C. 80b-2(a)(17), 80b-3, 80b-4, 80b-6(4), 0b-
6a, 80b-11, unless otherwise noted.
Section 275.203A-1 is also issued under 15 U.S.C. 80b-3a.
Section 275.203A-2 is also issued under 15 U.S.C. 80b-3a.
Section 275.204-2 is also issued under 15 U.S.C. 80b-6.
Section 275.205-3 is also issued under 15 U.S.C. 80b-5(e).
2. Section 275.205-3 is revised to read as follows:
Sec. 275.205-3 Exemption from the compensation prohibition of section
205(a)(1) for investment advisers.
(a) General. The provisions of section 205(a)(1) of the Act (15
U.S.C. 80b-5(a)(1)) will not be deemed to prohibit an investment
adviser from entering into, performing, renewing or extending an
investment advisory contract that provides for compensation to the
investment adviser on the basis of a share of the capital gains upon,
or the capital appreciation of, the funds, or any portion of the funds,
of a client, Provided, That the client entering into the contract
subject to this section is a qualified client, as defined in paragraph
(d)(1) of this section.
(b) Identification of the client. In the case of a private
investment company, as defined in paragraph (d)(3) of this section, an
investment company registered under the Investment Company Act of 1940,
or a business development company, as defined in section 202(a)(22) of
the Act (15 U.S.C. 80b-2(a)(22)), each equity owner of any such company
(except for the investment adviser entering into the contract and any
other equity owners not charged a fee on the basis of a share of
capital gains or capital appreciation) will be considered a client for
purposes of paragraph (a) of this section.
(c) Transition rule. An investment adviser that entered into a
contract before August 20, 1998 and satisfied the conditions of this
section as in effect on the date that the contract was entered into
will be considered to satisfy the conditions of this section; Provided,
however, that this section will apply with respect to any natural
person or company who is not a party to the contract prior to and
becomes a party to the contract after August 20, 1998.
(d) Definitions. For the purposes of this section:
(1) The term qualified client means:
(i) A natural person who or a company that immediately after
entering into the contract has at least $750,000 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 $1,500,000 at the
time the contract is entered into; 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
(iii) A natural person who immediately prior to entering into the
contract is:
(A) An executive officer, director, trustee, general partner, or
person serving in a similar capacity, of the investment adviser; or
(B) An employee of the investment adviser (other than an employee
performing solely clerical, secretarial or administrative functions
with regard to the investment adviser) who, in connection with his or
her regular
[[Page 39028]]
functions or duties, participates in the investment activities of such
investment adviser, provided that such employee has been performing
such functions and duties for or on behalf of the investment adviser,
or substantially similar functions or duties for or on behalf of
another company for at least 12 months.
(2) The term company has the same meaning as in section 202(a)(5)
of the Act (15 U.S.C. 80b-2(a)(5)), but does not include a company that
is required to be registered under the Investment Company Act of 1940
but is not registered.
(3) The term private investment company means a company that would
be defined as an investment company under section 3(a) of the
Investment Company Act of 1940 (15 U.S.C. 80a-3(a)) but for the
exception provided from that definition by section 3(c)(1) of such Act
(15 U.S.C. 80a-3(c)(1)).
(4) The term executive officer means the president, any vice
president in charge of a principal business unit, division or function
(such as sales, administration or finance), any other officer who
performs a policy-making function, or any other person who performs
similar policy-making functions, for the investment adviser.
Dated: July 15, 1998.
By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 98-19373 Filed 7-20-98; 8:45 am]
BILLING CODE 8010-01-P
