SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 275
[Release No. IA-1682, File No. S7-29-97]
RIN 3235-AH25
Exemption To Allow Investment Advisers To Charge Fees Based Upon a Share of
Capital Gains Upon or Capital Appreciation of a Client's Account
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rule.
SUMMARY: The Commission is proposing amendments to the rule under the
Investment Advisers Act of 1940 that permits investment advisers to charge
certain clients performance or incentive fees. The amendments would modify
the rule's criteria for clients eligible to enter into a contract under
which a performance fee is charged and eliminate provisions specifying
required contract terms and disclosures. The amendments would provide
investment advisers greater flexibility in structuring performance fee
arrangements with clients who are financially sophisticated or have the
resources to obtain sophisticated financial advice regarding the terms of
these arrangements.
DATES: Comments must be received on or before [60 days after publication
in the Federal Register].
ADDRESSES: Comments should be submitted in triplicate to Jonathan G. Katz,
Secretary, Securities and Exchange Commission, 450 Fifth Street, N.W., Stop
6-9, Washington, D.C. 20549. Comments also may be submitted electronically
at the following E-mail address: rule-comments@sec.gov. All comment
letters should refer to File No. S7-29-97; this file number should be
included on the subject line if E-mail is used. Comment letters will be
available for public inspection and copying in the Commission's Public
Reference Room, 450 Fifth Street, N.W., Washington, D.C. 20549.
Electronically submitted comment letters also will be posted on the
Commission's Internet web site (http://www.sec.gov).
FOR FURTHER INFORMATION CONTACT: Kathy D. Ireland, Attorney, or Jennifer
S. Choi, Special Counsel, at (202) 942-0716, Task Force on Investment
Adviser Regulation, Division of Investment Management, Stop 10-6,
Securities and Exchange Commission, 450 Fifth Street, N.W., Washington,
D.C. 20549.
SUPPLEMENTARY INFORMATION: The Commission is requesting public comment on
proposed amendments to rule 205-3 [17 CFR 275.205-3] under the Investment
Advisers Act of 1940 [15 U.S.C. 80b-1 et seq.] ("Advisers Act").
TABLE OF CONTENTS
EXECUTIVE SUMMARY
I. BACKGROUND
II. DISCUSSION
A. Elimination of Specific Contractual and Disclosure Requirements
B. Qualified Clients
C. Identification of the Client
D. Transition Rule
E. General Request for Comment
III. COST-BENEFIT ANALYSIS
IV. SUMMARY OF REGULATORY FLEXIBILITY ANALYSIS
V. STATUTORY AUTHORITY
TEXT OF PROPOSED RULE AMENDMENTS
EXECUTIVE SUMMARY
Rule 205-3 under the Advisers Act permits investment advisers to
charge performance fees to clients with at least $500,000 under the
adviser's management or with a net worth of more than $1,000,000. The rule
requires certain terms to be included in contracts providing for
performance fees and specific disclosures to be made to clients entering
into these contracts. The Commission is proposing to eliminate the
provisions of the rule that prescribe contractual terms and require
specific disclosures. In addition, the Commission is proposing to revise
======END OF PAGE 2======
the threshold levels for determining client eligibility to reflect the
effects of inflation on the levels set in 1985 when the rule was adopted
and to add a third criterion for eligibility. Under the proposed
amendments, eligible clients must have assets under management with the
adviser of at least $750,000, net worth of more than $1,500,000, or be
"qualified purchasers" under section 2(a)(51)(A) of the Investment Company
Act of 1940 ("Investment Company Act").<(1)>
I. BACKGROUND
Section 205(a)(1) of the Advisers Act generally prohibits an
investment adviser from entering into, extending, renewing, or performing
any investment advisory contract that provides for compensation to the
adviser based on a share of capital gains on, or capital appreciation of,
the funds or any portion of the funds of the client.<(2)> Congress
enacted the prohibition against performance fees in 1940 to protect
advisory clients from compensation arrangements that it believed might
encourage advisers to take undue risks with client funds to increase
advisory fees.<(3)>
<(1)> 15 U.S.C. 80a-2(a)(51)(A).
<(2)> 15 U.S.C. 80b-5(a)(1).
<(3)> H.R. REP. NO. 2639, 76th Cong., 3d Sess. 29 (1940).
Performance fees were characterized as "heads I win,
tails you lose" arrangements in which the adviser had
everything to gain if successful and little, if
anything, to lose if not. S. REP. NO. 1775, 76th
Cong., 3d Sess. 22 (1940). See also SEC, INVESTMENT
TRUSTS AND INVESTMENT COMPANIES, H.R. DOC. NO. 477,
76th Cong., 3d Sess. 30 (1939). Congress, however,
recognized that performance fees may not be harmful in
every context and initially excluded from the
prohibition contracts between investment advisers and
investment companies. Investment Advisers Act of 1940,
(continued...)
======END OF PAGE 3======
In 1970, Congress provided an exception from the prohibition in
section 205(a)(1) for advisory contracts relating to the investment of
assets in excess of $1,000,000,<(4)> so long as an appropriate
"fulcrum fee" is used.<(5)> This statutory exception was the only
provision under which advisers could enter into performance fee contracts
with so-called "high net worth" clients until 1985 when the Commission
adopted rule 205-3.<(6)>
<(3)>(...continued)
ch. 686, 205(1), 54 Stat. 847, 852 (1940) (amended
1970).
<(4)> Trusts, governmental plans, collective trust funds, and
separate accounts referred to in section 3(c)(11) of
the Investment Company Act [15 U.S.C. 80a-3(c)(11)] are
not eligible for this exception from the performance
fee prohibition under section 205(b)(2)(B) of the
Advisers Act [15 U.S.C. 80b-5(b)(2)(B)].
<(5)> 15 U.S.C. 80b-5(b). A fulcrum fee generally involves
averaging the adviser's fee over a specified period and
increasing and decreasing the fee proportionately with
the investment performance of the company or fund in
relation to the investment record of an appropriate
index of securities prices. See Adoption of Rule 205-2
Under the Investment Advisers Act of 1940, as Amended,
Defining "Specified Period" Over Which the Asset Value
of the Company or Fund Under Management is Averaged,
Investment Advisers Act Release No. 347 (Nov. 10, 1972)
[37 FR 24895 (Nov. 23, 1972)]; Adoption of Rule 205-1
Under the Investment Advisers Act of 1940 Defining
"Investment Performance" of an Investment Company and
"Investment Record" of an Appropriate Index of
Securities Prices, Investment Advisers Release No. 327
(Aug. 8, 1972) [37 FR 17467 (Aug. 29, 1972)].
In 1980, Congress added an exception for contracts
involving business development companies under
conditions set forth in section 205(b)(3) of the
Advisers Act [15 U.S.C. 80b-5(b)(3)].
<(6)> Rule 205-3 was adopted under section 206A of the
Advisers Act [15 U.S.C. 80b-6a], which grants the
Commission general exemptive authority. In providing
(continued...)
======END OF PAGE 4======
Under rule 205-3, an adviser may charge performance fees to a client
that has $500,000 under management with the adviser or has a net worth of
$1,000,000. Because of their wealth, financial knowledge, and experience,
the Commission presumed that these clients are less dependent on the
protections provided by the Advisers Act's restrictions on performance fee
arrangements.<(7)> The rule, however, imposes a number of required
provisions on performance fee contracts and obligates the adviser to
provide certain disclosures to clients. These provisions were included as
"alternative safeguards to the statutory prohibition."<(8)>
In 1992, the Commission's Division of Investment Management issued a
report concluding that the existing exemptions from the performance fee
prohibition should be expanded to permit certain sophisticated clients of
investment advisers to enter into arrangements without the restrictions in
the statutory or administrative exemptions.<(9)> The Division
expressed the view that "where a client appreciates the risk of performance
<(6)>(...continued)
this authority, Congress noted that the Commission
would be able to "exempt persons . . . from the bar on
performance-based advisory compensation" in appropriate
cases. H.R. REP. NO. 1382, 91st Cong., 2d Sess. 42
(1970); S. REP. NO. 184, 91st Cong., 1st Sess. 46
(1969).
<(7)> Exemption to Allow Registered Investment Advisers to
Charge Fees Based Upon a Share of Capital Gains Upon or
Capital Appreciation of a Client's Account, Investment
Advisers Act Release No. 996 (Nov. 14, 1985) [50 FR
48556 (Nov. 26, 1985)].
<(8)> Id. at Section I.C.
<(9)> See DIVISION OF INVESTMENT MANAGEMENT, U.S. SECURITIES
AND EXCHANGE COMMISSION, PROTECTING INVESTORS: A HALF
CENTURY OF INVESTMENT COMPANY REGULATION 237-49 (1992)
("Protecting Investors").
======END OF PAGE 5======
fees and is in a position to protect itself from overreaching by the
adviser, the determination of whether such fees provide value is best left
to the client."<(10)> The Division recommended that Congress enact
legislation specifically authorizing the Commission to provide exemptions
from the performance fee prohibition for advisory contracts with any person
whom the Commission determined did not need the protections of the
prohibition.<(11)> Four years later, Congress included in the
National Securities Markets Improvement Act of 1996 ("1996
Act")<(12)> two additional statutory exceptions from the performance
fee prohibition<(13)> and new section 205(e) of the Advisers Act,
which authorizes the Commission to exempt conditionally or unconditionally
from the performance fee prohibition advisory contracts with persons that
the Commission determines do not need its protections.<(14)>
<(10)> Id. at 245.
<(11)> Id. at 245, 247-48.
<(12)> Pub. L. No. 104-290, 110 Stat. 3416 (1996) (codified in
scattered sections of the U.S. Code).
<(13)> Section 210 of the 1996 Act added to section 205 of the
Advisers Act exceptions for contracts with companies
excepted from the definition of investment company by
section 3(c)(7) of the Investment Company Act [15
U.S.C. 80a-3(c)(7)] and contracts with persons who are
not residents of the United States. The definition of
"person" under section 202 of the Advisers Act includes
companies, which in turn includes corporations,
partnerships, associations, joint-stock companies,
trusts and organized groups of persons [15 U.S.C. 80b-
2(a)(5), (16)]; therefore, the exception for foreign
residents includes foreign investment companies.
<(14)> 15 U.S.C. 80b-5(e). Section 205(e) provides that the
Commission may determine that persons may not need the
protections of section 205(a)(1) on the basis of such
factors as "financial sophistication, net worth,
(continued...)
======END OF PAGE 6======
II. DISCUSSION
A. Elimination of Specific Contractual and Disclosure Requirements
As noted above, rule 205-3 contains several conditions on advisers
entering into performance fee contracts in addition to those related to the
eligibility of clients.<(15)> First, the compensation provided to
the adviser under the contract must be based on the performance of
securities that is calculated pursuant to two different methodologies
specified in the rule, depending upon the nature of the securities under
management.<(16)> In addition, the performance fee must be based on
<(14)>(...continued)
knowledge of and experience in financial matters,
amount of assets under management, relationship with a
registered investment adviser, and such other factors
as the Commission determines are consistent with
[section 205]."
<(15)> Before the enactment of the 1996 Act, rule 205-3 was
available only to Commission-registered investment
advisers. Title III of the 1996 Act, the Coordination
Act, which became effective on July 8, 1997, generally
limited Commission registration to larger investment
advisers but continued the application of the
prohibition of section 205(a)(1) of the Advisers Act to
all advisers (other than those exempt from registration
pursuant to section 203(b) of the Act [15 U.S.C. 80b-
3(b)]), regardless of whether they are prohibited from
registering with the Commission pursuant to the
Coordination Act. 1996 Act, supra note 12. In light
of this provision, the Commission amended rule 205-3
earlier this year to permit all advisers to take
advantage of the limited exemption in the rule. Rules
Implementing Amendments to the Investment Advisers Act
of 1940, Investment Advisers Act Release No. 1633 (May
15, 1997) [62 FR 28112 (May 22, 1997)] ("Implementing
Release"). The proposed amendments herein also include
conforming changes to the May 1997 rule amendments.
<(16)> If market quotations for the securities involved are
readily available, then the formula must include
realized capital losses and unrealized capital
depreciation of the securities. If market quotations
(continued...)
======END OF PAGE 7======
the gains less the losses in the client's account for a period of not less
than one year.<(17)> Second, the investment adviser must disclose to
the client, or to the client's independent agent, prior to entering into
the contract, all material information concerning the proposed advisory
arrangement, including: (1) the possibility that the arrangement may create
an incentive for the adviser to make riskier or more speculative
investments; (2) the fact (if applicable) that the adviser may receive
increased compensation based on unrealized appreciation as well as realized
gains; (3) the periods that will be used to measure investment performance
and their significance in the computation of the fee; (4) the nature and
significance of any index that will be used as a comparative measure of
investment performance, and why the index is appropriate; and (5) if the
fee is based on unrealized appreciation of securities for which market
quotations are not readily available, how the securities will be valued and
the extent to which the value will be determined independently.<(18)>
Finally, the adviser must reasonably believe that the contract represents
an arm's-length arrangement and that the client, alone or together with an
<(16)>(...continued)
are not readily available, then the formula still must
include realized capital losses, but need not include
unrealized capital depreciation unless it also includes
unrealized capital appreciation. Rule 205-3(c)(1), (2)
[17 CFR 275.205-3(c)(1), (2)].
<(17)> Rule 205-3(c)(3) [17 CFR 275.205-3(c)(3)].
<(18)> Rule 205-3(d) [17 CFR 275.205-3(d)].
======END OF PAGE 8======
independent agent, understands the proposed compensation arrangement and
its risks.<(19)>
Whether these provisions are necessary to protect sophisticated
clients of the type contemplated by rule 205-3 was examined by the Division
of Investment Management in 1992. The Commission agrees with the
Division's conclusion that if a client appreciates the risk of performance
fees and is in a position to protect itself from overreaching by the
adviser, then the terms of the arrangement are best left to the
client.<(20)> While the conditions of rule 205-3 are intended to
protect clients, the Commission's experience with the rule suggests they
also may inhibit flexibility of advisers and their clients in establishing
performance fee arrangements beneficial to both parties. Moreover, in
light of the other protections provided by the Advisers Act, the Commission
believes that these clients may not need the protections of the
rule.<(21)> Therefore, the Commission believes that the conditions
<(19)> Rule 205-3(e) [17 CFR 275.205-3(e)]. The rule also
contains a number of definitions of terms necessitated
by these conditions, including "affiliated person,"
"client's independent agent," "interested person,"
"securities for which market quotations are readily
available," and "securities for which market quotations
are not readily available." Rule 205-3(g)(3)-(6) [17
CFR 275.205-3(g)(3)-(6)].
<(20)> See Protecting Investors, supra note 9, at 245.
<(21)> Advisers are regarded as fiduciaries who are required
to deal fairly with their clients and to make full and
fair disclosure of, among other things, their
compensation agreements. See SEC v. Capital Gains
Research Bureau, 375 U.S. 180, 194 (1963). In
addition, advisers registered with the Commission are
required to provide their clients with a brochure
describing their fee arrangements. See Part II of Form
ADV.
======END OF PAGE 9======
may not be necessary to protect these types of clients and proposes,
pursuant to its exemptive authority under new section 205(e) of the
Advisers Act, to eliminate all of the contractual and disclosure provisions
in rule 205-3 other than the client eligibility tests.
Under the proposed rule amendments, performance fee contracts would no
longer be subject to the prescribed contract terms and disclosures. Thus,
an adviser would be free to negotiate all of the terms of a performance fee
contract with a client. The Commission emphasizes, however, that an
adviser charging a performance fee would continue to be subject to the
Advisers Act's prohibitions against fraud.<(22)> As a result, an
adviser could not enter into a performance fee arrangement that was
inconsistent with the adviser's fiduciary duties and could not fail to
disclose material information about the performance fee to the client.<(23)>
<(22)> Section 206 of the Advisers Act [15 U.S.C. 80b-6].
<(23)> The proposed amendments also would eliminate paragraph
(h) of the current rule, which states that "[a]n
investment adviser entering into or performing an
investment advisory contract under this rule is not
relieved of any obligations under section 206 of the
Advisers Act or of any other applicable provisions of
the federal securities laws." The Commission believes
that the proposed rule amendments by their terms
provide an exemption only from section 205(a)(1), and
that separate reference to section 206 and other
provisions of the federal securities laws is
unnecessary. By proposing to eliminate this reference,
the Commission does not intend in any way to suggest
that compliance with the amended rule would relieve
advisers of any obligations under section 206 of the
Advisers Act or of any other applicable provisions of
the federal securities laws.
The Commission further notes that advisers entering
into performance fee arrangements with employee benefit
plans covered by the Employee Retirement Income
Security Act of 1974 ("ERISA") are subject to the
(continued...)
======END OF PAGE 10======
Comment is requested on whether rule 205-3 should be amended to
eliminate all of the contractual and disclosure requirements for
sophisticated clients. Should the "arm's-length contract" or any of the
other provisions be retained? Are certain conditions on performance fee
contracts necessary to protect even clients the Commission presumes are
able to protect themselves? Are there alternative conditions that should
be considered?
B. Qualified Clients
As noted above, in adopting rule 205-3 in 1985, the Commission
concluded that clients having a net worth in excess of $1,000,000, or
assets under management of at least $500,000, do not need the full
protections provided by the Advisers Act's restrictions on
performance fee arrangements.<(24)> The Commission believes that a
similar finding by the Commission would support the proposed expansion of
the exemption under the new authority granted the Commission last year in
section 205(e) of the Advisers Act.<(25)>
<(23)>(...continued)
fiduciary responsibility and prohibited transaction
provisions of ERISA. 29 U.S.C. 1001-1461. The
proposed amendments to rule 205-3 would not affect an
adviser's obligation to comply with ERISA. Issues
involving performance fee arrangements under ERISA are
within the jurisdiction of the Department of Labor,
which is responsible for administering ERISA's
fiduciary provisions and has addressed performance fee
arrangements in a number of advisory opinions under
ERISA. U.S. Department of Labor Advisory Opinion No.
89-28A (Sept. 25, 1989); U.S. Department of Labor
Advisory Opinion 86-21A (Aug. 29, 1986); U.S.
Department of Labor Advisory Opinion 86-20A (Aug. 29,
1986).
<(24)> See supra note 7 and accompanying text.
<(25)> See supra note 14 and accompanying text.
======END OF PAGE 11======
The Commission recognizes that, since 1985, the net worth and assets
under management thresholds have been affected by inflation: $1,000,000 in
1985 dollars is now worth approximately $1,521,000; and $500,000 in 1985
dollars is now worth approximately $760,000. The Commission therefore
proposes to increase the amounts of the net worth and assets under
management tests from $1,000,000 and $500,000 to $1,500,000 and $750,000,
respectively. This increase is not intended to reduce the number or to
alter the types of clients with which an adviser may enter into a
performance fee arrangement, but to reflect the effects of inflation on the
rule.
The Commission also is proposing to permit advisers to enter into
performance fee contracts with clients who are "qualified purchaser[s]"
under section 2(a)(51)(A) of the Investment Company Act.<(26)> The
1996 Act amended the Investment Company Act, among other things, to add new
section 3(c)(7), which exempts from regulation under the Investment Company
Act certain investment pools whose interests are not offered to the public
and whose shareholders consist primarily of "qualified purchasers,"
including individuals with at least $5,000,000 of investments.<(27)>
Although, in most cases, persons who would be qualified purchasers under
section 2(a)(51)(A) would be eligible to enter into a performance fee
contract with advisers under rule 205-3, even as proposed to be amended, in
some cases, such persons would not.<(28)> Therefore, the Commission
<(26)> See supra note 1.
<(27)> 15 U.S.C. 80a-3(c)(7).
<(28)> For example, in determining the amount of investments
for purposes of the definition of qualified purchaser,
(continued...)
======END OF PAGE 12======
proposes to add "qualified purchasers" as eligible clients under the rule
so that an investor who meets the eligibility requirements of section
3(c)(7) also could enter into a performance fee arrangement outside the
context of a section 3(c)(7) company.<(29)>
Under the proposed amendments, clients who satisfy the new eligibility
criteria contained in rule 205-3 would be referred to as "qualified
client[s]."<(30)> Comment is requested on the revised criteria for
entering into a performance fee contract and whether the Commission should
consider alternative criteria for qualified clients. Are the criteria
sufficient for the Commission to make the required finding under section
205(e) that qualified clients do not need the protections of the statutory
prohibition on performance fee arrangements? Rather than including the
qualified purchaser as the third alternative criterion, should the
<(28)>(...continued)
only outstanding indebtedness incurred to acquire or
for the purpose of acquiring the investments must be
deducted. Rule 2a51-1(e) of the Investment Company Act
[17 CFR 270.2a51-1(e)]. See also Privately Offered
Investment Companies, Investment Company Act Release
No. 22597 (Apr. 3, 1997) [62 FR 17512 (Apr. 9, 1997)].
Thus, a person with less than $750,000 in assets under
management could have over $5,000,000 of investments,
but a net worth of less than $1,500,000 because of
other debt. Under the proposed rule amendments, such a
person would be eligible to enter into a performance
fee contract under rule 205-3.
<(29)> Under section 205(b)(4) of the Advisers Act [15 U.S.C.
80b-5(b)(4)], section 3(c)(7) companies may enter into
performance fee contracts without relying on rule 205-
3. Each investor in a section 3(c)(7) company need not
satisfy the eligibility criteria for an adviser to
charge performance fees to the section 3(c)(7) company.
See infra note 36.
<(30)> Proposed rule 205-3(d)(1).
======END OF PAGE 13======
Commission use the qualified purchaser threshold in lieu of the other two
tests?
In addition to criteria such as financial sophistication and knowledge
and experience in financial matters, section 205(e) permits the Commission
to consider whether a client may not need the protections of the Advisers
Act by virtue of its relationship with the adviser.<(31)> Should the
Commission exempt advisers that have a pre-existing relationship with
clients that suggests that the abuses Congress sought to prevent by
prohibiting performance fee arrangements are unlikely to occur? If so,
what should be the nature of those relationships?<(32)>
Should the Commission revise the criteria to prevent the net worth and
assets under management criteria from becoming less meaningful as a result
of inflation? Should the criteria be indexed to prevent future effective
lowering of the amounts? Should the Commission adopt more detailed
criteria to assure the financial sophistication of qualified clients if the
objective thresholds are effectively decreased as result of inflation?
C. Identification of the Client<(33)>
<(31)> See supra note 14.
<(32)> In the context of the definition of investment adviser
representative, the Commission has proposed that
natural persons with certain business or familial
relationships with the supervised person would not need
the protection of state qualification requirements.
Exemption for Investment Advisers Operating in Multiple
States; Revisions to Rules Implementing Amendments to
the Investment Advisers Act of 1940, Investment
Advisers Act Release No. 1681 (Nov. 13, 1997).
<(33)> The following discussion of the identity of the
"client" is relevant only for purposes of this rule and
not for purposes of section 206 of the Advisers Act [15
U.S.C. 80b-6].
======END OF PAGE 14======
Rule 205-3 provides that with respect to certain clients entering into
performance fee contracts with an adviser -- private investment
companies,<(34)> registered investment companies, and business
development companies -- the adviser must "look through" the legal entity
to determine whether each equity owner of the company would be a qualified
client.<(35)> The proposed amendments would retain the "look
through" provision<(36)> and clarify that any equity owners that are
not charged a performance fee would not be required to meet the qualified
client test.<(37)>
<(34)> The definition of "private investment company" included
in paragraph (g)(1) of the current rule [17 CFR
275.205-3(g)(1)] would continue in the amended rule to
refer solely to those companies excepted from the
definition of investment company under section 3(c)(1)
of the Investment Company Act [15 U.S.C. 80a-3(c)(1)].
Reference to section 3(c)(7) is unnecessary because, as
noted above, companies excepted from the definition of
investment company under this provision also are
excepted from the performance fee prohibition pursuant
to section 205(b)(4) of the Advisers Act [15 U.S.C.
80b-5(b)(4)].
<(35)> Rule 205-3(b)(2) [17 CFR 275.205-3(b)(2)].
<(36)> Proposed rule 205-3(b). The Commission is not
proposing to extend the "look through" provision of
rule 205-3 to section 3(c)(7) companies. In the 1996
Act, Congress explicitly excepted section 3(c)(7)
companies from the prohibition on performance fees
having concluded that "investors in a qualified
purchaser pool are sophisticated enough to be allowed
to enter into a fee arrangement that is not a fulcrum
fee." See S. REP. NO. 293, 104th Cong., 2d Sess. 11
(1996).
<(37)> Proposed rule 205-3(b). See, e.g., Hellmold
Associates, Inc. (pub. avail. Dec. 18, 1992) (adviser
may receive performance fee from certain limited
partners when the fee would be based solely on a
limited partner's capital account and not based on the
overall performance of the partnership). See also
(continued...)
======END OF PAGE 15======
Comment is requested whether this "look through" provision should
continue to be included in rule 205-3. The Commission also requests
comment concerning whether the rule should specifically address the
application of the "look through" provision to other entities.
D. Transition Rule
The proposed amendments would add a transition rule permitting
investment advisers and their clients to maintain their existing
performance fee arrangements notwithstanding the clients' failure to meet
the eligibility criteria after the thresholds increase to $750,000 and
$1,500,000.<(38)> Such arrangements could continue under the
transition rule if they were entered into before the effective date of the
amendments to the rule and they satisfied the requirements of the rule as
in effect on the date that they were entered into. A new party to an
existing arrangement, however, would be required to satisfy the new
qualified client test.
E. General Request for Comment
Any interested persons wishing to submit written comments on the
proposed rule amendments that are the subject of this Release, to suggest
additional changes (including changes to the provisions of the rule that
the Commission is not proposing to amend), or to submit comments on other
<(37)>(...continued)
Compass Investors (pub. avail. Dec. 18, 1996).
The proposed amendments would retain the provision in
rule 205-3 that an equity owner who is the investment
adviser entering into the performance fee contract need
not be a qualified client.
<(38)> Proposed rule 205-3(c).
======END OF PAGE 16======
matters that might have an effect on the proposals described above, are
requested to do so. Commenters suggesting alternative approaches are
encouraged to submit their proposed rule text.
III. COST-BENEFIT ANALYSIS
The Commission is sensitive to the costs and benefits imposed by its
rules. The Commission notes that the proposed rule amendments are pursuant
to new authority granted to it by Congress in the 1996 Act.
The proposed amendments would benefit investment advisers and their
qualified clients by providing more flexibility to enter into performance
fee arrangements. Specifically, investment advisers and their qualified
clients could enter into such arrangements without being subject to
prescribed compensation calculations and client disclosures. Thus, the
total number of performance fee arrangements may increase. On the other
hand, the proposed increase in the thresholds for determining eligibility
under the rule may cause the number of eligible clients to
decrease,<(39)> and, as a result, reduce the total number of
performance fee arrangements.<(40)> The Commission, however, does
<(39)> According to data from the 1995 Survey of Consumer
Finances conducted by the Federal Reserve Board,
approximately 1,100,000 households have net worth
between $1,000,000 and $1,500,000. This figure,
however, represents the net worth of households and not
the individual persons who might be clients.
Furthermore, the survey results do not address clients
that are not natural persons.
<(40)> The Commission knows of no information concerning the
incidence of performance fee arrangements in the United
States, and requests the submission of data concerning
such incidence. Performance fee arrangements, however,
appear to be accepted practices in many other
countries. See INTERNATIONAL SURVEY OF INVESTMENT
ADVISER REGULATION 15 (Marcia L. MacHarg & Roberta R.
(continued...)
======END OF PAGE 17======
not have information from which to analyze the precise effect of the
proposed amendments on the number of performance fee arrangements. Comment
is requested on whether the proposed amendments would increase or decrease
the number of performance fee arrangements.
To the extent that the proposed rule amendments increase the number of
performance fee arrangements, advisers and clients may benefit
overall.<(41)> For example, proponents of performance fees have
argued that these arrangements may benefit both parties to the advisory
contract because linking advisory compensation to performance may result in
a closer alignment of the goals of the adviser and the client.<(42)>
If the goals of both parties coincide, then the benefits of performance fee
arrangements would include fewer conflicts of interest in advisory
relationships. Better alignment of the goals of the adviser and the client
might also result in more efficient investing and allocation of capital.
<(40)>(...continued)
W. Kameda eds., 1994) (noting that performance fees
generally are permitted in Australia, Brazil, Canada
(Ontario, with client's written consent), France,
Germany, Italy, Japan, Spain, Switzerland (up to 20% of
net capital gain), the United Kingdom and Venezuela).
<(41)> The Commission's Division of Investment Management
discussed the advantages and disadvantages of
performance fees in more detail in its 1992 study.
Protecting Investors, supra note 9, at 239-40.
<(42)> Richard Grinold & Andrew Rudd, Incentive Fees: Who
Wins? Who Loses?, 43 FIN. ANALYSTS J. 27, 37 (Jan.-Feb.
1987); HARVEY E. BINES, THE LAW OF INVESTMENT
MANAGEMENT 5.03[2][b], at 5-43 (1978 & Supp. 1986)
(observing that the principal justification for
performance fees is that they permit the uncertainty in
the quality of the product -- the management of the
portfolio -- to be shared between the adviser and the
client).
======END OF PAGE 18======
Proponents also claim that performance fees may encourage better
performance by rewarding good performance rather than linking compensation
and assets under management as in more traditional
arrangements.<(43)> Thus, such arrangements may produce more cost-
effective results than arrangements with more traditional fee structures.
In addition, advocates of the increased use of performance fees assert
that they may encourage the establishment of new advisory
firms.<(44)> Performance fees could result in greater competition
and produce a wider array of investment advisers and services and lower
overall advisory costs. Proponents also state that performance fees
provide an incentive for investment advisers to service smaller accounts
that otherwise might be less attractive to the advisers.<(45)>
Furthermore, supporters argue that performance fees permit advisers to
focus on a smaller number of clients than they otherwise would under
traditional compensation arrangements by allowing them to generate
sufficient income without the necessity for a large asset base.<(46)>
Such results also could increase the variety of services provided to a
wider array of clients, and decrease advisory costs overall.
<(43)> See, e.g., Stephen Lofthouse, A Fair Day's Wages for a
Fair Day's Work, 4 JOURNAL OF INVESTING 74, 76 (Winter
1995); Grinold & Rudd, supra note 42, at 37; BINES,
supra note 42, at 5-36 to 5-37.
<(44)> Julie Roher, The Great Debate Over Performance Fees, 17
INSTITUTIONAL INVESTOR 123, 124 (Nov. 1983) (stating
that new firms can begin generating profits before
attracting a large asset base).
<(45)> See, e.g., id.
<(46)> See, e.g., id.
======END OF PAGE 19======
The increased use of performance fees, however, also may produce some
costs to advisory clients and the economy in general. Opponents of
advisory fees have cited the potential for the adviser under a performance
fee arrangement to engage in excessive risk taking with respect to the
client's account.<(47)> Excessive risk taking may result in
unexpected losses to the clients, which may prompt investors to withdraw
from the market and discourage capital formation. Critics also challenge
whether there is any basis, theoretical or analytical, for believing that
performance fees will improve performance.<(48)> In addition, some
detractors have expressed concern that performance fees might result in
discrimination against clients that do not pay performance fees. One form
of such discrimination may be advisers devoting more of their time and
resources to clients that pay such fees.<(49)> Such an argument
relies on an assumption, which may not be necessarily correct, that an
adviser cannot increase the amount of its advisory resources. Nonetheless,
this argument notes the potential for an increase in conflicts of interest
on the part of advisers.<(50)>
<(47)> Lofthouse, supra note 43, at 77; Roher, supra note 44,
at 127.
<(48)> Lofthouse, supra note 43, at 79 (citing the lack of
empirical data); Roher, supra note 44, at 128 (noting
that incentives for good performance already exist
because advisers are compensated on the basis of
account size and must perform well to retain their
clients); BINES, supra note 42, at 5-36 (indicating
that there is no demonstrable connection between
performance fees and superior performance).
<(49)> See, e.g., Lofthouse, supra note 43, at 77.
<(50)> See In re McKenzie Walker Investment Management, Inc.,
Investment Advisers Act Release No. 1571 (July 16,
(continued...)
======END OF PAGE 20======
The arguments for and against performance fee arrangements provide no
definitive answers concerning their effect on advisers, clients and the
markets in general. The costs and benefits of performance fee arrangements
in general are difficult to quantify because of their theoretical nature.
Comment is requested on whether the benefits and costs could be quantified.
The Commission has determined to permit clients who are financially
sophisticated or have the resources to obtain sophisticated financial
advice to weigh the costs and benefits of entering into such arrangements
and to determine for themselves whether to enter into such contracts.
Although an increase in the use of performance fees may impose some overall
costs, such costs could result from the existing rule 205-3 even if the
Commission did not adopt the proposed amendments.
With respect to the rule amendments at issue, the Commission believes
that the proposed amendments would not impose any additional costs on
investment advisers or their clients. Once the adviser determines that a
client is qualified, the rule does not prescribe detailed contractual
requirements or require specific disclosures to clients. The Commission
has observed over the years that the detailed conditions of the current
rule raise numerous interpretive issues.<(51)> The proposed rule
<(50)>(...continued)
1996) (investment adviser favoring its performance-fee
clients in the allocation of hot initial public
offerings).
<(51)> See, e.g., Valuemark Capital Management, Inc. (pub.
avail. June 4, 1997) (limited partners purchasing or
redeeming mid-year immaterial if performance fee based
on performance of partnership over a period of at least
one year); Securities Industry Association (pub. avail.
(continued...)
======END OF PAGE 21======
should reduce the costs of establishing and monitoring compliance with the
current rule.
Comment is requested on this cost-benefit analysis. Commentators are
requested to provide views and empirical data relating to any costs and
benefits associated with the proposed rules and performance fees in
general.
For purposes of the Small Business Regulatory Enforcement Fairness Act
of 1996, the Commission also is requesting information regarding the
potential effect of the proposed rule amendments on the economy on an
annual basis. Commentators should provide empirical data to support their
views.
IV. SUMMARY OF REGULATORY FLEXIBILITY ANALYSIS
The Commission has prepared an Initial Regulatory Flexibility Analysis
("IRFA") in accordance with 5 U.S.C. 603 regarding proposed amendments to
rule 205-3 under the Advisers Act. The following summarizes the IRFA.
As set forth in greater detail in the IRFA, the 1996 Act added section
205(e) to the Advisers Act, which authorizes the Commission to exempt
conditionally or unconditionally from the performance fee prohibition
contained in section 205(a)(1) of the Advisers Act advisory contracts with
persons that the Commission determines do not need the protections of the
prohibition. The IRFA states that the proposed rule amendments would
liberalize rule 205-3, which permits performance fees to be charged to
<(51)>(...continued)
Nov. 18, 1986) (use of rolling one-year periods after
initial one-year period); P.E. Becker, Inc. (pub.
avail. July 21, 1986) (individual limited partners may
be considered the "client" for purposes of the "arm's-
length" negotiation requirement).
======END OF PAGE 22======
sophisticated clients by eliminating required contract terms and
disclosures, update the current criteria for determining eligible clients
to reflect the effects of inflation on the current assets under management
and net worth tests, and add a new category of eligible clients based upon
the definition of "qualified purchaser" in section 2(a)(51)(A) of the
Investment Company Act.
The IRFA sets forth the statutory authority for the proposed rule
amendments. The IRFA also discusses the effect of the proposed rule
amendments on small entities. For the purposes of the Advisers Act and the
Regulatory Flexibility Act, an investment adviser generally is a small
entity (i) if it manages assets of $50 million or less, in discretionary or
non-discretionary accounts, as of the end of its most recent fiscal year or
(ii) if it renders other advisory services, has $50,000 or less in assets
related to its advisory business.<(52)> The Commission estimates
that approximately 17,650 investment advisers are small
entities.<(53)> The Commission does not have information, however,
<(52)> Rule 275.0-7 [17 CFR 275.0-7]. In January 1997, the
Commission proposed to revise this definition of "small
entity." See Definitions of "Small Business" or "Small
Organization" Under the Investment Company Act of 1940,
the Investment Advisers Act of 1940, the Securities
Exchange Act of 1934, and the Securities Act of 1933,
Release Nos. 33-7383, 34-38190, IC-22478, and IA-1609
(Jan. 22, 1997) [62 FR 4106 (Jan. 28, 1997)]. The
Commission expects to adopt a revised definition of
small investment adviser for Regulatory Flexibility Act
purposes to reflect the Coordination Act.
<(53)> This estimate of the number of small entities was made
for purposes of the Final Regulatory Flexibility
Analysis for the rules implementing the Coordination
Act. See Implementing Release, supra note 15, at
nn.189-190 and accompanying text. Under rule 203A-5 of
the Advisers Act, all investment advisers registered
(continued...)
======END OF PAGE 23======
from which to estimate either the number of clients of small entities who
would satisfy the tests of sophistication or the number of such clients who
would enter into performance fee arrangements under the rule. The
Commission, however, believes that it would be reasonable to estimate that
the overall effect of the proposed amendments to the rule would be to
increase the use of the exemption by small entities, and that the economic
effect on small entities may be significant.
The IRFA states that the proposed rule amendments would not impose any
new reporting, recordkeeping or compliance requirements, and that the
Commission believes that no rules duplicate, overlap or conflict with the
proposed rule amendments.
The IRFA discusses the various alternatives considered by the
Commission in connection with the proposed rule amendments that might
minimize the effect on small entities, including (a) the establishment of
<(53)>(...continued)
with the Commission were required to file a completed
Form ADV-T with the Commission by July 8, 1997,
indicating whether they remain eligible for Commission
registration. Of the 23,350 Commission-registered
investment advisers, approximately 7,200 advisers
indicated that they remain eligible for Commission
registration, 10,600 advisers withdrew their
registrations, and 5,800 advisers did not file their
Form ADV-T. The Commission believes that most of the
investment advisers that did not file the Form ADV-T
are either no longer in the advisory business or no
longer eligible to register with the Commission. The
Commission expects to cancel the registrations of most
of these investment advisers. The Commission also
expects to adopt a revised definition of small entity
for purposes of the Regulatory Flexibility Act. See
supra note 52. Therefore, the Commission plans to
revise its estimate of the number of advisers that are
small entities after the transition is complete so that
the Commission would have more accurate information to
determine the number of small entities under the new
definition of that term.
======END OF PAGE 24======
differing compliance or reporting requirements or timetables that take into
account the resources of small entities; (b) the clarification,
consolidation or simplification of compliance and reporting requirements
under the rule amendments for small entities; (c) the use of performance
rather than design standards; and (d) an exemption from coverage of the
rule or any portion of the rule, for small entities. As discussed in more
detail in the IRFA, the Commission believes that it would be inconsistent
with the purposes of the Advisers Act to exempt small entities from the
proposed rule amendments or to use performance standards to specify
different requirements for small entities. Different compliance or
reporting requirements for small entities are not necessary because the
proposed rule amendments do not establish any new reporting, recordkeeping
or compliance requirements. The Commission has determined that it is not
feasible to further clarify, consolidate or simplify the proposed rule
amendments for small entities.
The IRFA includes information concerning the solicitation of comments
with respect to the IRFA generally, and in particular, the number of small
entities that would be affected by the proposed rule amendments. A copy of
the IRFA may be obtained by contacting Kathy D. Ireland, Securities and
Exchange Commission, 450 5th Street, N.W., Mail Stop 10-6, Washington, D.C.
20549.
V. STATUTORY AUTHORITY
The Commission is proposing amendments to rule 205-3 pursuant to the
authority set forth in section 205(e) of the Investment Advisers Act of
1940 [15 U.S.C. 80b-5(e)].
List of Subjects in 17 CFR Part 275
======END OF PAGE 25======
Reporting and recordkeeping requirements, Securities.
TEXT OF PROPOSED RULE AMENDMENTS
For the reasons set out in the preamble, Title 17, Chapter II of the
Code of Federal Regulations is proposed to be amended as follows:
PART 275 - RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940
1. The authority citation for Part 275 is revised to read as
follows:
AUTHORITY: 15 U.S.C. 80b-2(a)(17), 80b-3, 80b-4, 80b-6(4), 80b-6a,
80b-11, unless otherwise noted.
Section 275.203A-1 is also issued under 15 U.S.C. 80b-3a.
Section 275.203A-2 is also issued under 15 U.S.C. 80b-3a.
Section 275.204-2 is also issued under 15 U.S.C. 80b-6.
Section 275.205-3 is also issued under 15 U.S.C. 80b-5(e).
2. Section 275.205-3 is revised to read as follows:
275.205-3 Exemption from the compensation prohibition of section
205(a)(1) for investment advisers.
(a) General. The provisions of section 205(a)(1) of the Act [15
U.S.C. 80b-5(a)(1)] will not be deemed to prohibit any investment adviser
from entering into, performing, renewing or extending an investment
advisory contract that provides for compensation to the investment adviser
on the basis of a share of the capital gains upon, or the capital
appreciation of, the funds, or any portion of the funds, of a client,
Provided, That the client entering into the contract subject to this
section is a qualified client, as defined in paragraph (d)(1) of this
section.
======END OF PAGE 26======
======END OF PAGE 27======
(b) Identification of the client. In the case of a private
investment company, as defined in paragraph (d)(3) of this section, an
investment company registered under the Investment Company Act of 1940, or
a business development company, as defined in section 202(a)(22) of the Act
[15 U.S.C. 80b-2(a)(22)], each equity owner of any such company (except for
the investment adviser entering into the contract and any other equity
owners not charged a fee on the basis of a share of capital gains or
capital appreciation) will be considered a client for purposes of paragraph
(a) of this section.
(c) Transition rule. An investment adviser that entered into a
contract before [insert the effective date of these amendments] and
satisfied the conditions of this section as in effect on the date that the
contract was entered into will be deemed to satisfy the conditions of this
section; Provided, however, that this section will apply with respect to
any natural person or company who is not a party to the contract prior to
and becomes a party to the contract after [insert the effective date of
these amendments].
(d) Definitions. For the purposes of this section:
(1) The term "qualified client" means a natural person who or a
company that:
(i) Immediately after entering into the contract has at least
$750,000 under the management of the investment adviser; or
(ii) The investment adviser entering into the contract (and any
person acting on his behalf) reasonably believes, immediately prior to
entering into the contract, either:
======END OF PAGE 28======
(A) Has a net worth (together, in the case of a natural person, with
assets held jointly with a spouse) of more than $1,500,000 at the time the
contract is entered into; or
(B) Is a qualified purchaser as defined in section 2(a)(51)(A) of the
Investment Company Act of 1940 [15 U.S.C. 80a-2(a)(51)(A)] at the time the
contract is entered into.
(2) The term "company" has the same meaning as in section 202(a)(5)
of the Act [15 U.S.C. 80b-2(a)(5)], but does not include a company that is
required to be registered under the Investment Company Act of 1940 but is
not registered.
(3) The term "private investment company" means a company that would
be defined as an investment company under section 3(a) of the Investment
Company Act of 1940 [15 U.S.C. 80a-3(a)] but for the exception provided
from that definition by section 3(c)(1) of such Act [15 U.S.C. 80a-
3(c)(1)].
By the Commission.
Jonathan G. Katz
Secretary
Dated: November 13, 1997