A recent SEC enforcement action illustrates the challenge of complying with changing regulations, particularly for newly registered advisers. The SEC found that the adviser violated the prohibition against charging performance fees to “non-qualified” clients.
Section 205(a)(1) of the Advisers Act generally prohibits registered investment advisers, and advisers required to register, from charging performance-based fees; that is, compensation based on a share of capital gains upon or capital appreciation of client assets. Rule 205-3 provides an exemption for charging performance-based fees to a “qualified client” as defined in Rule 205-3(d)(1).
In this case, the SEC found that some investors in three private funds advised by the adviser were not qualified clients. Although the adviser asked potential investors to complete a questionnaire designed to determine if they were qualified clients, the SEC found that in most cases that questionnaire was not completed. As a result, all investors in the funds were charged a performance fee, in addition to a fixed asset-based fee, under the terms of the limited partnership agreements.
The adviser offered interests in the funds in question around the time that the Dodd-Frank Act amended the Advisers Act. Among other things, the amendments required the adviser to register with the SEC. Upon registration, the SEC said that the prohibitions on charging performance fees applied.
The adviser was censured and charged a penalty of $35,000. The size of the penalty reflects, among other things, the adviser’s cooperation with the staff and the fact that it promptly refunded all inappropriately earned performance fees to the clients in question.
This case illustrates the kind of foot fault that can trip up a newly registered adviser not familiar with the requirements of the Advisers Act. Advisers should carefully review their compliance obligations under the Advisers Act and engage in a self-auditing process to ensure that their policies, procedures and agreements are consistent with the rules applicable to registered advisers. In certain cases, as in this case, the shift in registration status may necessitate changes to agreements that can change the economics of offering advisory services to certain types of clients.
The adviser settled the matter without admitting or denying the findings.