SEC Increases Qualified Client Thresholds

By David Mainzer

August 2011

On July 12, 2011, the Securities and Exchange Commission (the “SEC”) adjusted Rule 205-3 under the Investment Advisers Act of 1940 (the “Advisers Act”) to increase the dollar amount thresholds necessary for a person to qualify as a “qualified client.”  These adjustments will become effective on September 19, 2011.  Rule 205-3 is an SEC rule that allows investment advisers to charge their clients performance based fees, which are otherwise prohibited by Section 205(a)(1) of the Advisers Act.  For hedge funds and other funds, investors in the fund must be qualified clients in order for the fund to be able to pay performance fees to the investment adviser.

Currently, SEC Rule 205-3(d)(1)(i) and (ii) provides that individuals and companies are qualified clients if either (a) they have $750,000 under the management of the investment adviser immediately after entering into the investment management agreement providing for the performance fees or (b) the investment adviser reasonably believes that they have a net worth (for a natural person, this includes assets jointly held with a spouse) of more than $1.5 million immediately prior to entering into the investment management agreement providing for the performance fees.

The changes made by the SEC will increase these amounts, such that individuals and companies will be qualified clients if either (a) they have $1 million under the management of the investment adviser immediately after entering into the investment management agreement providing for the performance fees or (b) the investment adviser reasonably believes that they have a net worth (for a natural person, this includes assets jointly held with a spouse) of more than $2 million immediately prior to  entering into the investment management agreement providing for the performance fees.

The SEC has also proposed changes to the qualified client definition that, among other things, would (a) increase the foregoing dollar amounts every five years to reflect inflation and (b) exclude the value of a natural person’s primary residence in determining whether they meet these thresholds.  The SEC is still considering these further changes.

Investment advisers will be required to update their compliance policies and procedures, by September 19, 2011, to ensure compliance with the changed rule.  For managers of hedge funds and other private funds, this will generally require updates to the funds’ subscription documents and private placement memoranda.

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