By David Mainzer

March 2012

Effective on May 22, 2012, the Securities and Exchange Commission (the “SEC”) has amended Rule 205-3 under the Investment Advisers Act of 1940 (the “Advisers Act”) to adjust criteria necessary for a person to qualify as a “qualified client.”  Rule 205-3 is an SEC rule that allows investment advisers to charge their clients performance based fees, which are otherwise prohibited by Section 205(a)(1) of the Advisers Act.  For hedge funds and other funds, investors in the fund must be qualified clients in order for the fund to be able to pay performance fees to the investment adviser.

Since September 19, 2011, SEC Rule 205-3(d) has provided that individuals and companies are qualified clients if either (a) they have $1,000,000 under the management of the investment adviser (including capital contributions and bona fide capital commitments of private fund investors) immediately after entering into the investment management agreement providing for the performance fees or (b) the investment adviser reasonably believes that, immediately prior to entering into the investment management agreement providing for the performance fees, either (i) they have a net worth (for natural person, this includes assets jointly held with a spouse) of more than $2,000,000 or (ii) they are a “qualified purchaser” as defined in the Investment Company Act of 1940.

The latest rulemaking by the SEC will make three changes to the qualified client definition as of May 22, 2012.

First, in calculating the client’s net worth, the client will be required to exclude the value of the client’s primary residence from their net worth.  Client’s are generally also entitled to exclude the amount of any mortgage or other indebtedness secured by their primary residence, but the value of such indebtedness must be deducted from their net worth to the extent that (a) the indebtedness exceeds the fair market value of the client’s primary residence or (b) the indebtedness exceeds the amount of indebtedness that was secured by the client’s primary residence 60 days before the date on which the client’s net worth is calculated.  This change is similar to the change the SEC made to the net worth calculations in the “accredited investor” definition under the Securities Act of 1933.

Second, the new SEC rules provide that the foregoing amounts (i.e. $1,000,000 under management of the adviser or $2,000,000 of net worth) will be adjusted on or about May 1, 2016, and approximately every 5 years thereafter, to account for inflation.

Third, the SEC has amended the transition rules in Rule 205-3(c) to provide for certain arrangements that are already in place.  This means that clients and private fund investors who validly entered into contracts providing for performance fees prior to May 22, 2012 will generally be entitled to continue to pay performance fees under such existing contracts.

Investment advisers will need to update their compliance policies and procedures, by May 22, 2012, to ensure compliance with the changed rule.  For managers of hedge funds and other private funds, this will generally also require updates to the funds’ offering documents, including subscription documents and private placement memoranda.


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