61882 Federal Register / Vol. 62, No. 223 / Wednesday, November 19, 1997 / Proposed Rules

1 15 U.S.C. 80a–2(a)(51)(A).

2 15 U.S.C. 80b–5(a)(1).

3H.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, ch.

686, § 205(1), 54 Stat. 847, 852 (1940) (amended

1970).

4Trusts, 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

$10,000,000 Total Assets

First, is the account a ‘‘securities

portfolio?’’ The account is a securities

portfolio because securities as well as

cash and cash equivalents (which the

applicant has chosen to include as

securities)

($6,000,000+$1,000,000=$7,000,000)

comprise at least 50% of the value of the

account (here, 70%). (See Instruction

7(a))

Second, does the account receive

‘‘continuous and regular supervisory or

management services?’’ The entire

account is managed on a discretionary

basis and is provided ongoing

supervisory and management services,

and therefore receives continuous and

regular supervisory or management

services. (See Instruction 7(c))

Third, what is the entire value of the

account? The entire value of the account

($10,000,000) is included in the

calculation of the investment adviser’s

total assets under management.

[FR Doc. 97–30296 Filed 11–18–97; 8:45 am]

BILLING CODE 8010–01–P

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 January 20, 1998.

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 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

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
Federal Register / Vol. 62, No. 223 / Wednesday, November 19, 1997 / Proposed Rules 61883

‘‘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)).

6Rule 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 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).

7Exemption 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.

9See Division of Investment Management, U.S.

Securities and Exchange Commission, Protecting

Investors: A Half Century of Investment Company

Regulation 237–49 (1992) (‘‘Protecting Investors’’).

10 Id. at 245.

11 Id. at 245, 247–48.

12Pub. L. No. 104–290, 110 Stat. 3416 (1996)

(codified in scattered sections of the U.S. Code).

13Section 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, 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].’’

15Before 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

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)].

17Rule 205–3(c)(3) [17 CFR 275.205–3(c)(3)].

18Rule 205–3(d) [17 CFR 275.205–3(d)].

19Rule 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)].

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

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 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

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 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 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
61884 Federal Register / Vol. 62, No. 223 / Wednesday, November 19, 1997 / Proposed Rules

20See Protecting Investors, supra note 9, at 245.

21Advisers 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.

22Section 206 of the Advisers Act [15 U.S.C. 80b6].

23The 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 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).

24See supra note 7 and accompanying text.

25See supra note 14 and accompanying text.

26See supra note 1.

27 15 U.S.C. 80a–3(c)(7).

28For example, in determining the amount of

investments for purposes of the definition of

qualified purchaser, 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.

29Under 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.

30Proposed rule 205–3(d)(1).

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 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

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

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 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

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
Federal Register / Vol. 62, No. 223 / Wednesday, November 19, 1997 / Proposed Rules 61885

31See 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).

33The 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).

34The 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)).

35Rule 205–3(b)(2) [17 CFR 275.205–3(b)(2)].

36Proposed 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).

37Proposed 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 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.

38Proposed rule 205–3(c).

39According 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.

40The 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. 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).

41The 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 , at

239–40.

42Richard 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).

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

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

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 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 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
61886 Federal Register / Vol. 62, No. 223 / Wednesday, November 19, 1997 / Proposed Rules

43See, 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).

45See, e.g., id.

46See, e.g., id.

47Lofthouse, supra note 43, at 77; Roher, supra

note 44, at 127.

48Lofthouse, 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).

49See, e.g., Lofthouse, supra note 43, at 77.

50See In re McKenzie Walker Investment

Management, Inc., Investment Advisers Act Release

No. 1571 (July 16, 1996) (investment adviser

favoring its performance-fee clients in the allocation

of hot initial public offerings).

51See, 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. 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’slength’’ negotiation requirement).

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.

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 costeffective 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.

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

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 should reduce the

costs of establishing and monitoring

compliance with the current rule.

Comment is requested on this costbenefit 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

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-
Federal Register / Vol. 62, No. 223 / Wednesday, November 19, 1997 / Proposed Rules 61887

52Rule 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.

53This 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 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.

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, 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

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, DC

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

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. 80b5(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.

(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 the

final rule] 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 the final

rule].

(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:
61888 Federal Register / Vol. 62, No. 223 / Wednesday, November 19, 1997 / Proposed Rules

(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. 80a2(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. 80a3(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)).

Dated: November 13, 1997.

By the Commission.

Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 97–30295 Filed 11–18–97; 8:45 am]

BILLING CODE 8010–01–P