39022 Federal Register / Vol. 63, No. 139 /Tuesday, July 21, 1998 /Rules and Regulations

Issued in Kansas City, Missouri, on July 14,

1998.

Marvin R. Nuss,

Acting Manager, Small Airplane Directorate,

Aircraft Certification Service.

[FR Doc. 98–19328 Filed 7–20–98; 8:45 am]

BILLING CODE 4910–13–P

SECURITIES AND EXCHANGE

COMMISSION

17 CFR Part 275

[Release No. IA–1731, 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: Final rule.

SUMMARY: The Commission is adopting

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 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 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.

EFFECTIVE DATE: The rule amendments

will become effective August 20, 1998.

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, U.S. Securities and

Exchange Commission, 450 Fifth Street,

N.W., Mail Stop 5–6, Washington, D.C.

20549.

SUPPLEMENTARY INFORMATION: The

Commission today is adopting

amendments to rule 205–3 [17 CFR

275.205–3] under the Investment

Advisers Act of 1940 [15 U.S.C. 80b]

(‘‘Advisers Act’’).

Table of Contents

Executive Summary

I. Background

A. Introduction

B. Proposed Amendments to Rule 205–3

II. Discussion

A. Elimination of Specific Contractual and

Disclosure Requirements

B. Qualified Clients

1. Numerical Thresholds

2. Qualified Purchasers

3. Knowledgeable Employees

C. Identification of the Client

D. Transition Rule

III. Cost-Benefit Analysis

IV. Summary of Regulatory Flexibility

Analysis

V. Statutory Authority

Text of Rule

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 adopting rule

amendments to eliminate the provisions

of the rule that prescribe contractual

terms and require specific disclosures.

In addition, the amendments change the

client eligibility criteria to permit the

following clients to enter into

performance fee arrangements with their

investment advisers: (1) clients with at

least $750,000 under management with

the adviser or more than $1,500,000 of

net worth; (2) clients who are ‘‘qualified

purchasers’’ under section 2(a)(51)(A) of

the Investment Company Act of 1940
Federal Register / Vol. 63, No. 139 /Tuesday, July 21, 1998 /Rules and Regulations 39023

1 15 U.S.C. 80a–2(a)(51)(A).

2 15 U.S.C. 80b–5(a)(1).

3 15 U.S.C. 80b–5(b)(2). 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)].

4 15 U.S.C. 80b–5(b)(2). See discussion of fulcrum

fees in Proposing Release, infra note 11, at n.5.

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)].

5Rule 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).

6Exemption 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)].

7See Division of Investment Management, U.S.

Securities and Exchange Commission, Protecting

Investors: A Half Century of Investment Company

Regulation 245, 247–48 (1992) (‘‘Protecting

Investors’’).

8Pub. L. No. 104–290, 110 Stat. 3416 (1996)

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

9Section 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.

10 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].’’

11Exemption To Allow 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. 1682 (Nov. 13,

1997) [62 FR 61882 (Nov. 19, 1997)].

12See Proposing Release, supra note 11, at 8.

13See 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.

(‘‘Investment Company Act’’); 1 and (3)

knowledgeable employees of the

investment adviser.

I. Background

A. Introduction

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 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

$1,000,000,3 so long as an appropriate

‘‘fulcrum fee’’ is used.4 This 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

205–3.5

Under current rule 205–3, an adviser

may charge performance fees to a client

who has at least $500,000 under

management with the adviser or has a

net worth of more than $1,000,000. The

Commission presumed that these

clients, because of their wealth,

financial knowledge, and experience,

are less dependent on the protections

provided by the Advisers Act’s

restrictions on performance fee

arrangements.6 The rule, however,

imposes several conditions on advisers

entering into performance fee contracts

in addition to those related to the

eligibility of clients.

In 1992, the Commission’s Division of

Investment Management issued a report

recommending, among other things, that

Congress enact legislation clarifying the

authority of the Commission to provide

exemptions from the performance fee

prohibition for advisory contracts with

any persons whom the Commission

determined did not need the protections

of the prohibition.7 Four years later,

Congress included in the National

Securities Markets Improvement Act of

1996 (‘‘1996 Act’’) 8 two additional

statutory exceptions from the

performance fee prohibition 9 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.10

B. Proposed Amendments to Rule 205–

3

On November 13, 1997, the

Commission issued a release proposing

amendments to rule 205–3 (‘‘Proposing

Release’’).11 The proposed amendments

were intended to provide increased

flexibility to investment advisers and

their clients in entering into

performance fee arrangements and to

revise the client eligibility criteria under

the rule.

The Commission received 22

comment letters on the proposed

amendments to rule 205–3. Commenters

supported the proposed amendments;

many urged the Commission to expand

further the types of clients eligible to

enter into such arrangements. The

Commission is adopting amendments to

rule 205–3 with one change from the

amendments as proposed, in view of the

issues raised by commenters. As

suggested by commenters, the

Commission is adding certain

knowledgeable employees of investment

advisers as another category of clients

eligible to enter into performance fee

arrangements under rule 205–3.

II. Discussion

A. Elimination of Specific Contractual

and Disclosure Requirements

Current rule 205–3 imposes a number

of required provisions on performance

fee contracts, obligates the adviser to

provide certain disclosures to clients,

and requires that the adviser reasonably

believe that the contract represents an

arm’s length arrangement and that the

client (or its independent agent)

understands the method of

compensation and its risks. In the

Proposing Release, the Commission

explained that, although these

conditions were intended to protect

clients, they have inhibited the

flexibility of advisers and their clients

in establishing performance fee

arrangements beneficial to both

parties.12 In light of the other

protections provided by the Advisers

Act, the Commission believed that these

clients may not need the protections of

the rule. Therefore, the Commission

proposed, 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. All but one of the

commenters supported these proposed

amendments, which the Commission is

adopting as proposed.

The Commission emphasizes that the

elimination of the contractual and

disclosure provisions from rule 205–3

does not alter the obligation of an

adviser, as a fiduciary, to deal fairly

with its clients and to make full and fair

disclosure of its compensation

arrangements.13 This obligation

includes full client disclosure of all

material information regarding a

proposed performance fee arrangement
39024 Federal Register / Vol. 63, No. 139 /Tuesday, July 21, 1998 /Rules and Regulations

14The disclosure obligation flows from the

Advisers Act’s prohibitions against fraud in section

206 of the Advisers Act [15 U.S.C. 80b–6]. The

amendments also 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 rule 205–3 by its terms provides an exemption

only from section 205(a)(1), and that separate

reference to section 206 and other provisions of the

federal securities laws in the rule is unnecessary.

By eliminating 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 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 amendments to rule 205–3

do 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).

15See supra note 6 and accompanying text.

16One commenter requested that the Commission

clarify whether a trust, governmental plan,

collective trust fund, or separate account referred to

in section 3(c)(11) of the Investment Company Act

may be charged a fulcrum fee (or any other kind of

performance fee) under rule 205–3. The

Commission believes that a trust, governmental

plan, collective trust fund, or separate account that

satisfies all the conditions of rule 205–3 may enter

into a performance fee (including a fulcrum fee)

arrangement under the rule.

17See Proposing Release, supra note 11, at 10.

18One commenter went further and

recommended a substantial increase in the

thresholds beyond those set forth in the proposal.

19Although the proposed transition rule would

‘‘grandfather’’ existing arrangements with existing

clients, the new thresholds would apply to new

clients to existing arrangements. See infra Section

II.D.

20See supra note 1.

21 15 U.S.C. 80a–3(c)(7).

22For example, in determining the amount of

investments for purposes of the definition of

qualified purchaser, only outstanding indebtedness

incurred to acquire the investments must be

deducted. Rule 2a51–1(e) under 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 more than $5,000,000 of

investments, but a net worth of less than $1,500,000

because of other debt. Under the rule amendments,

such a person would be eligible to enter into a

performance fee contract under rule 205–3.

23Under 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 of

rule 205–3 for an adviser to charge performance fees

to the section 3(c)(7) company.

as well as any material conflicts posed

by the arrangement.14

B. Qualified Clients

Currently, rule 205–3 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. As noted above,

in adopting rule 205–3 in 1985, the

Commission concluded that clients who

satisfy these criteria do not need the full

protections provided by the Advisers

Act’s restrictions on performance fee

arrangements.15

The Commission proposed to raise the

net worth and assets-under-management

threshold levels and to add a third

category of eligible clients, ‘‘qualified

purchasers’’ under section 2(a)(51)(A) of

the Investment Company Act. Under the

proposed amendments, clients who

satisfied the new eligibility criteria

contained in rule 205–3 would be

referred to as ‘‘qualified clients.’’ The

Commission is adopting amendments to

the criteria for determining the

eligibility of clients with one

modification to the proposal in response

to suggestions by commenters, as

discussed below.16

1. Numerical Thresholds

As discussed in the Proposing

Release, the Commission recognized

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 $1,500,000; and $500,000

in 1985 dollars is now worth

approximately $750,000.17 The

Commission therefore proposed 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. Five

commenters supported the increased net

worth and assets-under-management

thresholds. One commenter noted that

increasing the thresholds to reflect

inflation would ensure that

unsophisticated retail clients continue

to receive the protections of the

performance fee prohibition.18

Nine commenters opposed increasing

the thresholds as unnecessary to ensure

adequate client sophistication, often

citing the lack of a history of abuse and

the costs and inconvenience of

incorporating new thresholds into

existing agreements.19 None of the

commenters, however, suggested any

alternative criteria to the objective

thresholds, as requested by the

Commission in the Proposing Release.

Moreover, responding to the

Commission’s request for comment, the

commenters opposed any indexing of

the thresholds to take into account

automatically the effects of inflation.

The Commission has decided to adopt

the amendments to the threshold levels

as proposed. In light of the expansion of

the performance fee exemption and the

effects of inflation on the threshold

levels, the Commission believes that, in

order to continue to determine that

clients who satisfy the numerical

thresholds do not need the protections

of the performance fee prohibition, it

should increase the thresholds.

2. Qualified Purchasers

The Commission also proposed 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.20 New section 3(c)(7) of

the Investment Company Act, as added

by the 1996 Act, 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.21 Although,

in most cases, persons who would be

qualified purchasers under section

2(a)(51)(A) would satisfy the assetsunder-management or net worth

criterion under rule 205–3, even as

amended, in some cases, such persons

would not.22 Therefore, the Commission

proposed to add ‘‘qualified purchasers’’

as eligible clients under the rule so that

an investor who meets the eligibility

requirements to invest in a section

3(c)(7) company also could enter into a

performance fee arrangement outside

the context of a section 3(c)(7)

company.23 The commenters supported

this provision, which the Commission is

adopting as proposed.

3. Knowledgeable Employees

The Proposing Release requested

comment on whether the Commission

should exempt from the performance fee

prohibition arrangements between

advisers and clients who have certain

pre-existing relationships. These

relationships would be of a type that

suggests that the abuses Congress sought

to prevent by prohibiting performance

fee arrangements are unlikely to occur.

Section 205(e) permits the Commission

to consider, in addition to criteria such

as financial sophistication and

knowledge and experience in financial

matters, whether a client may not need

the protections of the performance fee
Federal Register / Vol. 63, No. 139 /Tuesday, July 21, 1998 /Rules and Regulations 39025

24See supra note 10.

25 15 U.S.C. 80a–3(c)(1).

26Rule 3c–5 [17 CFR 270.3c–5].

27 15 U.S.C. 80b–5(b)(4).

28The 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].

29Rule 205–3(b)(2) [17 CFR 275.205–3(b)(2)].

30Conditional 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. 961 at n.21 (March 15,

1985) [50 FR 11718 (March 25, 1985)].

31Amended rule 205–3(b) [17 CFR 275.205–3(b)].

The Commission notes that an adviser charging a

performance fee to only certain clients in this

context should provide appropriate disclosure

concerning the existence of the performance fee to

those clients who do not pay a performance fee. In

addition, the amendments 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.

Furthermore, as stated in the Proposing Release, the

look through provision does not apply to section

3(c)(7) companies, which are excepted from the

performance fee prohibition by section 205(b)(4) of

the Advisers Act.

32One commenter urged that the look through

provision not apply if the first tier company and the

second tier company are independent of each other.

This commenter reasoned that where a second tier

section 3(c)(1) company is truly independent of the

first tier section 3(c)(1) company, the adviser

receiving the performance fee could not seek to

circumvent the purpose of the look through

provision and pool clients to avoid the qualified

client requirement. Another commenter urged that

the look through provision not apply if the first tier

company and the second tier company are section

3(c)(1) companies, unless the adviser to the first tier

company also is the adviser to the second tier

company. This commenter reasoned that the

financial sophistication of the managers of the

second tier company would protect the interests of

their investors in negotiating a performance fee at

arm’s length, which is consistent with the rule 205–

3 exemption from the performance fee prohibition.

The Commission has decided not to amend the rule;

it, however, will entertain requests for relief from

the application of the look through provision in

circumstances where the policies and purposes of

section 205 of the Advisers Act would not be served

by its application.

33Amended rule 205–3(c) [17 CFR 275.205–3(c)].

34The Commission knows of no information

concerning the incidence of performance fee

arrangements in the United States. 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).

prohibition by virtue of the client’s

relationship with the adviser.24

Many commenters recommended that

the Commission add to the list of

qualified clients certain ‘‘knowledgeable

employees,’’ consistent with the concept

of ‘‘knowledgeable employees’’ eligible

to invest in section 3(c)(1) 25 and section

3(c)(7) companies in accordance with

rule 3c–5 under the Investment

Company Act.26 Under rule 3c–5,

knowledgeable employees include

executive officers, directors, trustees,

general partners, and advisory board

members of a section 3(c)(1) or a section

3(c)(7) company, and those who serve in

similar capacities. The rule also

includes certain other employees of the

fund or its management affiliate who

participate in investment activities and

have performed such functions for at

least 12 months.

One commenter asserted that such

employees are inherently sophisticated

because of their knowledge of the dayto-day investment activities of the

adviser and are in the best position to

evaluate the risks of performance fees

and protect themselves from

overreaching on the part of the adviser.

Another commenter noted that

inclusion of knowledgeable employees

as qualified clients would allow such

employees to invest in section 3(c)(1)

companies that enter into performance

fee arrangements as well as section

3(c)(7) companies, which are excepted

from the performance fee prohibition

pursuant to section 205(b)(4) of the

Advisers Act.27

The Commission agrees that

employees who actively participate in

the investment activities of the adviser

are likely to be sophisticated financially

and do not need the protections of the

performance fee prohibition. Therefore,

the Commission is adding certain

knowledgeable employees of the

investment adviser as another criterion

for ‘‘qualified clients’’ under the rule.

The new category is similar to the

definition of knowledgeable employee

in rule 3c–5 under the Investment

Company Act, and would include an

executive officer, director, trustee,

general partner, or person serving in a

similar capacity, of the investment

adviser, as well as certain other

employees of the adviser who

participate in investment activities and

have performed such functions for at

least 12 months.

C. Identification of the Client 28

Rule 205–3 provides that with respect

to certain clients entering into

performance fee contracts with an

adviser—private investment companies,

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.29 Under this provision,

each ‘‘tier’’ of such entities must be

examined in this manner. Thus, if a

private investment company seeking to

enter into a performance fee contract

(the first tier company) is owned by

another private investment company

(the second tier company), the look

through provision applies to the second

(and any other) level private investment

company, and thus the adviser must

look to the ultimate client to determine

whether the arrangement satisfies the

requirements of the rule.30

The Commission proposed to retain

the ‘‘look through’’ provision and to

clarify that any ‘‘equity owners’’ that are

not charged a performance fee would

not be required to meet the qualified

client test.31 The Commission is

adopting this provision as proposed.

Some commenters urged the

Commission to eliminate the look

through provision with respect to

certain entities, such as private

investment companies. Others opposed

such changes, arguing that it would

permit circumvention of the client

eligibility requirements of the rule and

result in performance fees being charged

to groups of unsophisticated investors.

The Commission has decided not to

eliminate the look through provision of

the rule at this time.32

D. Transition Rule

The Commission is adopting, as

proposed, 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 $1,500,000.33 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 satisfy

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.

III. Cost-Benefit Analysis

The Commission is sensitive to the

costs and benefits imposed by its rules.

The Commission notes that the rule

amendments are pursuant to new

authority granted to it by Congress in

the 1996 Act.

As discussed below, although costs

and benefits of the rule amendments are

difficult to quantify, the Commission

believes that these amendments will

benefit investment advisers and their

clients without imposing any

measurable costs.

The rule amendments will likely alter

the total number of investment advisers

that rely on the performance fee

exemption.34 The number of

performance fee contracts may increase
39026 Federal Register / Vol. 63, No. 139 /Tuesday, July 21, 1998 /Rules and Regulations

35According 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.

36The Division discussed the advantages and

disadvantages of performance fees in more detail in

its 1992 study. Protecting Investors, supra note 7,

at 239–40.

37Richard 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).

38See, 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

37; at 37; Bines, supra note 37, at 5–36 to 5–37.

39 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).

40Lofthouse, supra note 38, at 77; Roher, supra

note 39, at 127.

41See 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).

42See, 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).

because the performance fee

arrangement will no longer be subject to

prescribed contract terms. Moreover, the

rule amendments will add two new

categories of clients eligible to enter into

performance fee arrangements—

qualified purchasers and knowledgeable

employees who may not have been

eligible under the numerical thresholds.

On the other hand, the increase in the

net worth and assets-under-management

thresholds for determining eligibility

under the rule may reduce the number

of eligible clients 35 and, as a result, the

total number of performance fee

arrangements. Overall, however, the

Commission believes it is reasonable to

estimate that the amendments to the

performance fee rule will increase the

number of performance fee

arrangements.

To the extent that the rule

amendments increase the number of

performance fee arrangements, advisers

and clients may benefit overall.36 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.37

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.38 In addition,

advocates of the increased use of

performance fees assert that they may

encourage the establishment of new

advisory firms39 and may result in

greater competition and produce a

wider array of investment advisers and

services and lower overall advisory

costs.

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.40 In addition, some detractors

have expressed concern that

performance fees might result in

discrimination against clients that do

not pay performance fees.41

The arguments for and against

performance fee arrangements provide

no definitive answers concerning their

effect on advisers, clients and the

markets. The costs and benefits of

performance fee arrangements in general

are difficult to quantify because of their

theoretical nature. Although the

Commission requested comment in the

Proposing Release on whether the

benefits and costs could be quantified,

no commenters responded to this

request.

Similarly, it is difficult to quantify the

effect of the rule amendments on

advisers, their clients, or the economy.

The Commission has no data from

which to measure the total effect of

these amendments. For example, the

Commission knows of no information

concerning the number of advisers that

have performance fee contracts or the

average number of performance fee

contracts per adviser. The Commission

requested the submission of data

concerning incidence of performance

fees in the Proposing Release, but no

commenters responded to this request.

In addition, the Commission has no

information concerning either the

number of clients who would no longer

qualify under the new criteria or the

number of clients who would qualify

only under the new criteria.

Although the Commission cannot

quantify the effects of the rule

amendments, the Commission believes

that the amendments will benefit

advisers and their qualified clients by

providing them with more flexibility in

structuring performance fee

arrangements that may benefit both

parties. The amendments eliminate all

the prescribed compensation

calculations and other required contract

terms, which have raised a number of

interpretative issues and technical

concerns over the years.42 Thus, the

amendments allow investment advisers

and their clients who are financially

sophisticated or have the resources to

obtain sophisticated financial advice to

negotiate the terms of their performance

fee contracts. Moreover, the

Commission believes that these

amendments should reduce the costs of

establishing and monitoring compliance

with the current rule, and thus benefit

both investment advisers and their

clients who wish to enter into

performance fee arrangements.

IV. Summary of Regulatory Flexibility

Analysis

A summary of the Initial Regulatory

Flexibility Analysis (’’IRFA’’) was

published in the Proposing Release. No

comments were received on the IRFA.

The Commission has prepared a Final

Regulatory Flexibility Analysis

(‘‘FRFA’’) in accordance with 5 U.S.C.

604 regarding amendments to rule 205–

3 under the Advisers Act. The following

summarizes the FRFA.

As set forth in greater detail in the

FRFA, 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 FRFA states that

the rule amendments will 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 new categories of eligible

clients—‘‘qualified purchasers’’ under

section 2(a)(51)(A) of the Investment

Company Act, and ‘‘knowledgeable

employees’’ of the investment adviser.

The FRFA also discusses the effect of

the 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
Federal Register / Vol. 63, No. 139 /Tuesday, July 21, 1998 /Rules and Regulations 39027

43Rule 275.0–7 [17 CFR 275.0–7]. The

Commission has revised the definition of ‘‘small

entity,’’ effective July 30, 1998. 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. 33–7548, 34–40122, IC–23272,

and IA–1727 (June 24, 1998) [63 FR 35508 (June 30,

1998)]. Because the IRFA concerning the proposed

amendments to rule 205–3 was prepared under the

old definition, that definition applies to the

Commission’s preparation of the FRFA concerning

these amendments. Id. at n.32.

44This estimate of the number of small entities

was made for purposes of the Final Regulatory

Flexibility Analysis for the rules implementing

Title III of the 1996 Act, the Investment Advisers

Supervision Coordination Act (the ‘‘Coordination

Act’’). See 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)] at nn.189–190 and

accompanying text.

million or less, in discretionary or nondiscretionary 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.43 The Commission

estimates that approximately 17,650

investment advisers are small entities.44

The Commission does not have

information from which to estimate the

number of advisers managing assets of

$50 million or less whose clients will be

able to meet the eligibility tests under

the amended rule and thereby will

qualify to enter into a performance fee

arrangement under the rule. However,

the Commission believes that the

number may be substantial. The

Commission also believes that it would

be reasonable to estimate that the

overall effect of the 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 FRFA states that the rule

amendments will not impose any new

reporting, recordkeeping or compliance

requirements. The FRFA also discusses

the various alternatives considered by

the Commission in connection with the

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 FRFA, the

amended rule will reduce the regulatory

burden on all investment advisers,

impose no new compliance or reporting

requirements, and include a transition

rule allowing existing arrangements to

continue. The Commission therefore

believes that it would be inappropriate

to establish a different timetable for

small entities, to further clarify,

consolidate or simplify the rule’s

requirements for small entities, or to

provide an even broader exemption for

small entities.

The FRFA is available for public

inspection in File No. S7–29–87, and a

copy may be obtained by contacting

Kathy D. Ireland, Securities and

Exchange Commission, 450 5th Street,

N.W., Mail Stop 5–6, Washington, D.C.

20549.

V. Statutory Authority

The Commission is adopting

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 Rule

For the reasons set out in the

preamble, Title 17, Chapter II of the

Code of Federal Regulations is 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), 0b–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. 80b–

5(a)(1)) will not be deemed to prohibit

an 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 August 20, 1998 and satisfied the

conditions of this section as in effect on

the date that the contract was entered

into will be considered 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 August 20, 1998.

(d) Definitions. For the purposes of

this section:

(1) The term qualified client means:

(i) A natural person who or a

company that immediately after

entering into the contract has at least

$750,000 under the management of the

investment adviser;

(ii) A natural person who or a

company that the investment adviser

entering into the contract (and any

person acting on his behalf) reasonably

believes, immediately prior to entering

into the contract, either:

(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; or

(iii) A natural person who

immediately prior to entering into the

contract is:

(A) An executive officer, director,

trustee, general partner, or person

serving in a similar capacity, of the

investment adviser; or

(B) An employee of the investment

adviser (other than an employee

performing solely clerical, secretarial or

administrative functions with regard to

the investment adviser) who, in

connection with his or her regular
39028 Federal Register / Vol. 63, No. 139 /Tuesday, July 21, 1998 /Rules and Regulations

functions or duties, participates in the

investment activities of such investment

adviser, provided that such employee

has been performing such functions and

duties for or on behalf of the investment

adviser, or substantially similar

functions or duties for or on behalf of

another company for at least 12 months.

(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)).

(4) The term executive officer means

the president, any vice president in

charge of a principal business unit,

division or function (such as sales,

administration or finance), any other

officer who performs a policy-making

function, or any other person who

performs similar policy-making

functions, for the investment adviser.

Dated: July 15, 1998.

By the Commission.

Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 98–19373 Filed 7–20–98; 8:45 am]

BILLING CODE 8010–01–P

DEPARTMENT OF HEALTH AND

HUMAN SERVICES

Food and Drug Administration

21 CFR Part 558

New Animal Drugs for Use in Animal

Feeds; Bacitracin Methylene

Disalicylate and Nitarsone

AGENCY: Food and Drug Administration,

HHS.

ACTION: Final rule.

SUMMARY: The Food and Drug

Administration (FDA) is amending the

animal drug regulations to reflect

approval of a new animal drug

application (NADA) filed by Alpharma

Inc. The NADA provides for using

approved bacitracin methylene

disalicylate and nitarsone Type A

medicated articles to make combination

drug Type C medicated turkey feeds

used as an aid in the prevention of

blackhead, and for increased rate of

weight gain and improved feed

efficiency.

EFFECTIVE DATE: July 21, 1998.

FOR FURTHER INFORMATION CONTACT:

Charles J. Andres, Center for Veterinary

Medicine (HFV–128), Food and Drug

Administration, 7500 Standish Pl.,

Rockville, MD 20855, 301–594–1600.

SUPPLEMENTARY INFORMATION: Alpharma

Inc., One Executive Dr., P.O. Box 1399,

Fort Lee, NJ 07024, is sponsor of NADA

141–088 that provides for combining

approved BMD (10, 25, 30, 40, 50, 60,

or 75 grams per pound (g/lb) bacitracin

methylene disalicylate) and Histostat

(227 g/lb nitarsone) Type A medicated

articles to make Type C medicated feeds

for growing turkeys containing 4 to 50

g per ton bacitracin methylene

disalicylate and 0.01875 percent

nitarsone. The Type C medicated turkey

feed is used as an aid in the prevention

of blackhead, and for increased rate of

weight gain and improved feed

efficiency in growing turkeys. The

NADA is approved as of June 17, 1998,

and §§ 558.76(d)(3) and 558.369(d) (21

CFR 558.76(d)(3) and 558.369(d)) are

amended to add new entries to reflect

the approval. The basis for approval is

discussed in the freedom of information

summary.

Also, due to enactment of the Generic

Animal Drug and Patent Term

Restoration Act in 1988, National

Academy of Science/National Research

Council (NAS/NRC) NADA’s are no

longer approved. Therefore, the text of

§ 558.369(c) NAS/NRC status is

removed and the paragraph reserved.

In accordance with the freedom of

information provisions of 21 CFR part

20 and 514.11(e)(2)(ii), a summary of

safety and effectiveness data and

information submitted to support

approval of this application may be seen

in the Dockets Management Branch

(HFA–305), Food and Drug

Administration, 5630 Fishers Lane, rm.

1061, Rockville, MD 20852, between 9

a.m. and 4 p.m., Monday through

Friday.

This approval is for use of single

ingredient Type A medicated articles to

make combination drug Type C

medicated feeds. One ingredient,

nitarsone, is a Category II drug as

defined in 21 CFR 558.3(b)(1)(ii). Prior

to enactment of the Animal Drug

Availability Act of 1996 (Pub. L. 104–

250) (ADAA), an approved medicated

feed application (MFA) was required for

feed mills to make Type C medicated

feeds from Category II drugs. The ADAA

revised the Federal Food, Drug, and

Cosmetic Act to replace the requirement

for MFA’s with that for feed mill

licenses. Use of Type A medicated

articles to make Type C medicated feeds

as in this NADA is limited to licensed

feed mills.

FDA has determined under 21 CFR

25.33(a)(2) that this action is of a type

that does not individually or

cumulatively have a significant effect on

the human environment. Therefore,

neither an environmental assessment

nor an environmental impact statement

is required.

List of Subjects in 21 CFR Part 558

Animal drugs, Animal feeds.

Therefore, under the Federal Food,

Drug, and Cosmetic Act and under

authority delegated to the Commissioner

of Food and Drugs and redelegated to

the Center for Veterinary Medicine, 21

CFR part 558 is amended as follows:

PART 558—NEW ANIMAL DRUGS FOR

USE IN ANIMAL FEEDS

1. The authority citation for 21 CFR

part 558 continues to read as follows:

Authority: 21 U.S.C. 360b, 371.

2. Section 558.76 is amended by

adding paragraph (d)(3)(xvi) to read as

follows:

§ 558.76 Bacitracin methylene disalicylate.

* * * * *

(d) * * *

(3) * * *

(xvi) Nitarsone alone or in

combination as in § 558.369.

3. Section 558.369 is amended by

removing paragraph (c) and reserving it,

by revising the introductory text of

paragraph (d), by redesignating

paragraphs (d)(1), (d)(2), and (d)(3) as

paragraphs (d)(1)(i), (d)(1)(ii), and

(d)(1)(iii), respectively, by adding a

heading to paragraph (d)(1), and by

adding new paragraph (d)(2), to read as

follows:

§ 558.369 Nitarsone.

* * * * *

(c) [Reserved]

(d) Conditions of use. It is used as

follows:

(1) Chickens and turkeys.

* * * * *

(2) Turkeys—(i) Amount. Nitarsone

0.01875 percent, plus bacitracin

methylene disalicylate 4 to 50 grams per

ton.

(ii) Indications for use. As an aid in

the prevention of blackhead, and for

increased rate of weight gain and

improved feed efficiency.

(iii) Limitations. For growing turkeys.

Feed continuously as sole ration. Early

medication is essential to prevent

spread of disease. Adequate drinking

water must be provided near feeders at

all times. Overdosage or lack of water

may result in leg weakness or paralysis.

The drug is not effective in preventing