Introduction

On February 15, 2012, the U.S. Securities and Exchange Commission (SEC) amended the “qualified client” standard of Rule 205-3 under the Investment Advisers Act of 1940, as amended (Advisers Act). Under the Advisers Act, and the rules promulgated thereunder, investment advisors registered with the SEC, or required to be registered with the SEC, may only charge “qualified clients” performance fees (fees calculated as a share of capital gains on, or appreciation of, the funds of a client). The amendments to Rule 205-3 codify revisions to the qualified client standard that the SEC recently adopted by an order effective September 19, 2011, which order was required to be issued by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). This note briefly describes the key features of the amendments.

The Amendments

Prior to the SEC’s recent order adopting revisions to Rule 205-3, a qualified client was defined as any natural person or company with (i) at least $750,000 under management with the investment advisor or (ii) a net worth of at least $1.5MM. The SEC’s recent order, now codified by amendments to Rule 205-3, increased those amounts to $1MM and $2MM, respectively.

In addition to changing the definition’s dollar thresholds, the SEC also carved out certain exceptions, effective May 22, 2012, to the calculation of a natural person’s net worth. First, the calculation of a person’s net worth will no longer include the value of such person’s primary residence as an asset. Second, indebtedness secured by a primary residence up to the fair market value of the residence will no longer be counted as a liability. However, debt secured by a primary residence will still be included in the net worth calculation: (1) to the extent such debt exceeds the fair market value of the residence7 and (2) if such debt was incurred during the sixty-day period prior to entry into the investment advisory contract—except if such indebtedness resulted from the acquisition of the primary residence (i.e., the indebtedness was a mortgage used to purchase the residence). In a release announcing the adoption of the final rule, the SEC explained that the above-described exceptions were adopted to prevent individuals from taking out home-equity loans for the purpose of acquiring other assets and thereby inflating their net worth.