The Securities Exchange Commission proposed new rules that would increase the threshold for investment advisers to charge incentive compensation to qualified clients. The Commission also proposed new rules that would, among other things, revise the definition of “qualified client” to exclude the value of the principal residence from the calculation of net worth. This Client Alert summarizes the background and the new and proposed rules concerning “qualified client” standards.

Section 205(a)(1) of the Investment Advisers Act of 1940 (“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. Rule 205-3 under the Advisers Act exempts an investment adviser from the prohibition against charging a client performance fees with respect to investors that are “qualified clients.” “Qualified clients” are generally defined to include (i) natural persons or companies that, immediately after entering into the contract, have at least $750,000 under management with the adviser (“Assets under Management Test”) and (ii) natural persons or companies that the adviser reasonably believes, immediately prior to entering the contract, either have a net worth of more than $1,500,000 at the time the contract is entered into (together, in the case of a natural person, with assets held jointly with a spouse) (“Net Worth Test”) or are “qualified purchasers,” as defined in the Investment Company Act of 1940 (“Investment Company Act”), at the time the contract is entered into.