Wednesday, October 10, 2012

NASAA Proposes Changes to Model Rules on Adviser Performance Fees

The North American Securities Administrators Association (NASAA) has released for public comment a proposal to amend the NASAA Model Rules that allow investment advisers to change certain clients performance based fees. As discussed in today's Notice of Request for Public Comment, the proposed changes are intended to align NASAA's performance fee model rules more closely with federal Rule 205-3 under the Investment Advisers Act of 1940. 

Although NASAA's Model Rules under both the 1956 and 2002 Uniform Securities Acts contain provisions that allow investment advisers to charge certain clients a performance based fee, the performance fee model rules have not been updated in tandem with the SEC's to amendments Rule 205-3. As a result, NASAA believes that the performance fee rules need to be amended in order to account for inflation and changes to federal law. 

As discussed in the release, the “performance fee” rule is designed to limit the type of clients that may be charged a fee based on capital gains. Although Section 205(a)(1) of the Investment Advisers Act of 1940 generally prohibits the assessment of these fees by most federally registered investment advisers, Rule 205-3 allows for the assessment of performance fees to "qualified clients."

The public comment period will remain open to December 10, 2012. NASAA has requested that comments be sent to Greg Abram, Chair of the Investment Adviser Section Regulatory Policy and Review Project Group, and to Joseph Brady and A.Valerie Mirko of the NASAA Legal Department. Although NASAA encourages comments to be submitted by e-mail, hard copy comments can also be submitted to the NASAA Legal Department in Washington, D.C. NASAA also welcomes any general comments on Model Rules 102(f)-3 and 502(c). 

A summary of the significant changes may be found below.

Model Rule 102(f)-3 Under the Uniform Securities Act of 1956

NASAA Model Rule 102(f)-3 contains the exemption to the general prohibition related to performance based fees found in Section 102(c)(1) of the Uniform Securities Act of 1956. NASAA has proposed to amend Rule 102(f)-3 structurally to mirror Rule 205-3 by moving the definitions to the end of the rule. 

Subsection (a), which has been amended extensively, now lists the requirements for the exemption. The rule now specifically states that an adviser can charge performance fees if either: (1) the adviser is not registered and not required to be registered or (2) the requirements of new (a)(2)(A) and (a)(2)(B) are complied with. According to NASAA, the purpose for clarifying that an adviser that is not required to be registered may charge performance fees originates from the fact that the federal prohibition on performance based fees is limited to advisers that are registered or required to be registered. As the prohibition under the 1956 Uniform Act is not limited to registered or required to be registered advisers, the rule creates a specific exemption for those advisers that are not registered and do not need to be registered. This will be especially significant in jurisdictions that adopt an exemption from registration for advisers to private funds, NASAA noted.

Subsection (a)(2) of the prior version of Rule 102(f)-3 listed specific requirements with respect to the computation of a performance fee. The Model Rule is being amended to remove those specific requirements primarily because they were previously removed from the federal Rule 205-3. Furthermore, removing these requirements will allow parties to an advisory contract more flexibility in negotiating the fee. Given the changes to the definition of a “qualified client” and the ongoing applicability of the anti-fraud provisions, NASAA believes that it is appropriate to remove the specific requirements from the rule.

Proposed Subsection (a)(2)(A) is similar to the Rule 205-3 requirement and ties the definition of “qualified client” directly to the federal definition. In addition to reflecting the SEC's amendments to Rule 205-3 that made changes to the dollar amount thresholds and the exclusion of a person’s primary residence value from the net worth computation for qualified clients, the new structure of Rule 102(f)-3 will ensure that states adopting the Model Rule will be able to account for inflation without having to modify their respective rule. 

NASAA noted that the disclosure requirements under (a)(2)(B) as modified are not in Rule 205-3. Although the SEC had removed similar disclosure from Rule 205-3 in 1998, NASAA has not removed the requirements from the Model Rule in order to emphasize the importance of the information and to provide direct notice to investment advisers about the necessary disclosures. Additionally, the Model Rule makes it clear that an investment adviser may make these disclosures through Part 2 of the Form ADV, thus facilitating advisers’ efforts to comply with the disclosure requirements.

Subsection (b) has been added to Model Rule 102(f)-3 in order to make it clear that an investor in a private fund must be a “qualified client” before the adviser can charge such investor a performance fee. NASAA observed that a fund can be composed of investors that are qualified clients and non-qualified, in which case the adviser must look-through to the ultimate client and assess performance fees solely if the client is a qualified client. SEC Rule 205-3 contains the same specification, which in practice requires that each “tier” of entities must be subject to a look-through to determine whether performance fees may be charged. 

Subsection (c) constitutes a new addition to the Model Rule and is also included in Rule 205-3. NASAA commented that the current (and anticipated future) amendments to the performance fee rule, specifically the definition of “qualified client”, would require advisers to re-assess which existing clients could be charged a performance fee any time that they extend or renew a contract with the client. Under new Subsection (c), this impact would be avoided to the extent that the adviser was in compliance with the performance fee rule effective when the contract was most recently entered into, extended, or otherwise renewed. The definitions portion in Subsection (d) has been amended to only retain terms relevant to the amended rule.

Model Rule 502(c) Under the Uniform Securities Act of 2002

As with the amendments to Rule 102(f)-3 of the 1956 Rules, the primary focus of the amendments to Rule 502(c) was to closely align the Model Rule to Rule 205-3. NASAA noted, however, that the 2002 version of the performance fee rule is structured differently than the 1956 version. Most significantly, Rule 502(c) establishes both the prohibition on assessing a performance fee and the exemption from such prohibition. Rule 502(c) also is not limited solely to the performance fee issue but also specifies several other requirements related to investment advisory contracts.

Subsection (a) establishes four requirements with respect to the terms of an investment advisory contract, while Subsection (a)(3) specifically establishes the general prohibition related to the assessment of performance fees. The primary change to Subsection (a) is the deletion of references to “investment adviser representative” and “federally covered investment adviser." The reference to “investment adviser representative” was not deemed necessary because the investment advisory contract would be established between the investment adviser and the client. Subsection (a)(1) was slightly modified, however, to make it clear that an investment advisory contract must indicate if the investment adviser “or any of its” investment adviser representatives was being granted discretionary authority. References to “federally covered investment adviser” were deleted from Subsection (a) because state jurisdiction related to federally covered investment advisers is limited to fraud matters. 

Subsections (c), (d), and (e) have been modified to match USA 1956 Rules 105(f)-3(a), (b), and (c). Unlike the 1956 version, however, the performance based fee prohibition is actually contained within the 2002 Model Rule. As a result, NASAA considered amending subsection (a) to limit the prohibition to those advisers that are registered or need to be registered. As there are other prohibitions under subsection (a), however, it was decided to avoid making changes that could impact issues beyond the performance fee.

Subsections (f) and (g) have been deleted as unnecessary restatements of established legal principles, with new Subsection (f) now forming the definitions portion of Rule 502(c). This section has been modified by deleting the terms that were no longer necessary as a result of the other amendments to Rule 502(c), including: “affiliate”; “client’s independent agent”; “executive officer”; “interested person”; and “qualified client."