Document ID: SEC-2021-0719-0001
Agency: sec
Document Type: Proposed Rule
Title: Performance Based Investment Advisory Fees
Posted Date: 2021-05-17T04:00Z

[Federal Register Volume 86, Number 93 (Monday, May 17, 2021)]
[Proposed Rules]
[Pages 26685-26687]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2021-10164]

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 275

[Release No. IA-5733; File No. S7-05-21]

Performance-Based Investment Advisory Fees

AGENCY: Securities and Exchange Commission.

ACTION: 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 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 also increase, to reflect 
inflation, the minimum dollar amount of assets under management.
    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 4, 2021. 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. Any such 
communication should be emailed to the Commission's Secretary at 
Secretarys-Office@sec.gov.

FOR FURTHER INFORMATION CONTACT: Matthew Cook, Senior Counsel, at (202) 
551-6787 or IArules@sec.gov, Investment Adviser Regulation Office, 
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 Advisers Act, and all references to 
rules under the 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 any person that the Commission determines does 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, 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 that 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

[[Page 26686]]

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, 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 footnote 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, 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, by order, adjust for the effects of inflation the 
dollar amount thresholds included in rules issued under section 205(e), 
rounded to the nearest multiple of $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\
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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 
tests in a rule that exempts a person or transaction from section 
205(a)(1) of the Advisers Act if the dollar amount test 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, Advisers 
Act Release No. 3198 (May 10, 2011) [76 FR 27959 (May 13, 2011)]. 
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. See Order Approving Adjustment 
for Inflation of the Dollar Amount Tests in Rule 205-3 under the 
Investment Advisers Act of 1940, 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 
applied to contractual relationships entered into on or after the 
effective date and did 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.\14\ On February 15, 2012, the Commission 
adopted these proposed amendments, which amended rule 205-3 to carry 
out the inflation adjustment of the rule's dollar amount 
thresholds.\15\ Rule 205-3, as amended, states 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,\16\ and 
specifies 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,\17\ and is used in other provisions of the federal securities 
laws.\18\
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    \14\ See May 2011 Release, supra footnote 13.
    \15\ See Investment Adviser Performance Compensation, Advisers 
Act Release No. 3372 (Feb. 15, 2012) [77 FR 10358 (Feb. 22, 2012)] 
(amending rule 205-3 by, in part, revising the dollar amount 
thresholds to codify the 2011 Order); see also rule 205-3(d)(1)(i)-
(ii).
    \16\ See rule 205-3(e).
    \17\ See rule 205-3(e)(1). The PCE Index is an indicator of 
inflation in the personal sector of the U.S. economy. See 
Performance-Based Investment Advisory Fees, Advisers Act Release No. 
4388 (May 18, 2016) [81 FR 32686 (May 24, 2016)], at text 
accompanying n.20.
    \18\ 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, 
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; 
see also Securities Investor Protection Corporation, Securities 
Investor Protection Act of 1970 Release No. 183 (Jan. 27, 2021) [86 
FR 7900 (Feb. 2, 2021)].
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    On June 14, 2016, the Commission issued an order adjusting for 
inflation, as appropriate, the dollar amount thresholds of the assets-
under-management test and the net worth test.\19\ As of August 15, 
2016, the dollar amount of the assets-under-management test is 
$1,000,000, and the dollar amount of the net worth test is 
$2,100,000.\20\
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    \19\ Order Approving Adjustment for Inflation of the Dollar 
Amount Tests in Rule 205-3 under the Investment Advisers Act of 
1940, Advisers Act Release No. 4421 (June 14, 2016) [81 FR 39985 
(June 20, 2016)] (``2016 Order''). The 2016 Order was effective as 
of August 15, 2016. Id.
    \20\ Id. As a result of the 2016 Order, the dollar amount 
threshold of the net worth test was increased to $2,100,000, but the 
dollar amount threshold of the assets-under-management test remained 
at $1,000,000 because the amount of the Commission's inflation 
adjustment calculation was smaller than the rounding amount 
specified under rule 205-3. Id., at nn.8-9 and accompanying text.
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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 \21\ 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, rule 205-3(e) requires that 
we adjust the dollar amount thresholds of the rule by order on or about 
May 1, 2016 and every five years thereafter. We intend to issue an 
order that would increase the dollar amount of the assets-under-
management test from $1,000,000 to $1,100,000, and would increase the 
dollar amount of the net worth test from $2,100,000 to $2,200,000. 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. Because the amount of the Commission's inflation 
adjustment calculations are larger than the rounding amount specified 
under rule 205-3, the dollar amounts of both tests would be adjusted as 
a result of the Commission's inflation adjustment calculation effected 
pursuant to the rule.\22\
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    \21\ 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).
    \22\ 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, 2020), 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 29, 2021, the end-of-year 2020 PCE Index was 111.146, and the 
end-of-year 1997 PCE Index was 74.623. Assets-under-management test 
calculation to adjust for the effects of inflation: (111.146/74.623) 
x $750,000 = $1,117,075.16; $1,117,075.16 rounded to the nearest 
multiple of $100,000 = $1,100,000. Net worth test calculation to 
adjust for the effects of inflation: (111.146/74.623) x $1,500,000 = 
$2,234,150.33; $2,234,150.33 rounded to the nearest multiple of 
$100,000 = $2,200,000. 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 
https://apps.bea.gov/iTable/iTable.cfm?reqid=19&step=3&isuri=1&select_all_years=0&nipa_table_list=64&series=a&first_year=1997&last_year=2020&scale=-99&categories=survey&thetable= (last visited Apr. 30, 2021).
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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

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date.\23\ 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.\24\
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    \23\ When the Commission issued the 2011 and 2016 Orders 
adjusting the dollar amount tests of rule 205-3 as described above, 
the effective dates of the Orders were approximately 60 days 
following their issuance. See 2011 Order, supra footnote 13, at 
section III; 2016 Order, supra footnote 19, at section III.
    \24\ 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 footnote 13, at section II.B.3.

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    By the Commission.

    Dated: May 10, 2021.
J. Matthew DeLesDernier,
Assistant Secretary.
[FR Doc. 2021-10164 Filed 5-14-21; 8:45 am]
BILLING CODE 8011-01-P