Performance-Based Investment Advisory Fees Update

Performance-Based Investment Advisory Fees Update

On November 4, 2021, the Securities and Exchange Commission (SEC) issued amendments to Rule 205-3 under the Investment Advisers Act of 1940 ("Advisers Act") that permits investment advisers to charge performance-based fees to "qualified clients." Under the rule, qualified clients are defined as clients who have at least $500,000 under the adviser's management (assets-under-management) or with a net worth (net worth test) of more than $1,000,000.

The Advisers Act bans a registered investment adviser from engaging in any investment advisory contract that ties the compensation to a share of capital gains or capital appreciation. Congress enacted these restrictions to protect clients from fee arrangements that could encourage advisers from partaking in speculative trading to increase advisory fees. However, under the new amendments to Rule 205-3 of the Adviser Act, the SEC permits advisers to base compensation on capital gains and capital appreciation if the client falls under the definition of a "qualified client."

In 2011, the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank Act") allowed the SEC to adjust the "qualified client" definition dollar amount threshold every five years to account for the effects of inflation. Later that year, the SEC increased the dollar amount thresholds from $500,000 to $1,000,000 for assets-under-management and increased net worth test dollar value from $1,000,000 to $2,000,000. Adjustments for inflation were conducted in 2016 and most recently in June 2021, where the SEC increased the dollar amount threshold of asset-under-management and net worth test to $1,100,000 and $2,200,000, respectively.

When adopting amendments to Rule 205-3, the SEC typically codifies the specific dollar amount thresholds in Section D(1) by issuing an order and then provides the next adjustment date in Section E(1). For example, prior to adopting this amendment, Section E of the rule states, "this section shall be adjusted by order of the Commission, on or about May 1, 2016, and issued approximately every five years thereafter." Under these amendments, any future changes to Rule 205-3 will now refer to the SEC's "most recent order," rather than a specific dollar amount threshold, and will also update Section E to state the particular date of the next inflation adjustment, which is now May 1, 2026.

The SEC believes this approach will ensure that the rule remains consistent by having the dollar amounts contained within the orders and will provide clarity to market participants. According to the SEC, as of August 2021, 36% of all registered advisers reported that they practice performance-based compensation. However, the Commission does not expect these amendments to Rule 205-3 having substantial impact on the market and its participants since this amendment does not change the dollar amount threshold. The amendments to Rule 205-3 are intended to help investment advisers and clients identify the current thresholds of a "qualified client" more easily. Furthermore, these amendments will allow market participants to quickly identify the next adjustment date as it will be explicitly stated.

These amendments to Rule 205-3 took effect on November 10, 2021. Your SEC reporting partner must keep up with the latest disclosures. Contact one of our experts at CompSci to see how we can address your SEC compliance needs.