[Federal Register Volume 62, Number 223 (Wednesday, November 19, 1997)]
[Proposed Rules]
[Pages 61882-61888]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-30295]


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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.

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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: <a href="/cdn-cgi/l/email-protection#483a3d242d652b2725252d263c3b083b2d2b662f273e"><span class="__cf_email__" data-cfemail="82f0f7eee7afe1edefefe7ecf6f1c2f1e7e1ace5edf4">[email protected]</span></a>. 
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'').<SUP>1</SUP>
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    \1\ 15 U.S.C. 80a-2(a)(51)(A).
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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.<SUP>2</SUP> 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.<SUP>3</SUP>
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    \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, ch. 686, Sec. 205(1), 54 
Stat. 847, 852 (1940) (amended 1970).
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    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,<SUP>4</SUP> so long as an appropriate 
``fulcrum fee'' is used.<SUP>5</SUP> This

[[Page 61883]]

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.<SUP>6</SUP>
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    \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 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).
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    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.<SUP>7</SUP> 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.'' <SUP>8</SUP>
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    \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.
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    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.<SUP>9</SUP> 
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.'' <SUP>10</SUP> 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.<SUP>11</SUP> Four years later, Congress included in the 
National Securities Markets Improvement Act of 1996 (``1996 Act'') 
<SUP>12</SUP> two additional statutory exceptions from the performance 
fee prohibition <SUP>13</SUP> 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.<SUP>14</SUP>
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    \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'').
    \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, 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].''
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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.<SUP>16</SUP> 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.<SUP>17</SUP> 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.<SUP>18</SUP> 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.<SUP>19</SUP>
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    \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 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)].
    \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)].
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    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

[[Page 61884]]

the client.<SUP>20</SUP> 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.<SUP>21</SUP> 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.
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    \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.
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    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.<SUP>22</SUP> 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.<SUP>23</SUP>
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    \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 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).
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    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.<SUP>24</SUP> 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.<SUP>25</SUP>
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    \24\ See supra note 7 and accompanying text.
    \25\ See supra note 14 and accompanying text.
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    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.<SUP>26</SUP> 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.<SUP>27</SUP> 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.<SUP>28</SUP> 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.<SUP>29</SUP>
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    \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, 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.
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    Under the proposed amendments, clients who satisfy the new 
eligibility criteria contained in rule 205-3 would be referred to as 
``qualified client[s].'' <SUP>30</SUP> 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?
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    \30\ Proposed rule 205-3(d)(1).
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    In addition to criteria such as financial sophistication and 
knowledge and experience in financial matters, section 205(e) permits 
the Commission

[[Page 61885]]

to consider whether a client may not need the protections of the 
Advisers Act by virtue of its relationship with the 
adviser.<SUP>31</SUP> 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? <SUP>32</SUP>
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    \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).
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    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 <SUP>33</SUP>
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    \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).
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    Rule 205-3 provides that with respect to certain clients entering 
into performance fee contracts with an adviser--private investment 
companies,<SUP>34</SUP> 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.<SUP>35</SUP> The proposed amendments would retain the 
``look through'' provision <SUP>36</SUP> and clarify that any equity 
owners that are not charged a performance fee would not be required to 
meet the qualified client test.<SUP>37</SUP>
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    \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 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.
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    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.<SUP>38</SUP> 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.
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    \38\ Proposed rule 205-3(c).
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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,<SUP>39</SUP> and, as a result, reduce the 
total number of performance fee arrangements.<SUP>40</SUP> 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.
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    \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. 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).
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    To the extent that the proposed rule amendments increase the number 
of performance fee arrangements, advisers and clients may benefit 
overall.<SUP>41</SUP> 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.<SUP>42</SUP> If the goals of both parties coincide, then

[[Page 61886]]

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.
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    \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 , 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 para. 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).
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    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.<SUP>43</SUP> Thus, such arrangements may produce more 
cost-effective results than arrangements with more traditional fee 
structures.
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    \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.
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    In addition, advocates of the increased use of performance fees 
assert that they may encourage the establishment of new advisory 
firms.<SUP>44</SUP> 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.<SUP>45</SUP> 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.<SUP>46</SUP> Such results also could increase the variety 
of services provided to a wider array of clients, and decrease advisory 
costs overall.
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    \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.
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    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.<SUP>47</SUP> 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.<SUP>48</SUP> 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.<SUP>49</SUP> 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.<SUP>50</SUP>
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    \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, 1996) (investment 
adviser favoring its performance-fee clients in the allocation of 
hot initial public offerings).
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    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.<SUP>51</SUP> The proposed rule should reduce the costs of 
establishing and monitoring compliance with the current rule.
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    \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. 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).
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    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 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-

[[Page 61887]]

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.<SUP>52</SUP> The Commission 
estimates that approximately 17,650 investment advisers are small 
entities.<SUP>53</SUP> 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.
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    \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 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.
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    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:


Sec. 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.
    (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:

[[Page 61888]]

    (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)).

    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


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