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SEC Proposes Changes to the Qualified Client Definition

May.24.2011

The SEC has proposed amendments to Rule 205-3 under the Investment Advisers Act. Concerned investment advisers should consider providing comments to the SEC on its proposed amendments and, more broadly, consider whether their existing client intake policies and subscription documents will comply with the proposed SEC amendments on a prospective basis.

Rule 205(a)(1) generally prohibits SEC-registered investment advisers from charging performance fees, incentive allocations or carried interest to their clients. As an exception to Rule 205(a)(1), Rule 205-3 permits SEC-registered investment advisers to charge these types of performance-based fees to their "qualified clients." SEC Rule 205-3 currently defines "qualified clients" as including clients that either have (1) a net worth of at least $1 million (the "net worth test") or (2) at least $750,000 in assets under management with the adviser (the "assets under management test"). To comply with the requirements of the Dodd-Frank Act, the SEC has proposed amendments to Rule 205-3 to increase the numerical thresholds for (1) the minimum net worth test to $2 million and (2) the minimum assets under management test to $1 million.

Importantly, and in a change not required by the Dodd-Frank Act but which parallels the SEC's change to the definition of "accredited investor" under the Securities Act of 1933, the SEC has proposed to exclude the value of the client's primary residence from the calculation of net worth and to decrease the client's net worth by the amount of mortgage debt on the client's primary residence in excess of the fair market value of the residence. The proposed amendments also include a mechanism to adjust these numerical thresholds for future inflation.

The SEC has proposed two transitional arrangements for existing clients of investment advisers. First, the SEC has proposed grandfathering clients who satisfied Rule 205-3 at the time that they originally entered into the investment advisory contract (even with respect to additional investments made by those clients following the effectiveness of the proposed amendments). Second, the SEC has proposed grandfathering clients of investment advisers previously exempt from registration with the SEC pursuant to SEC Rule 203 at the time they originally entered into the investment advisory contract. This second transitional arrangement will be important for those investment advisers who will be required to register with the SEC for the first time as a result of the Dodd-Frank Act.

The proposed amendments to Rule 205-3 do not affect funds' ability to rely on the exception from registration as an investment company pursuant to Section 3(c)(7) of the Investment Company Act. Therefore, funds relying on the Section 3(c)(7) exception will continue to be exempt from the requirements of Rule 205-3. However, funds relying on the exception from registration under Section 3(c)(1) of the Investment Company Act are subject to Rule 205-3, and therefore need to consider the impact of the proposed changes to Rule 205-3.

In its release describing the proposed amendments, the SEC sought comment on a number of important issues for investment advisers, including:

  • Is the SEC's proposed exclusion of the value of the client's primary residence from the calculation of the client's net worth, and its proposed treatment of mortgage debt, appropriate?
  • Are the transitional arrangements described above appropriate?
  • When should the proposed amendments to Rule 205-3 become effective?

The comment period for Rule 205-3 is open until July 11, 2011. To date, the SEC has published only limited public comments to the proposed rule. In light of the fact that the SEC has explicitly sought comment on the proposed amendments, concerned investment advisers should consider commenting to the SEC.

In addition, if the proposed amendments become effective in their current form, investment advisers will need to consider whether they have adequate policies in place for new clients and up-to-date subscription documents for their clients and funds. Up-to-date policies and forms will be important because many states follow Rule 205-3 for state-registered investment advisers.

The SEC notice can be found here.

The full proposed rule can be found here.

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For more information, please contact the professional(s) listed below, or your regular Crowell & Moring contact.

Richard B. Holbrook Jr.
Partner – Washington, D.C.
Phone: +1 202.508.8779
Email: rholbrook@crowell.com
Jenny E. Cieplak
Counsel – Washington, D.C.
Phone: +1 202.624.2542
Email: jcieplak@crowell.com