On Monday, May 10, 2021, the U.S. Securities and Exchange Commission (“SEC”) issued a Notice of Intent to Issue an Order that “would adjust for inflation dollar amount thresholds in the rule under the Investment Advisers Act of 1940 (the “1940 Act”), which permits investment advisers to charge performance-based fees” to certain clients. That Rule, 205-3, was originally adopted in 1985 and has been revised in 1998, 2011, and 2016, in each case adjusting the thresholds higher.

Performance-Based Fees

Rule 205-3 was adopted under Section 205(a)(1) of the 1940 Act, which prohibits an investment adviser from charging fees based on capital gains or capital appreciation of the client’s funds. This was intended to protect clients from adviser arrangements that “might encourage advisers to take undue risks with client funds.” Indeed, in a February 1, 1994, letter from the SEC’s Division of Investment Management, the Division Director explains that the prohibition in Section 205 (a)(1) was included because “Performance fees in effect …[in 1940] rewarded an adviser …for good performance, without penalizing it for poor performance.”

In 1970, Congress enacted an exception to the prohibition of performance-based fees in investment adviser contracts if the contract covered investment of over $1 million, so long as a so-called “fulcrum fee” was charged. In general, a fulcrum fee involves averaging the fee over a specified period, and increasing or decreasing the fee in proportion to investment performance. One factor that may have made Congress more receptive in 1970 to allowing performance-based fees for advisers dealing with well-to-do investors was the 1969 publication of the Wheat Report (an SEC Report authored by Commissioner Frank Wheat), which called for the creation of an integrated disclosure system so that much more current information would be available about public companies even when no offer is occurring under the Securities Act of 1933, as amended.

Raising the Bar

In 1985, the SEC adopted Rule 205-3, which allowed an adviser to charge a performance-based fee if EITHER the client had at least $500,000 under management with the adviser (the “assets-under-management” or “AUM” test), OR the adviser reasonably believed that the client had a net worth of more than $1 million (the “net worth test”). The SEC stated that these standards “would limit the availability of the exemption to clients who are financially experienced AND able to bear the risks of performance fee arrangements.” [Emphasis added]. Clients who meet one of the two thresholds are characterized as “qualified clients” under the Rule. The Rule also imposes specific disclosure requirements and restrictions on how the fee is to be calculated.

In 1998, the SEC revised the Rule to reflect the impact of inflation, raising the AUM test to $750,000 and the net worth test to $1,500,000. In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act amended Section 205 of the 1940 Act to require the SEC to adjust the two tests for the effects of inflation every five years, rounding the increases to the nearest $100,000. In 2011, the SEC issued a responsive order raising the AUM test to $1 million and the net worth test to $2 million.

That 2011 Order specifically provided that the tests applied only to investment adviser contracts entered into after the Order took effect, i.e., that it had no retroactive effect so that an arrangement that was in compliance before that date remained compliant. The Rule further provided that the SEC would issue an Order approximately May 1, 2016, and every five years thereafter. Rule 205-3 also specified that the inflation should be measured by the Personal Consumption Expenditures Chain-Type Price Index (the “PCE Index”), published by the U.S. Department of Commerce. Interestingly the PCE Index is used in a number of other places in the securities laws, including the cash limit protection of each investor under the Securities Investor Protection Act of 1970.

SEC Proposal to Increase Thresholds

On June 14, 2016, the SEC issued an Order leaving the AUM test amount unchanged but raising the net worth test to $2,100,000. The lack of change in the AUM test for the five-year period 2011-2016 reflected the very slow growth of inflation during that time. The SEC now proposes to raise the AUM test to $1,100,000 and the net worth test to $2,200,000. Interested persons may request a hearing by submitting a written request by 5:30 p.m., Friday, June 4, 2021. Unless the SEC orders a hearing, a threshold adjustment Order will issue. The SEC notes that it anticipates that the adjustment Order will become effective 60 days after the Order date.