Section 205 under the Investment Advisers Act of 1940 generally prohibits a federally registered investment adviser (RIA) from receiving compensation based on a share of the capital gains on or appreciation of the assets of an advisory client (i.e., performance fees). Rule 205-3 under the Advisers Act provides an exemption from this prohibition for clients that meet the definition of “Qualified Client” found in the rule.

Currently, the definition of Qualified Client includes, among other persons, a company that, or a natural person who:

• has at least $1 million of assets under the management of the RIA; or
• has a net worth (together, in the case of a client that is a natural person, with assets held jointly with a spouse) that the RIA reasonably believes to be in excess of $2 million.

On June 14, the Securities and Exchange Commission issued an order increasing the dollar amount of the net worth threshold in Rule 205-3 from $2 million to $2.1 million, effective as of August 15. The increase in the net worth threshold is based on adjustments for inflation. The dollar amount of the required assets under management threshold under Rule 205-3 will remain at $1 million.

The change impacts performance fees charged to private funds that rely on Section 3(c)(1) of the Investment Company Act of 1940, as well as to separately managed accounts. RIAs who charge performance fees should revise applicable net worth representations in their investment advisory agreements and in 3(c)(1) fund subscription agreements to reflect the updated threshold for new separately managed account clients and 3(c)(1) fund investors.

However, Rule 205-3 specifically provides that existing investors and clients that no longer meet the new net worth threshold can continue to be charged performance fees provided they met the net worth threshold at the time they entered into the advisory contract under which they are charged such performance fees.

The SEC order is available here.