[Federal Register Volume 63, Number 139 (Tuesday, July 21, 1998)]
[Rules and Regulations]
[Pages 39022-39028]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-19373]


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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.

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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

[[Page 39023]]

(``Investment Company Act''); \1\ and (3) knowledgeable employees of 
the investment adviser.
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    \1\ 15 U.S.C. 80a-2(a)(51)(A).
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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\
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    \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)].
    \5\ 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 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.
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    \6\ 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)].
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    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\
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    \7\ See 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'').
    \8\ Pub. L. No. 104-290, 110 Stat. 3416 (1996) (codified in 
scattered sections of the U.S. Code).
    \9\ 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.
    \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].''
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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.
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    \11\ Exemption 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)].
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    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.
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    \12\ See Proposing Release, supra note 11, at 8.
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    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

[[Page 39024]]

as well as any material conflicts posed by the arrangement.\14\
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    \13\ 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.
    \14\ The 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).
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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\
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    \15\ See supra note 6 and accompanying text.
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    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\
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    \16\ One 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.
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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\
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    \17\ See Proposing Release, supra note 11, at 10.
    \18\ One commenter went further and recommended a substantial 
increase in the thresholds beyond those set forth in the proposal.
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    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.
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    \19\ Although 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.
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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 assets-under-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.
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    \20\ See supra note 1.
    \21\ 15 U.S.C. 80a-3(c)(7).
    \22\ For 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.
    \23\ 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 of rule 
205-3 for an adviser to charge performance fees to the section 
3(c)(7) company.
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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

[[Page 39025]]

prohibition by virtue of the client's relationship with the 
adviser.\24\
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    \24\ See supra note 10.
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    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.
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    \25\ 15 U.S.C. 80a-3(c)(1).
    \26\ Rule 3c-5 [17 CFR 270.3c-5].
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    One commenter asserted that such employees are inherently 
sophisticated because of their knowledge of the day-to-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\
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    \27\ 15 U.S.C. 80b-5(b)(4).
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    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\
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    \28\ 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].
    \29\ Rule 205-3(b)(2) [17 CFR 275.205-3(b)(2)].
    \30\ Conditional 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)].
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    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.
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    \31\ Amended 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.
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    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\
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    \32\ One 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.
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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.
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    \33\ Amended rule 205-3(c) [17 CFR 275.205-3(c)].
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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

[[Page 39026]]

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.
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    \34\ The 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).
    \35\ 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.
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    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 firms\39\ and may result in greater competition and 
produce a wider array of investment advisers and services and lower 
overall advisory costs.
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    \36\ The Division discussed the advantages and disadvantages of 
performance fees in more detail in its 1992 study. Protecting 
Investors, supra note 7, at 239-40.
    \37\ 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).
    \38\ 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 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).
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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.\40\ In addition, some detractors have 
expressed concern that performance fees might result in discrimination 
against clients that do not pay performance fees.\41\
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    \40\ Lofthouse, supra note 38, at 77; Roher, supra note 39, at 
127.
    \41\ 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. 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.
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    \42\ 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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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

[[Page 39027]]

million or less, in discretionary or non-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.\43\ The Commission estimates that approximately 
17,650 investment advisers are small entities.\44\
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    \43\ Rule 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.
    \44\ This 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.
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    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:


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 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

[[Page 39028]]

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