Rule 205-3

SEC Issues Order Increasing the Net Worth Test Under Rule 205-3 Under the Investment Advisers Act of 1940 to $2.1 Million

Section 205(a)(1) of the Investment Advisers Act of 1940 (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 of the client. Rule 205-3 under the Advisers Ac exempts an investment adviser from this prohibition in certain circumstances when the client is a “qualified client.”  The definition of “qualified client” includes an assets under management standard set as $1,00,000 and a net worth test that set at (in the case of a natural person, with assets held jointly with a spouse), more than $2,000,000.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) amended Section 205(e) of the Advisers Act to provide that, by July 21, 2011 and every five years thereafter, the SEC shall adjust for inflation the dollar amount thresholds included in rules issued under Section 205(e), rounded to the nearest $100,000.  Rule 205-3 now states that the SEC 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 (published by the United States Department of Commerce).  Based upon this requirement, no change in the assets under management test is required, but the dollar amount of the net worth test would increase to $2,100,000.

Accordingly, on June 14, the SEC issued an Order, effective as of August 15, 2016, that:

  1. for purposes of Rule 205-3(d)(1)(i) under the Advisers Act, a “qualified client” means a natural person who, or a company that, immediately after entering the contract has at least $1,000,000 under the management of the investment adviser; and
  2. for purposes of Rule 205-3(d)(1)(ii)(A) under the Advisers Act, 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.

SEC Order to Increase Performance Fee Thresholds

On July 12, pursuant to Section 418 of the Dodd-Frank Act, the SEC issued an order that raises two of the thresholds that determine whether an investment adviser can charge its clients performance fees pursuant to Rule 205-3 under the Investment Advisers Act. The order increases the dollar amount tests for: (i) assets under management from $750,000 to $1 million; and (ii) net worth from $1.5 million to $2 million. The order will be effective on September 16. SEC Release. SEC Order.

SEC Proposed Rule on Inflation Indexing of Performance Fees

On May 10, pursuant to Section 418 of the Dodd-Frank Act, the SEC proposed amending Rule 205-3 under the Investment Advisers Act, which mandates certain dollar thresholds be met before an investment adviser may charge a client performance fees. The proposed amendment would increase required assets under management and net worth thresholds from $750,000.00 and $1.5 million to $1 million and $2 million, respectively. The net worth test would exclude the value of a client’s principal residence and existing contracts in compliance with the original Rule 205-3 would be grandfathered. Comments must be submitted no later than July 11. SEC Release. SEC Proposed Rule.