The North American Securities Administrators Association (NASAA) has expressed support for recent proposals by the SEC concerning the rules governing performance-based compensation for investment advisers. Commenting on the SEC’s proposed revisions to Rule 205-3 under the Investment Advisers Act of 1940, NASAA backed the SEC’s proposal to revise the dollar amounts of both the assets-under-management and net worth tests used for determining when an investment adviser may charge a fee based on the performance of an investor’s account. NASAA also strongly supported the SEC’s proposal to exclude the value of a person’s primary residence from the “qualified client" net worth test under Rule 205-3.
NASAA noted that the limitations on performance-based fees contained in Rule 205-3 embody important investor protections, given the conflict that arises when an adviser’s fee is generated, either completely or in part, from the performance of an investor’s account. Accordingly, NASAA appreciated Congress’s directive to the SEC in Section 418 of the Dodd-Frank Act to update the tests for determining when a person constitutes a “qualified client" with whom the adviser can enter into a performance-based fee arrangement. The SEC’s proposal to increase the assets-under-management test to $1 million and the net worth test to $2 million will ensure that these tests are at least as effective as when they were last updated in 1998, NASAA believes.
NASAA also believes that the SEC has taken an appropriate and necessary step in proposing that the “qualified client" definition in Rule 205-3 exclude the value of a client’s primary residence from the net worth test. In NASAA’s view, the value of an individual’s primary residence does not indicate an individual’s level of investment sophistication, one of the factors on which the exemption in Rule 205-3 is based. Moreover, the change would be consistent with the changes to the exclusion of the primary residence in the net worth test for accredited investors, as mandated by Section 413(a) of the Dodd-Frank Act. NASAA believes that inconsistent standards between the qualified client and accredited investor tests would be unnecessarily burdensome and costly, given that investment advisers to private funds offered under Rule 506 often require investors to meet both tests in order to collect performance-based fees under Rule 205-3.
NASAA urged the SEC to require that the calculation of an investor’s net worth be made on a specified date, such as 60 or 90 days prior to the date on which the parties enter into the advisory contract. This approach will assist in protecting investors from unscrupulous advisers who may advise them to borrow against their homes solely in order to inflate their net worth and attain qualified client status. Placing the net worth calculation date 60 to 90 days before the date that the contract is signed will make such refinancing transactions less feasible, NASAA believes, and would not make the calculation of net worth unduly complex. NASAA also supported the SEC’s proposal to exclude indebtedness secured by an individual’s primary residence only up to the fair market value of the residence.