SHARTSIS, FRIESE & GINSBURG LLP
One Maritime Plaza
San Francisco, California 94111
Telephone: (415) 421-6500
Facsimile: (415) 421-2922
January 20, 1998
VIA E-MAIL AND FEDERAL EXPRESS
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W., Stop 6-9
Washington, D.C. 20549
Re: Proposed Changes to Rule 205-3 of the Investment
Advisers Act of 1940; File No. S7-29-97
Dear Mr. Katz:
We write in response to the request by the Securities and Exchange Commission (the "Commission") for public comment on the proposed amendments (the "Proposed Amendments") to Rule 205-3 (the "Rule") under the Investment Advisers Act of 1940, as amended (the "Advisers Act"), that were published on November 13, 1997, in Release No. IA-1682.
As background, our firm has a large investment advisory practice. We represent approximately 300 investment advisers, who manage more than 200 investment limited partnerships throughout the United States. Of the forty-five attorneys at our firm, fifteen devote all or a substantial part of their time to counseling investment advisers. Our practice group includes three former Commission enforcement attorneys. One of our partners, John P. Broadhurst, is a member of the ABA Subcommittee on Private Investment Entities. The views expressed in this letter, however, are those of our firm and are not submitted on behalf of that Subcommittee or any of our clients.
In general, we commend the Commission on the Proposed Amendments. We previously outlined our concerns regarding some of the provisions being eliminated in a letter from John P. Broadhurst to Robert E. Plaze dated May 3, 1996, a copy of which is enclosed. The proposed revisions address those concerns appropriately, and we suggest revisions only with respect to the proposed higher eligibility requirements, as discussed below.
The Proposed Amendments' elimination of the prescribed terms of performance fee contracts and the required specific disclosures to clients who are charged performance fees will allow advisers and their clients to negotiate more flexible performance compensation arrangements that are beneficial to both parties. In response to the Commission's request for comments on this issue, we agree that all of the contract and specific disclosure requirements should be eliminated, as proposed.
With respect to the Proposed Amendments concerning eligibility criteria, we agree that "qualified purchasers" as defined under section 2(a)(51) (A) of the Investment Company Act of 1940, as amended (the "Company Act"), should be included as "eligible clients" under the Rule. We believe, however, that applying the "qualified purchaser" threshold alone, instead of as an alternative to the net worth/assets under management tests, would set a needlessly high standard that would exclude many clients who are well able to protect themselves and who should be allowed to enter into performance fee arrangements. The "qualified purchaser" standard was intended to ensure a more comprehensive degree of investor sophistication (relating to an investor's ability to evaluate all aspects of unregulated investment pools, including not only management fees but also governance, transactions with affiliates, leverage and other investment practices, and other matters) than is relevant to evaluating the appropriateness of performance fees.
We also believe that the net worth/assets under management criteria currently in the Rule are sufficient for the Commission to make the required finding under section 205(e) of the Advisers Act that qualified clients do not need the protections of the statutory prohibition on performance fees, and that additional or more detailed criteria are unnecessary.
Thus, we have a number of concerns regarding the proposal to raise the eligibility tests to $1,500,000 net worth or $750,000 under management. All of our concerns are based on the fact that the costs and inconvenience imposed by the changes outweigh the public policy benefits, if any, of providing increased protection to investors.
First, amending the Rule to raise the eligibility tests will create inconsistencies between federal law and various state regulations. Many states have adopted versions of the Rule, including the current eligibility tests. Although some such state regulations incorporate the entire Rule by express reference, others duplicate the text of all or part of the Rule or paraphrase it, usually specifying the $1,000,000 net worth requirement. Because the National Securities Markets Improvement Act of 1996 may be viewed as preempting only state registration, licensing and qualification laws with respect to SEC-registered investment advisers, state regulations governing performance fees may apply to all investment advisers operating in such states, whether or not they are SEC-registered.
The inconsistencies between state regulations and the Proposed Amendments will unfairly burden SEC-registered advisers operating in those states. Unless those states amend their regulations to comply with the Proposed Rule, those advisers may be required to comply both with the higher eligibility tests of the Proposed Rule (under federal law) and the contract requirements for performance fees under the existing Rule (under state law). This would result in some SEC-registered advisers being subject to more stringent performance fee regulation than existed prior to the Proposed Amendments. We believe that many states with performance fee rules may, in time, adopt the Proposed Amendments. There is no guarantee that this will occur, however, and it will likely take many months and could take years.
Second, raising the eligibility thresholds will create significant practical difficulties for advisers that are subject to the Rule and that advise investment limited partnerships ("Funds"). We counsel the advisers to hundreds of Funds, the offering documents of which incorporate the current Rule's eligibility tests. Raising these tests will require each Fund to amend its offering documents immediately for the sole purpose of incorporating the new higher tests, at great inconvenience and expense (which in most cases will be borne by the Funds, and therefore largely by their investors).
Third, raising the eligibility thresholds would create an inconsistency between individuals who are eligible to enter into performance fee contracts and individuals who are accredited investors under Rule 501 of Regulation D promulgated under the Securities Act of 1933, as amended. We see no justification for applying higher eligibility standards to individuals entering into performance fee agreements than to individuals investing in privately offered securities. We believe that investors who are capable of protecting themselves in securities offerings under Regulation D are equally capable of evaluating the risks and benefits of performance fee arrangements. In addition, an investor in a Fund is in many cases already subject to several different qualification standards, including the accredited investor test, the eligibility test under the Rule, and the "qualified eligible participant" test under section 4.7 of the Commodity Exchange Act regulations. Making the Rule's eligibility requirements inconsistent with the accredited investor standard would further complicate this already confusing scheme of qualification standards.
Fourth, raising the eligibility tests in response to inflation assumes a relationship between purchasing power and investor sophistication that we believe may not exist. Although because of inflation, individuals with a net worth of $1,000,001 in 1998 have less buying power in 1998 than individuals with the same net worth did in 1985, they have a very significant amount of assets to invest and monitor, and therefore they should not be assumed to be any less sophisticated with respect to financial matters. To the extent that investment sophistication arises out of investment experience, it depends more on having assets to invest than on the buying power of those assets. Inflation may make it easier to become a millionaire, but it does not necessarily make millionaires less sophisticated.
We are not aware of any empirical studies that suggest that investment sophistication correlates any less closely to net worth of $1,000,000 than to net worth of $1,500,000. To our knowledge, existing evidence indicates that the current eligibility tests are working well. We are not aware of abuses alleged by clients of our advisory clients, by industry groups, or in routine regulatory examinations of our clients or enforcement actions brought by the Commission. We believe that in the twelve years since the Rule was adopted, abuses would have surfaced if they existed. In addition, we believe that clients who satisfy the current eligibility tests have demonstrated a significant degree of sophistication by insisting on certain concessions from advisers charging performance fees, such as high water marks and hurdle rates, that have now become standard in the industry.
Accordingly, we believe the client sophistication requirement is adequately served by the Rule's existing $1,000,000 net worth/$500,000 under management standard. Neither raising the standard to reflect inflation nor indexing it to inflation is necessary to maintain the standard's usefulness as a measure of client sophistication.
We propose, therefore, that the Commission not raise the Rule's current client eligibility requirements. Alternatively, we suggest that if the Commission does raise the eligibility requirements as proposed, the Commission expand the transition rule to permit Funds organized prior to the adoption of the Proposed Amendments to continue to apply the current $1,000,000/$500,000 eligibility tests to future as well as existing investors, in recognition of the considerable practical costs associated with requiring existing Funds to amend their investor eligibility requirements. We recommend in such cases that, in accordance with the Proposed Amendments, those Funds be permitted to eliminate the contract terms prescribed under the existing Rule from their performance fee arrangements.
In addition, we suggest that two groups of clients be excepted from the Rule's eligibility requirements, because of certain relationships that make it unlikely that abuses relating to performance fees will occur. First, we recommend that advisers be permitted to charge performance fees to "accommodation clients," even if such persons do not satisfy the eligibility tests of the Rule. Such clients would include (a) relatives, spouses and relatives of spouses of the adviser or any investment advisory representative of the adviser, (b) partners, officers, members, managers or directors of the adviser, and (c) other "knowledgeable employees" of the adviser, as defined in Rule 3c-5(a)(4) under the Investment Company Act of 1940, as amended. The first two parts of this definition parallel the definition of "excepted person," which Proposal II of Advisers Act Release No. 1681 would exclude from the count of clients of investment adviser representatives in Rule 203A-3 under the Advisers Act.
Second, we believe that clients with established relationships with advisers should not be subject to the Rule's eligibility requirements. We believe that, over time, clients generally develop effective ways of communicating with their advisers and that such communication mitigates against performance fee abuses. Similarly, we believe that where established relationships exist, advisers are especially motivated to ensure that clients understand and are satisfied with their advisory fee arrangements. We suggest, therefore, that clients who have had contractual relationships with their advisers for at least one year not be subject to the Rule's eligibility requirements.
Please contact me or any of my partners listed below at your convenience if you would like to discuss any of these matters.
Very truly yours,
Carolyn S. Reiser
cc: Douglas L. Hammer, Esq.
John P. Broadhurst, Esq.
Eric M. Sippel, Esq.
Christopher J. Rupright, Esq.