On June 14, 2016, the Securities and Exchange Commission (the “SEC”) issued an order1, effective August 15, 2016, with respect to Rule 205-3 under the Investment Advisers Act of 1940 (the “Advisers Act”). Rule 205-3 creates exemptions to Section 205(a)(1) of the Advisers Act such that investment advisers may enter into performance-based compensation arrangements with “qualified clients.” Prior to the August 2016 Order, based upon an SEC order effective May 22, 20122, “qualified clients” included (i) clients that had at least $1,000,000 in assets under the management of the investment adviser immediately after entering into the contract (the “AUM Test”), and (ii) clients that the investment adviser reasonably believes had a net worth of more than $2,000,000 immediately prior to entering into the contract (the “Net Worth Test”). The May 2012 Order also requires the SEC to issue an order every five years adjusting for inflation the dollar thresholds for the AUM Test and Net Worth Test based on the Personal Consumption Expenditures Chain-Type Price Index published by the Department of Commerce.

The August 2016 Order amends the Net Worth Test threshold to $2,100,000. The AUM Test threshold remains at $1,000,000.

Exclusion of Value of and Indebtedness Secured by Primary Residence from Net Worth Calculation

For the purposes of calculating a natural person’s net worth under Rule 205-3, the principles below must be followed:

  • The person’s primary residence must not be included as an asset;
  • Indebtedness secured by the person’s primary residence, up to the estimated fair market value of the primary residence at the time the investment advisory contract is entered into, may not be included as a liability (except that if the amount of such indebtedness outstanding at the time of calculation exceeds the amount outstanding 60 days before such time, other than as a result of acquiring the primary residence, the amount of such excess must be included as a liability); and
  • Indebtedness that is secured by the person’s primary residence in excess of the estimated fair market value of the residence must be included as a liability.

Transition Rules

The $2,100,000 Net Worth Test threshold will not apply to agreements that were entered into before August 15, 2016 and complied with the $2,000,000 Net Worth Test threshold, unless a natural person or company who was not a party to the agreement becomes a party (including an equity owner of a private investment company advised by the adviser) after August 15, 2016, in which case that person or company must meet the $2,100,000 Net Worth Test threshold.

For the purpose of the foregoing, a transfer of an equity interest in a private investment company by gift, bequest, or under a legal separation or divorce agreement will not cause the transferee to “become a party.”