Effective August 15, 2016, the federal definition of “qualified client” will change to raise the “Net Worth Test” threshold from $2,000,000 to $2,100,000. Passed on June 14, 2016 by Order of the U.S. Securities and Exchange Commission (“SEC”), the change represents a five percent (5%) increase to the Net Worth Test. Notably, many states follow the same framework for the performance-based fee exemption and expressly incorporate the SEC’s qualified client definition into the state’s assessment. This means that the federal Order may also directly affect many smaller state-registered registered investment adviser (RIA) firms without need for legislative or administrative action directly by the state.
The adjustment is important because the Investment Advisers Act of 1940 (“Adviser’s Act”) general prohibits an adviser from receiving performance-based fees (compensation based on a share of capital gains on or capital appreciation of a client’s account), but Rule 205-3 carves out an exemption from this prohibition for qualified clients. In general, a “Qualified Client” satisfies one of the following tests:
- Assets Under Management (AUM) Test: a natural person or company who at the time of entering into such agreement has at least $1,000,000 under the management of the investment adviser.
- Net Worth Test: a natural person or company who the adviser reasonably believes at the time of entering into the contract: (A) has a net worth of jointly with his or her spouse of more than $2,100,000 excluding the value of the client’s primary residence; or (B) is a qualified purchaser as defined in the Investment Company Act of 1940.
- Bona Fide Employee Test: a natural person who at the time of entering into the contract is: (A) An executive officer, director, trustee, general partner, or person serving in similar capacity of the investment adviser; or (B) An employee of the investment adviser (other than an employee performing solely clerical, secretarial, or administrative functions with regard to the investment adviser), who has participated in the adviser’ investment activities for at least 12 months.
The reason for the adjustment is that both the Net Worth Test and the AUM Test are to be updated every five (5) years per the Adviser’s Act and the Dodd-Frank Act to account for inflation based on the U.S. Department of Commerce’s Personal Consumption Expenditures Chain-Type Price Index (more commonly referred to as the PCE price index). Any revisions to the dollar amount under these two tests are rounded to the nearest $100,000 and are based on inflation from 2011 to the end of 2015.
For many RIA firms, this comparatively small increase will not make much difference when assessing whether a client can be charged a performance-based fees. That is because:
- The net worth of most prospective clients will either (i) easily fall below or (ii) easily surpass the new threshold.
- The other two prongs of the definition (the AUM Test and Bona Fide Employee Test) remain unchanged.
- Note: Because the PCE price index inflation increase was below the rounding threshold, the AUM Test will remain unchanged at this time.
- The increased net worth threshold will not generally affect agreements in place before August 15, 2016.
- Note: The lack of retroactive application could provide incentive for firms with prospective clients or private fund investors in the $2,000,000 net worth range to reach an agreement before the effective date.
- Note: If, however, a person not covered by the agreement becomes a party an agreement already in place, then the increased net worth threshold will apply to that new party (natural person or company).
- Most RIA firms do not offer a performance-based fee structure.
However, any advisers even offering a performance-based fee structure -whether under the Net Worth qualification or otherwise, and regardless of whether any client actually pays a performance-based fee- should ensure that all documentation regarding the qualified client definition is properly updated. This would include, inter alia, fund offering documents, investment advisory agreements for separately managed accounts, investor/client assessment or intake forms, and Form ADV.
For further details, the full text of the SEC Order is available for download here. Investment advisers with questions about how recent changes, scheduled future changes, and performance-based fees in general may affect their practice are encouraged to contact us.