Document ID: SEC-2016-0895-0001
Agency: sec
Document Type: Proposed Rule
Title: Performance Based Investment Advisory Fees
Posted Date: 2016-05-24T04:00Z

[Federal Register Volume 81, Number 100 (Tuesday, May 24, 2016)]
[Proposed Rules]
[Pages 32686-32688]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2016-12167]

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 275

[Release No. IA-4388; File No. S7-08-16]

Performance-Based Investment Advisory Fees

AGENCY: Securities and Exchange Commission.

ACTION: Notice of intent to issue order.

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SUMMARY: The Securities and Exchange Commission (``Commission'') 
intends to issue an order that would adjust for inflation, as 
appropriate, dollar amount thresholds in the rule under the Investment 
Advisers Act of 1940 that permits investment advisers to charge 
performance-based fees to ``qualified clients.'' Under that rule, an 
investment adviser may charge performance-based fees if a ``qualified 
client'' has a certain minimum net worth or minimum dollar amount of 
assets under the management of the adviser. The Commission's order 
would increase, to reflect inflation, the minimum net worth that a 
``qualified client'' must have under the rule. The order would not 
increase the minimum dollar amount of assets under management.

DATES: Hearing or Notification of Hearing: An order adjusting the 
dollar amount tests specified in the definition of ``qualified client'' 
will be issued unless the Commission orders a hearing. Interested 
persons may request a hearing by writing to the Commission's Secretary. 
Hearing requests should be received by the Commission's Office of the 
Secretary by 5:30 p.m. on June 13, 2016. Hearing requests should state 
the nature of the writer's interest, the reason for the request, and 
the issues contested. Persons who wish to be notified of a hearing may 
request notification by writing to the Commission's Secretary.

ADDRESSES: Secretary, Securities and Exchange Commission, 100 F Street 
NE., Washington, DC 20549-1090.

FOR FURTHER INFORMATION CONTACT: Amanda Hollander Wagner, Senior 
Counsel, Investment Company Rulemaking Office, at (202) 551-6792, 
Division of Investment Management, Securities and Exchange Commission, 
100 F Street NE., Washington, DC 20549-8549.

SUPPLEMENTARY INFORMATION: The Commission intends to issue an order 
under the Investment Advisers Act of 1940 (``Advisers Act'' or 
``Act'').\1\
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    \1\ 15 U.S.C. 80b. Unless otherwise noted, all references to 
statutory sections are to the Investment Advisers Act, and all 
references to rules under the Investment Advisers Act, including 
rule 205-3, are to Title 17, Part 275 of the Code of Federal 
Regulations [17 CFR 275].
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I. Background

    Section 205(a)(1) of the Advisers Act generally prohibits an 
investment adviser from entering into, extending, renewing, or 
performing any investment advisory contract that provides for 
compensation to the adviser based on a share of capital gains on, or 
capital appreciation of, the funds of a client.\2\ Congress prohibited 
these compensation arrangements (also known as performance compensation 
or performance fees) in 1940 to protect advisory clients from 
arrangements that Congress believed might encourage advisers to take 
undue risks with client funds to increase advisory fees.\3\ In 1970, 
Congress provided an exception from the prohibition for advisory 
contracts relating to the investment of assets in excess of 
$1,000,000,\4\ if an appropriate ``fulcrum fee'' is used.\5\ Congress 
subsequently authorized the Commission to exempt, by rule or order, any 
advisory contract from the performance fee prohibition if the contract 
is with persons who the

[[Page 32687]]

Commission determines do not need the protections of that 
prohibition.\6\
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    \2\ 15 U.S.C. 80b-5(a)(1).
    \3\ H.R. Rep. No. 2639, 76th Cong., 3d Sess. 29 (1940). 
Performance fees were characterized as ``heads I win, tails you 
lose'' arrangements in which the adviser had everything to gain if 
successful and little, if anything, to lose if not. S. Rep No. 1775, 
76th Cong., 3d Sess. 22 (1940).
    \4\ 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 of 1940 (``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.
    \5\ 15 U.S.C. 80b-5(b). A fulcrum fee generally involves 
averaging the adviser's fee over a specified period and increasing 
or decreasing the fee proportionately with the investment 
performance of the company or fund in relation to the investment 
record of an appropriate index of securities prices. See rule 205-2 
under the Advisers Act; Adoption of Rule 205-2 under the Investment 
Advisers Act of 1940, As Amended, Definition of ``Specified Period'' 
Over Which Asset Value of Company or Fund Under Management is 
Averaged, Investment Advisers Act Release No. 347 (Nov. 10, 1972) 
[37 FR 24895 (Nov. 23, 1972)].
     In 1980, Congress added another exception to the prohibition 
against charging performance fees, for contracts involving business 
development companies under certain conditions. See section 
205(b)(3) of the Advisers Act.
    \6\ Section 205(e) of the Advisers Act. Section 205(e) of the 
Advisers Act authorizes the Commission to exempt conditionally or 
unconditionally from the performance fee prohibition advisory 
contracts with persons who the Commission determines do not need its 
protections. Section 205(e) provides that the Commission may 
determine that persons do 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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    The Commission adopted rule 205-3 in 1985 to exempt an investment 
adviser from the prohibition against charging a client performance fees 
in certain circumstances.\7\ The rule, when adopted, allowed an adviser 
to charge performance fees if the client had at least $500,000 under 
management with the adviser immediately after entering into the 
advisory contract (``assets-under-management test'') or if the adviser 
reasonably believed, immediately prior to entering into the advisory 
contract, that the client had a net worth of more than $1,000,000 at 
the time the contract was entered into (``net worth test''). The 
Commission stated that these standards would limit the availability of 
the exemption to clients who are financially experienced and able to 
bear the risks of performance fee arrangements.\8\ In 1998, the 
Commission amended rule 205-3 to, among other things, change the dollar 
amounts of the assets-under-management test and net worth test to 
adjust for the effects of inflation since 1985.\9\ The Commission 
revised the former from $500,000 to $750,000, and the latter from 
$1,000,000 to $1,500,000.\10\
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    \7\ Exemption To Allow Registered Investment Advisers To Charge 
Fees Based Upon a Share of Capital Gains Upon or Capital 
Appreciation of a Client's Account, Investment Advisers Act Release 
No. 996 (Nov. 14, 1985) [50 FR 48556 (Nov. 26, 1985)] (``1985 
Adopting Release''). The exemption applies to the entrance into, 
performance, renewal, and extension of advisory contracts. See rule 
205-3(a).
    \8\ See 1985 Adopting Release, supra note 7, at Sections I.C and 
II.B. The rule also imposed other conditions, including specific 
disclosure requirements and restrictions on calculation of 
performance fees. See id. at Sections II.C-E.
    \9\ See 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. 1731 (July 
15, 1998) [63 FR 39022 (July 21, 1998)].
    \10\ See id. at Section II.B.1.
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    The Dodd-Frank Wall Street Reform and Consumer Protection Act 
(``Dodd-Frank Act'') \11\ amended section 205(e) of the Advisers Act to 
provide that, by July 21, 2011 and every five years thereafter, the 
Commission shall adjust for inflation the dollar amount thresholds 
included in rules issued under section 205(e), rounded to the nearest 
$100,000.\12\ In May 2011, the Commission published a release (the 
``May 2011 Release'') that included a notice of intent to issue an 
order revising the dollar amount thresholds of the assets-under-
management test (from $750,000 to $1,000,000) and the net worth test 
(from $1,500,000 to $2,000,000).\13\ The Commission issued an order to 
revise the dollar amount thresholds of the assets-under-management and 
net worth tests, as described above, on July 12, 2011.\14\
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    \11\ Public Law 111-203, 124 Stat. 1376 (2010).
    \12\ See section 418 of the Dodd-Frank Act (requiring the 
Commission to issue an order every five years revising dollar amount 
thresholds in a rule that exempts a person or transaction from 
section 205(a)(1) of the Advisers Act if the dollar amount threshold 
was a factor in the Commission's determination that the persons do 
not need the protections of that section).
    \13\ See Investment Adviser Performance Compensation, Investment 
Advisers Act Release No. 3198 (May 10, 2011) [76 FR 27959 (May 13, 
2011)].
    \14\ See Order Approving Adjustment for Inflation of the Dollar 
Amount Tests in Rule 205-3 under the Investment Advisers Act of 
1940, Investment Advisers Act Release No. 3236 (July 12, 2011) [76 
FR 41838 (July 15, 2011)] (``2011 Order''). The 2011 Order was 
effective as of September 19, 2011. Id. The 2011 Order applies to 
contractual relationships entered into on or after the effective 
date and does not apply retroactively to contractual relationships 
previously in existence.
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    The May 2011 Release also proposed amendments to rule 205-3 
providing, among other things, that the Commission would issue an order 
every five years in the future adjusting the rule's dollar amount 
thresholds for inflation.\15\ On February 15, 2012, the Commission 
adopted these proposed amendments, which amended rule 205-3 in three 
ways to carry out the inflation adjustment of the rule's dollar amount 
thresholds.\16\ First, the amendments revised the dollar amount 
thresholds in rule 205-3, in order to codify the order the Commission 
issued on July 12, 2011.\17\ Second, the amendments added to rule 205-
3, as proposed, a new paragraph stating that the Commission will issue 
an order on or about May 1, 2016, and approximately every five years 
thereafter, adjusting for inflation the dollar amount thresholds of the 
rule's assets-under-management and net worth tests.\18\ Finally, the 
amendments to rule 205-3 specify the price index on which future 
inflation adjustments will be based--the Personal Consumption 
Expenditures Chain-Type Price Index (``PCE Index''), which is published 
by the United States Department of Commerce.\19\ The PCE Index is an 
indicator of inflation in the personal sector of the U.S. economy \20\ 
and is used in other provisions of the federal securities laws, 
including the determination of whether a person meets a specific net 
worth minimum in Regulation R under the Securities Exchange Act of 1934 
[15 U.S.C. 78a].\21\
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    \15\ See May 2011 Release, supra note 13.
    \16\ See Investment Adviser Performance Compensation, Investment 
Advisers Act Release No. 3372 (Feb. 15, 2012) [77 FR 10358 (Feb. 22, 
2012)].
    \17\ See rule 205-3(d)(1)(i) and (ii).
    \18\ See rule 205-3(e).
    \19\ See rule 205-3(e)(1).
    \20\ See, e.g., Jo Craven McGinty, CPI vs. PCE: Untangling the 
Alphabet Soup of Inflation Gauges, The Wall Street Journal (Mar. 20, 
2015), available at http://www.wsj.com/articles/cpi-vs-pce-untangling-the-alphabet-soup-of-inflation-gauges-1426867398; Clinton 
P. McCully, Brian C. Moyer, and Kenneth J. Stewart, ``Comparing the 
Consumer Price Index and the Personal Consumption Expenditures Price 
Index,'' Survey of Current Business (Nov. 2007) at 26 n.1 (PCE Index 
measures changes in ``prices paid for goods and services by the 
personal sector in the U.S. national income and product accounts'' 
and is primarily used for macroeconomic analysis and forecasting).
    \21\ See Definitions of Terms and Exemptions Relating to the 
``Broker'' Exceptions for Banks, Securities Exchange Act Release No. 
56501 (Sept. 24, 2007) [72 FR 56514 (Oct. 3, 2007)] (adopting 
periodic inflation adjustments to the fixed-dollar thresholds for 
both ``institutional customers'' and ``high net worth customers'' 
under Rule 701 of Regulation R); see also Amendments to Form ADV, 
Investment Advisers Act Release No. 3060 (July 28, 2010) [75 FR 
49234 (Aug. 12, 2010)] (increasing for inflation the threshold 
amount for prepayment of advisory fees that triggers an adviser's 
duty to provide clients with an audited balance sheet and the dollar 
threshold triggering the exception to the delivery of brochures to 
advisory clients receiving only impersonal advice).
     The Dodd-Frank Act also requires the use of the PCE Index to 
calculate inflation adjustments for the cash limit protection of 
each investor under the Securities Investor Protection Act of 1970. 
See section 929H(a) of the Dodd-Frank Act.
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II. Discussion

A. Order Adjusting Dollar Amount Tests

    Pursuant to section 418 of the Dodd-Frank Act and rule 205-3(e), 
today we are providing notice \22\ that the Commission intends to issue 
an order making the required inflation adjustment to the assets-under-
management test and the net worth test in the definition of ``qualified 
client'' in rule 205-3. As discussed above, section 418 of the Dodd-
Frank Act and rule 205-3(e) require that we adjust the dollar amount 
thresholds of the rule by order on or about May 1, 2016 and every five 
years thereafter.\23\ We intend to issue an order that would maintain 
the dollar amount of the assets-under-management test at $1,000,000, 
and would increase the dollar amount of the net worth test from 
$2,000,000 to

[[Page 32688]]

$2,100,000. As required under rule 205-3, both dollar amounts would 
take into account the effects of inflation by reference to historic and 
current levels of the PCE Index. While the dollar amount of the assets-
under-management test would not change, because the amount of the 
Commission's inflation adjustment calculation is smaller than the 
rounding amount specified under rule 205-3, the dollar amount of the 
net worth test would be adjusted as a result of the Commission's 
inflation adjustment calculation effected pursuant to the rule.\24\
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    \22\ See section 211(c) of the Advisers Act (requiring the 
Commission to provide appropriate notice of and opportunity for 
hearing for orders issued under the Advisers Act).
    \23\ See supra notes 12 and 18 and accompanying text.
    \24\ Specifically, rule 205-3(e) provides that the adjusted 
dollar amounts shall be computed by: (1) Dividing the year-end value 
of the PCE Index (or any successor index thereto) for the calendar 
year preceding the calendar year in which the order is being issued 
(in this case, 2015), by the year-end value of the PCE Index (or 
successor) for the calendar year 1997 (such quotient, the 
``Adjustment Percentage''); (2) for the assets-under-management 
test, multiplying $750,000 by the Adjustment Percentage and rounding 
the product to the nearest multiple of $100,000; and (3) for the net 
worth test, multiplying $1,500,000 by the Adjustment Percentage and 
rounding the product to the nearest multiple of $100,000.As of April 
8, 2016, the end-of-year 2015 PCE Index was 109.819, and the end-of-
year 1997 PCE Index was 79.657. Assets-under-management test 
calculation to adjust for the effects of inflation: (109.819/79.657) 
x $750,000 = $1,033,986.34; $1,033,986.34 rounded to the nearest 
multiple of $100,000 = $1,000,000. Net worth test calculation to 
adjust for the effects of inflation: (109.819/79.657) x $1,500,000 = 
$2,067,972.68; $2,067,972.68 rounded to the nearest multiple of 
$100,000 = $2,100,000.The values of the PCE Index are available from 
the Bureau of Economic Analysis, a bureau of the United States 
Department of Commerce. See http://www.bea.gov; see also Bureau of 
Economic Analysis, Table 2.3.4., ``Price Indexes for Personal 
Consumption Expenditures by Major Type of Product,'' available at 
http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1#reqid=9&step=1&isuri=1&903=64 (last 
visited April 8, 2016).
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    We anticipate that future changes to the dollar amount tests that 
are issued by order will be reflected in technical amendments to rule 
205-3(d), which would be adopted after such order is issued.\25\
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    \25\ See May 2011 Release, supra note 13, at n.27 (noting that 
the Commission anticipated, when it issued its notice of intent to 
issue an order revising the dollar amount thresholds of the assets-
under-management test and the net worth test, that ``future changes 
to the dollar amount test that are issued by order, will be 
reflected in technical amendments to rule 205-3'').
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B. Effective Date

    We anticipate that, if we issue the order described above, the 
effective date will be 60 days following the order date.\26\ To the 
extent that contractual relationships are entered into prior to the 
order's effective date, the dollar amount test adjustments in the order 
would not generally apply retroactively to such contractual 
relationships, subject to the transition rules incorporated in rule 
205-3.\27\
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    \26\ When the Commission issued the 2011 Order adjusting the 
dollar amount tests of rule 205-3 as described above, the 2011 
Order's effective date was approximately 60 days following its 
issuance. See supra note 14.
    \27\ See rule 205-3(c)(1) (``If a registered investment adviser 
entered into a contract and satisfied the conditions of this section 
that were in effect when the contract was entered into, the adviser 
will be considered to satisfy the conditions of this section; 
Provided, however, that if a natural person or company who was not a 
party to the contract becomes a party (including an equity owner of 
a private investment company advised by the adviser), the conditions 
of this section in effect at that time will apply with regard to 
that person or company.''); see also May 2011 Release, supra note 
13, at section II.B.3.

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    By the Commission.

     Dated: May 18, 2016.
Brent J. Fields,
Secretary.
[FR Doc. 2016-12167 Filed 5-23-16; 8:45 am]
 BILLING CODE 8011-01-P