Increases to the Qualified Client Standard

There are so many buckets for classifying clients and investors under the SEC regulatory standards. Lots of focus and discussion has been targeted at the “accredited investor” standard for private placements. The “Qualified Client” standard under the Investment Advisers Act seems to attract very little attention.

Rule 205-3 under the Advisers Act exempts an investment adviser from the prohibition against charging a client performance fees when the client is a “qualified client.” The rule allows an adviser to charge performance fees for clients with a lot of money.

There are two ways to qualify as a “Qualified Client”:  

(1) “a natural person who, or a company that, immediately after entering into the contract has at least $1,000,000 under the management of the investment adviser” or

(2) “a natural person who, or a company that, the investment adviser entering into the contract (and any person acting on his behalf) reasonably believes, immediately prior to entering into the contract … has a net worth (together, in the case of a natural person, with assets held jointly with a spouse) of more than $2,000,000.

The Dodd-Frank Wall Street Reform and Consumer Protection Act amended section 205(e) of the Advisers Act to provide that every five years, the SEC has to adjust for the effects of inflation the dollar amount thresholds for a Qualified Client, rounded to the nearest multiple of $100,000. That five year mark has come around and the standards are increasing as of August 16, 2021.

Registered investment advisers entering into performance-based compensation arrangements with clients on or after Aug. 16, 2021 will have to make sure the client has assets under management of at least $1.1 million or have a net worth of at least $2.2 million.

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Increasing the Threshold for Qualified Clients and Performance Fees

The U.S. Securities and Exchange Commission proposed to increase the net worth threshold for “Qualified Clients” from $2 million to $2.1 million.

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Rule 205-3 currently requires “qualified clients” to have at least $1 million of assets under management with the adviser or a net worth of at least $2 million.

Under the Investment Advisers Act, an adviser can only charge a performance fee if the client is a “qualified client”. The SEC equates net worth with sophistication, so a “qualified client” had to have a level assets to prove their financial sophistication.

The Dodd-Frank Wall Street Reform and Consumer Protection Act required a change for Section 205(e) of the Advisers Act by adjusting the levels for inflation and to re-adjust the levels every five years. The SEC also tossed out the value of a person’s primary residence, just as they did with the accredited investor standards.

The last inflation adjusted increase was in 2011, so it’s time to adjust again.

Inflation has been low, so the increase is small. So small that the inflation increase for the $1 million assets under management prong is below the rounding amount specified in Rule 205-3.

So it’s time to revise you client intake / investor subscription documents.

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Steps to Determine if an Investor is Accredited

Private funds will be able to advertise and solicit for investor, provided all of the investors are “accredited investors.” The will dramatically change the way capital raising for private funds operates.

The drawback is the loss of 35 non-accredited investors in the fund. That exception has been eliminated. Funds will need to wait until the Securities and Exchange Commission issues the rules under Section 201 of the JOBS Act.

Part of those rules may be a mandated approach to determine if someone is an accredited investor.

“Such rules shall require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission.”

The SEC may take the opportunity to mandate an approach to validate an investor’s financial standing. As with most regulations, it could clear up uncertainty or create a paperwork headache (or both).

Will you need a copy of an investor’s W-2? A certified financial statement? Those are reasonable requests. However it would create much more personal information that would need to be safeguarded by the fund sponsor.

There is the possibility that the mandated approach would also address the requirements to determine if an investor is “qualified client” under the Investment Advisers Act or a “qualified purchaser” under the Investment Company Act.

We will have to wait and see what comes out of 100 F Street.

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Private Fund Advisers and State Registration

As a result of the shifting boundaries between state and federal regulation of investment advisers, NASAA created a model rule for Registration Exemption for Investment Advisers to Private Funds. The rule tracks the general parameters of the new federal rules for investment adviser registration for private fund advisers.

Massachusetts became the latest state to adopt its own regulations with such an exemption. A new private fund adviser exemption was adopted by the Massachusetts Securities Division, along with amendments to the “qualified institutional buyer” definition and IA custody requirements.

While the amendments took effect February 3, 2012, they will be not be enforced until August 3, 2012. You’ve got six months to get in compliance. The rules apply to adviser firms doing business in the Commonwealth, which generally means having a place of business in Massachusetts.

The new Massachusetts exemption is available to advisers to private funds that take money only from “qualified clients.” That definition carries over from Rule 205-3. Under that updated SEC rule,  “qualified clients” must have at least $1 million of assets under management with the adviser, up from $750,000, or a net worth of at least $2 million, up from $1 million.

Private funds using the Section 3(c)(7) exemption under the Investment Company should already meet this standards. Managers to section 3(c)1 funds will need to increase their threshold for investors from accredited investors to qualified clients.

The Massachusetts regulation tries to complement the SEC changes affecting private fund advisers under Dodd-Frank. So private fund advisers with between $25M-$150M in AUM, would have to file the exempt-reporting adviser sections of Form ADV. Those with more than $150M in AUM would have to notice file in the state as well as register with the SEC. Those private fund advisers with under $25M in AUM would also complete the exempt reporting sections of the form for Massachusetts.

States are still trying to catch up to the Dodd-Frank requirements:

They are well behind, leaving some uncertainty for managers of smaller private funds about their registration requirements.

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Tighter Rules on Advisory Performance Fee Charges

Under the Investment Advisers Act, an adviser can only charge a performance fee if the client was a “qualified client”. The SEC equates net worth with sophistication, so a “qualified client” had to have a level assets to prove their financial sophistication. Those levels are now officially increased.

The original standard was that the client had to have at least $500,000 under management with the adviser immediately after entering into the advisory contract (“assets-under-management test”) or if the adviser reasonably believed the client had a net worth of more than $1 million at the time the contract was entered into (“net worth test”). Those levels were increased to $750,000 and $1.5 million in 1985 to adjust for inflation.

The Dodd-Frank Wall Street Reform and Consumer Protection Act called for Section 205(e) of the Advisers Act to adjust those levels for inflation and re-adjust the levels every five years. The SEC also decided to toss out the value of a person’s primary residence, just as they did with the new accredited investor standards.

The rule now requires “qualified clients” to have at least $1 million of assets under management with the adviser, up from $750,000, or a net worth of at least $2 million, up from $1 million.

The SEC is using the same primary residence calculation they used in the new accredited investor standard. So, if you owe more on your mortgage than the value of your house, then you need to treat the overage as a negative asset. As the SEC did with the accredited investor standard, the SEC requires certain mortgage refinancings to be counted against net worth. If the borrowing occurs in the 60 days preceding the purchase of securities in the exempt offering and is not in connection with the acquisition of the primary residence, the new increase in debt secured by the primary residence must be treated as a liability in the net worth calculation. This is intended to prevent manipulation of the net worth standard, by eliminating the ability of individuals to artificially inflate net worth under the new definition by borrowing against home equity shortly before participating in an exempt securities offering. Once again, owning a house can only be a negative for the SEC standards.

While I used the CPI-I standard as the benchmark for inflation, the SEC chose to use the Personal Consumption Expenditures Chain-Type Price Index (“PCE Index”), published by the Department of Commerce. One of the questions from the SEC in the proposed rule was whether the PCE index was the appropriate measure of inflation. They’ve decided to use this index and continue to benchmark it against the original test amounts. In five years, you will be able to predict what the new levels will be.

As for private  funds, Rule 205-3(b) requires a look -through from the fund to the investors in the fund. Each “equity owner … will be considered a client for purposes of the” limitation.  If the fund is relying on the 3(c)(7) exemption from the Investment Company Act then the fund’s investors should be “qualified purchasers”  and you won’t need to look much further. If the fund is using the 3(c)(1) exemption, then it will need to take a closer look at its investors to make sure that each is a qualified client.

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The SEC Is Making it Harder for Investment Advisers to Earn Performance Fees

The Securities and Exchange Commission is proposing to raise the dollar thresholds for someone to be considered a “qualified client.”

The definition of a qualified client is set out in Rule 205-3. This is an exemption to the Section 205(a)(1) general prohibition on performance fees.  Section 205(e) grants the SEC the power to create an exemption from the limitation “on the basis of such factors as financial sophistication, net worth, knowledge of and experience in financial matters, amount of assets under management, relationship with a registered investment adviser,” and other factors. The SEC created an exemption in Rule 205-3 for “qualified clients.”

Section 418 of the requires the SEC to adjust the standard for a Qualified Client for the effects of inflation within one year and then every five years.

Back in August I predicted the standard would be raised to a minimum investment of $1 million and the minimum net worth would rise to $2 million. I was proven wrong about my prediction of a rise in the accredited investor standard.

The SEC is proposing that the standard increase to a minimum investment of $1 million and the minimum net worth would rise to $2 million. As to net worth, they are excluding the value of a person’s primary residence.

The SEC is using the same primary residence calculation they used in the “new” accredited investor standard. So, if you owe more on your mortgage than the value of your house, then you need to treat the overage as a negative asset. Once again, owning a house can only be a negative for the SEC standards.

While I used the CPI-I standard as the benchmark for inflation, the SEC chose to use the Personal Consumption Expenditures Chain-Type Price Index (“PCE Index”), published by the Department of Commerce

One of the comments the SEC is seeking in the proposed rule is whether the PCE index is the appropriate measure of inflation.

As for private  funds, Rule 205-3(b) requires a look -through from the fund to the investors in the fund. Each “equity owner … will be considered a client for purposes of the” limitation.  If the fund is relying on the 3(c)(7) exemption from the Investment Company Act then the fund’s investors should be “qualified purchasers”  and you won’t need to look much further. If the fund is using the 3(c)(1) exemption, then it will need to take a closer look at its investors to make sure that each is a qualified client.

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Changes to the Qualified Client Standard

In addition to the changing standard for an accredited investor, the standard for a “qualified client” under the Investment Advisers Act is also changing. Section 418 of the requires the SEC to increase the standard.

SEC. 418. QUALIFIED CLIENT STANDARD.
Section 205(e) of the Investment Advisers Act of 1940 (15 U.S.C. 80b–5(e)) is amended by adding at the end the following: ‘‘With respect to any factor used in any rule or regulation by the Commission in making a determination under this subsection, if the Commission uses a dollar amount test in connection with such factor, such as a net asset threshold, the Commission shall, by order, not later than 1 year after the date of enactment of the Private Fund Investment Advisers Registration Act of 2010, and every 5 years thereafter, adjust for the effects of inflation on such test. Any such adjustment that is not a multiple of $100,000 shall be rounded to the nearest multiple of $100,000.’’.

Unlike some of the arguments over whether the accredited investor standard should be adjusted based on inflation, this standard is explicitly tied to inflation.

The definition of a qualified client is set out in Rule 205-3.

Currently, the investor has to have at least $750,000 under management with the adviser/fund.  That standard was adopted in July 1998. Using the CPI-U of 163.2 in  July 1998 and 217.965 in June 2010, the minimum investment amount should increase to $1,000,000.

The net worth amount of $1.5 million was also adopted in July 1998. Using the same ratio, I would expect the minimum net worth to rise to $2 million.

As for private  funds, Rule 205-3 requires a look -through from the fund to the investors in the fund. If the fund is relying on the 3(c)(7) exemption from the Investment Company Act then the fund’s investors should all be qualified purchasers or knowledgeable employees and you won’t need to look much further.

If the fund is using the 3(c)(1) exemption, then it will need to take a closer look at its investors to make sure that each is a qualified client.

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That fancy SEC logo appeared briefly on the SEC’s website on Monday. (Thanks for pointing this out Bruce.) It was odd enough that I thought it should be re-used.