The Securities and Exchange Commission (the "SEC") has announced a proposal to amend Rule 205-3 under the Investment Advisers Act of 1940 (the "Advisers Act") which permits registered investment advisers to charge certain clients performance fees (i.e., fees based upon the capital appreciation in a client's account).
The Advisers Act generally prohibits a registered investment adviser from entering into or performing any investment advisory contract that provides for compensation to the adviser based on a share of capital gains or capital appreciation in a client's account (a "Performance Fee Contract"). Currently, Rule 205-3 permits an adviser to enter into a Performance Fee Contract, and to receive a performance fee from, a client who has $500,000 under management with the adviser or who has a net worth in excess of $1,000,000. However, Rule 205-3 mandates that certain contractual provisions appear in all Performance Fee Contracts.
The proposed amendments to Rule 205-3 would:
o Limit the category of clients eligible for Performance Fee Contracts to those who either (i) have $750,000 under management with the adviser, (ii) have a net worth of $1,500,000, or (iii) are "qualified purchasers" under Section 2(a)(51)(A) of the Investment Company Act of 1940 (the "Investment Company Act"), and
o Eliminate the provisions specifying required contract terms and disclosures.
QUALIFIED CLIENTS
When the SEC adopted Rule 205-3 in 1985, it concluded that clients having at least $500,000 under management or a net worth in excess of $1,000,000 do not need the full protection provided by the Advisers Act's restrictions on performance fee arrangements. The SEC has stated that because the assets under management and net worth thresholds have been affected by inflation since 1985, it is proposing to increase the amount of the assets under management standard from $500,000 to $750,000 and the net worth standard from $1,000,000 to $1,500,000.
The SEC has also proposed to permit investment advisers to enter into Performance Fee Contracts with clients who are "qualified purchasers" under Section 2(a)(51)(A) of the Investment Company Act. Among other things, the National Securities Markets Improvement Act of 1996 (the "Improvement Act") amended the Investment Company Act and the Advisers Act to create a new type of private fund (a "Section 3(c)(7) Fund") which may be sold to an unlimited number of "qualified purchasers" and to allow investment advisers to charge performance fees to Section 3(c)(7) Funds without restriction. Generally, qualified purchasers include natural persons and family owned companies owning at least $5 million of investments, trusts whose trustees and asset contributors are all qualified purchasers described in the preceding clause, and institutional investors that own and invest at least $25 million of investments in a discretionary basis. Although, in most cases, persons who are qualified purchasers are eligible to enter into a Performance Fee Contract under Rule 205-3, even as it is proposed to be amended, in some cases such persons would not be eligible. Nevertheless, the SEC believes that qualified purchasers, too, do not need the full protection provided by the Advisers Act's restrictions on performance fee arrangements. Therefore, the SEC has proposed to permit advisers to enter into performance fee arrangements with "qualified purchasers" under circumstances not involving a Section 3(c)(7) Fund, even if the qualified purchaser fails to satisfy either of the $750,000/$1,500,000 thresholds.
All clients who satisfy the new eligibility criteria under Rule 205-3 will be referred to by the SEC as "Qualified Clients".
"LOOKING THROUGH" TO THE ULTIMATE CLIENT
Currently, Rule 205-3 provides that with respect to certain clients entering into Performance Fee Contracts
private investment companies, registered investment companies, and business development companies -- the adviser must "look through" the legal entity of the client to determine whether each equity owner of the client would be a Qualified Client. The SEC's proposed amendment would retain the "look through" provision but clarify that any equity owner that is exempt from or is otherwise not charged a performance fee would not be required to be a Qualified Client.
TRANSITION RULE
The SEC recognizes that many clients who currently satisfy the eligibility requirements of Rule 205-3 may not be Qualified Clients under the proposed amendments. To avoid interference with existing adviser-client relationships, the proposed amendments would add a transition rule permitting investment advisers and their clients to maintain their existing performance fee arrangements notwithstanding the clients' failure to satisfy eligibility criteria after the thresholds increase to $750,000/$1,500,000. Such arrangements could continue under the transition rule if they were entered into before the effective date of the amendments and they satisfied the requirements of Rule 205-3 as in effect at that time. A new party to an existing arrangement, however, would be required to satisfy the new Qualified Client criteria. Thus, for example, hedge funds managed by registered investment advisers would have to modify their eligibility criteria, both for new investors and for permitted transferees of limited partnership or other equity interests, in order to continue their existing performance fee practices.
ELIMINATION OF SPECIFIC CONTRACT AND DISCLOSURE REQUIREMENTS
In an effort to give investment advisers greater flexibility in structuring fee arrangements with financially sophisticated investors, the proposed amendments to Rule 205-3 would eliminate the prescribed contract terms and disclosure currently applicable to Performance Fee Contracts. These requirements include the "One Year Rule" which mandates that any compensation paid to an adviser with respect to the performance of any security over a given period of time be based on all appreciation, net of all depreciation, in the client's account for a period of not less than one year. As a consequence of the One Year Rule, many hedge funds incorporate lock-up provisions that preclude investors from withdrawing any capital during their first year of participation in the fund. If the proposals are adopted, the One Year Rule would be eliminated and advisers would be free to negotiate all of the terms of a Performance Fee Contract with a Qualified Client, free of mandatory contract provisions. Although the proposed amendments would eliminate the need for lock-up provisions, many advisers will probably attempt to retain them for business reasons.
Currently, Rule 205-3 requires an adviser to disclose to clients all material information concerning its performance fees, including (1) that the fee arrangement may create an incentive for the adviser to enter into riskier or more speculative investments than would be the case otherwise; (2) if applicable, that the adviser may receive increased compensation based on unrealized appreciation as well as realized gains in the client's account; (3) a description of the period used to measure investment performance and its significance; (4) if applicable, the nature, significance and appropriateness of any index used to measure comparative investment performance; and (5) if the adviser's compensation is based in part on unrealized appreciation, the method used to value securities for which market quotations are not readily available. The SEC has noted, however, that an adviser charging a performance fee would continue to be subject to the anti-fraud prohibitions of Section 206 of the Advisers Act. As a result, an adviser would still be unable to enter into a performance fee arrangement that was inconsistent with the adviser's fiduciary duties and could not fail to all disclose material information about the performance fee to the client. As such, the elimination of mandatory Rule 205-3 disclosures will have little practical effect on performance fee arrangements.
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While providing some new flexibility to structure performance fee arrangements, the principal effect of the proposed amendments to Rule 205-3 will be to narrow the universe of "Qualified Clients" with whom registered investment advisers are free to enter into Performance Fee Contracts.
If you would like further information relating to hedge funds and their investment managers, contact Howard Neuman at (212) 818-9200.
SATTERLEE STEPHENS BURKE & BURKE LLP
230 Park Avenue New York, N.Y. 10169 Phone: (212) 818-9200 Fax: (212) 818-960747 Maple Street Summit, N.J. 07901-2518 Phone: (908) 277-2221 Fax: (908) 277-2038
World Wide Web Site:http://www.ssbb.com
To take action on any of the information contained in this report, you should seek professional advice.