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  1. 1. SATTERLEE STEPHENS BURKE & BURKE LLP HEDGE FUND & INVESTMENT MANAGERS ADVISORY July 22, 1998 SEC AMENDS RULE ALLOWING INVESTMENT ADVISERS TO CHARGE PERFORMANCE FEES The Securities and Exchange Commission (the "SEC") has finalized its proposed amendment to 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 rule amendments will become effective August 20, 1998. EXECUTIVE SUMMARY 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, the Rule currently mandates that certain contractual provisions appear in all Performance Fee Contracts. The adopted amendments to Rule 205-3:  limit the category of clients eligible for Performance Fee Contracts (“Qualified Clients”) to those who either (i) have $750,000 under management with the adviser, (ii) have a net worth of $1,500,000, (iii) are "qualified purchasers" under Section 2(a)(51)(A) of the Investment Company Act of 1940 (the "Investment Company Act"), or (iv) are “knowledgeable employees” of the Investment Adviser; and  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 increasing the amount of the assets under management
  2. 2. standard from $500,000 to $750,000 and the net worth standard for Qualified Clients from $1,000,000 to $1,500,000. However, the amended Rule adds additional categories of investors as Qualified Clients. As amended, the Rule permits 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. In general there are five categories of qualified purchasers: (1) Natural persons owning “investments” of at least $5 million; (2) Family owned companies owning not less than $5 million in investments; (3) Trusts whose trustees or equivalent decision makers and whose settlors or other asset contributors are all qualified purchasers described in (1) and (2) above; (4) Institutional investors, acting for their own accounts or for other qualified purchasers, that own and invest on a discretionary basis “investments” of at least $25 million, including employee benefit plans that are not participant-directed; and (5) Certain qualified institutional buyers (“QIBs” acting for their own accounts or for other QIBs or qualified purchasers. Specifically excluded from the definition of qualified purchasers are (i) participant- directed employee benefit plans and (ii) with respect to any particular Section 3(c)(7) Fund, any entity formed for their specific purpose of investing in that Fund unless all of the entity’s beneficial owners are themselves qualified purchasers. The SEC will now also permit certain “knowledgeable employees” of the investment adviser to be considered Qualified Clients. The new category is similar to the definition of knowledgeable employee in Rule 3c-5 under the Investment Company Act, and includes executive officers, directors, trustees, and general partners of the investment adviser, and other persons serving in similar capacities, as well as certain other employees of the adviser who participate in investment activities and have performed such functions for at least 12 months. “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. Although the Rule amendment retains the "look through" provision, it clarifies it by stating 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
  3. 3. interference with existing adviser-client relationships, the adopted amendments have a transition rule permitting investment advisers and their clients to maintain their existing performance fee arrangements notwithstanding a client’s 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 August 20, 1998 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 will 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 amendments to Rule 205-3 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. The elimination of the One Year Rule allows advisers to negotiate all of the terms of a Performance Fee Contract with a Qualified Client, free of mandatory contract provisions. Although the amendments have eliminated the need for lock-up provisions, advisers may still want 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 will 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 arrangement disclosures. * * * * *
  4. 4. Copyright 1998 Satterlee Stephens Burke & Burke LLP. All Rights Reserved. This and other articles published by Satterlee Stephens Burke & Burke LLP are intended as general information only, not specific legal advice. We encourage interested parties to contact the authors for information on the subjects discussed in their articles. Before acting on any of the information in this publication, the services of an attorney should be sought.