[Federal Register Volume 86, Number 215 (Wednesday, November 10, 2021)]
[Rules and Regulations]
[Pages 62473-62475]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2021-24525]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 275

[Release No. IA-5904]


Performance-Based Investment Advisory Fees

AGENCY: Securities and Exchange Commission.

ACTION: Final rule.

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SUMMARY: The Securities and Exchange Commission (``Commission'' or 
``SEC'') is adopting amendments to the rule under the Investment 
Advisers Act of 1940 (``Advisers Act'') that permits investment 
advisers to charge performance-based compensation to ``qualified 
clients.'' The rule defines ``qualified client'' with reference to 
specific dollar amount thresholds, which are required to be adjusted 
every five years to account for the effects of inflation. These 
amendments replace specific dollar amount thresholds in the rule's 
``qualified client'' definition with references to the Commission's 
``most recent order,'' as defined by the amended rule, containing the 
specific dollar amount thresholds adjusted for inflation.

DATES: The amendments are effective on November 10, 2021.

FOR FURTHER INFORMATION CONTACT: Matthew Cook, Senior Counsel, at (202) 
551-6787 or [email protected], Investment Adviser Regulation Office, 
Division of Investment Management, Securities and Exchange Commission, 
100 F Street NE, Washington, DC 20549-8549.

SUPPLEMENTARY INFORMATION: The Commission is adopting amendments to 17 
CFR 275.205-3 (rule 205-3) under the Advisers Act.\1\
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    \1\ 15 U.S.C. 80b. Unless otherwise noted, all references to 
statutory sections are to 15 U.S.C. 80b of the United States Code, 
at which the Advisers Act is codified, and all references to rules 
under the Advisers Act, including rule 205-3, are to title 17, part 
275 of the Code of Federal Regulations [17 CFR part 275].
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I. Background

    Section 205(a)(1) of the Advisers Act generally prohibits an 
investment adviser registered or required to be registered with the 
Commission 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.\2\ Congress restricted these compensation 
arrangements (also known as performance compensation or performance 
fees) in 1940 to protect advisory clients from fee arrangements it 
believed could encourage advisers to engage in speculative trading 
practices while managing client funds in order to realize or increase 
advisory fees.\3\ Congress subsequently authorized the Commission to 
exempt any advisory contract from the performance fee prohibition if 
the contract is with any person that the Commission determines does not 
need the protections of this restriction.\4\ Rule 205-3 under the 
Advisers Act exempts an investment adviser from the prohibition against 
charging a client performance fees when the client is a ``qualified 
client.'' \5\ A qualified client includes a client that has at least a 
certain dollar amount in assets under management with the adviser 
immediately after entering into the advisory contract (``assets-under-
management test''), and a client that the adviser reasonably believes, 
immediately prior to entering into the contract, had a net worth of 
more than a certain dollar amount (``net worth test'').\6\
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    \2\ 15 U.S.C. 80b-5(a)(1).
    \3\ See Exemption to Allow Registered Investment Advisers to 
Charge Fees Based Upon a Share of Capital Gains Upon or Capital 
Appreciation of a Client's Account, Investment Advisers Act Release 
No. 996 (Nov. 14, 1985) [50 FR 48556 (Nov. 26, 1985)] (``1985 
Adopting Release''), at Section I.A and footnote 3.
    \4\ Section 205(e) of the Advisers Act. Section 205(e) provides 
that the Commission may determine that persons do not need the 
protections of section 205(a)(1) on the basis of such factors as 
``financial sophistication, net worth, knowledge of and experience 
in financial matters, amount of assets under management, 
relationship with a registered investment adviser, and such other 
factors as the Commission determines are consistent with [section 
205].''
    \5\ 1985 Adopting Release, supra footnote 3. The exemption 
applies to the entrance into, performance, renewal, and extension of 
advisory contracts. See rule 205-3(a).
    \6\ Rule 205-3(d)(1)(i) through (ii). The dollar amount 
thresholds of the assets-under-management and net worth tests were 
$500,000 and $1 million, respectively, when the Commission adopted 
rule 205-3 in 1985. See 1985 Adopting Release, supra footnote 3. In 
1998, the Commission amended rule 205-3 to, among other things, 
revise the dollar amounts of the assets-under-management test and 
net worth test to adjust for the effects of inflation since 1985 
(the amounts were adjusted to $750,000 and $1.5 million, 
respectively). See Exemption To Allow Investment Advisers To Charge 
Fees Based Upon a Share of Capital Gains Upon or Capital 
Appreciation of a Client's Account, Investment Advisers Act Release 
No. 1731 (July 15, 1998) [63 FR 39022 (July 21, 1998)]. These dollar 
amount thresholds were subsequently adjusted to account for the 
effects of inflation by Commission orders in 2011, 2016 and 2021, as 
discussed infra footnotes 9, 11, and 12 and accompanying text.
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    The Dodd-Frank Wall Street Reform and Consumer Protection Act 
(``Dodd-Frank Act'') \7\ amended section 205(e) of the Advisers Act to 
provide that, by July 21, 2011, and every five years thereafter, the 
Commission shall, by order, adjust for the effects of inflation the 
dollar amount thresholds included in rules issued under section 205(e), 
rounded to the nearest multiple of $100,000.\8\ In 2011, the Commission 
issued an order to revise the dollar amount thresholds of the assets-
under-management and net worth tests to $1,000,000 and $2,000,000, 
respectively.\9\ In 2012, the Commission amended rule 205-3 to codify 
the dollar amount thresholds in the 2011 Order and, among other

[[Page 62474]]

amendments, to add a new paragraph (e) that states that the Commission 
will issue an order on or about May 1, 2016, and approximately every 
five years thereafter, adjusting for inflation the dollar amount 
thresholds of the assets-under-management and net worth tests of the 
rule.\10\
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    \7\ Public Law 111-203, 124 Stat. 1376 (2010).
    \8\ See section 418 of the Dodd-Frank Act (requiring the 
Commission to issue an order every five years revising dollar amount 
thresholds in a rule that exempts a person or transaction from 
section 205(a)(1) of the Advisers Act if the dollar amount threshold 
was a factor in the Commission's determination that the person does 
not need the protections of that section).
    \9\ Order Approving Adjustment for Inflation of the Dollar 
Amount Tests in Rule 205-3 under the Investment Advisers Act of 
1940, Investment Advisers Act Release No. 3236 (July 12, 2011) [76 
FR 41838 (July 15, 2011)] (``2011 Order'').
    \10\ Rule 205-3(d) and (e). See Investment Adviser Performance 
Compensation, Investment Advisers Act Release No. 3372 (Feb. 15, 
2012) [77 FR 10358 (Feb. 22, 2012)]. Rule 205-3(e) also specifies 
the methodology and price index on which inflation adjustments must 
be based.
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    Since then, the Commission has twice issued orders adjusting for 
the effects of inflation the dollar amount thresholds in accordance 
with rule 205-3(e). In 2016, the Commission issued an order increasing 
the dollar amount threshold of the net worth test (to $2,100,000) and 
maintaining the dollar amount threshold of the assets-under management 
test (at $1,000,000).\11\ On June 17, 2021, the Commission issued an 
order, effective as of August 16, 2021, increasing the dollar amount 
threshold of the assets-under-management test from $1,000,000 to 
$1,100,000 and the dollar amount threshold of the net worth test from 
$2,100,000 to $2,200,000.\12\
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    \11\ Order Approving Adjustment for Inflation of the Dollar 
Amount Tests in Rule 205-3 under the Investment Advisers Act of 
1940, Investment Advisers Act Release No. 4421 (June 14, 2016) [81 
FR 39985 (June 20, 2016)] (``2016 Order'').
    \12\ Order Approving Adjustment for Inflation of the Dollar 
Amount Tests in Rule 205-3 under the Investment Advisers Act of 
1940, Investment Advisers Act Release No. 5756 (June 17, 2021) [86 
FR 32993 (June 23, 2021)] (``2021 Order''). Both the 2016 Order and 
the 2021 Order stated that to the extent that contractual 
relationships were entered into prior to the order's effective date, 
the adjustments to the dollar amount thresholds would not generally 
apply retroactively to such contractual relationships, subject to 
the transition rules of rule 205-3, which are described infra 
footnote 14.
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II. Discussion

A. Amendments to Rule 205-3

    We are adopting amendments to rule 205-3 to replace the specific 
dollar amount thresholds in the rule's net worth and assets-under-
management tests with references to the ``most recent order'' issued by 
the Commission containing the specific dollar amount thresholds 
adjusted for inflation. We define ``most recent order'' in the rule to 
mean ``the most recently issued Commission order in accordance with 
paragraph (e) of this section and as published in the Federal 
Register.'' \13\
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    \13\ Such orders are published in the Federal Register, but are 
also available on the SEC's website at www.sec.gov/rules/other.shtml. See, e.g., 2021 Order, supra footnote 12. Publication 
of the orders on the website may precede publication in the Federal 
Register.
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    As discussed above, the Commission is required to issue an order 
every five years adjusting for inflation the dollar amount thresholds 
of the assets-under-management and net worth tests of the rule. By 
amending the rule to refer to the ``most recent order'' for the dollar 
amount thresholds in the rule's ``qualified client'' tests, the rule 
will reference the most recently issued and published adjusted dollar 
amounts,\14\ and more directly tie the relevant amount to the mechanism 
by which it is established (i.e., the order).
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    \14\ The effective dates of the adjustments are specified in the 
``most recent order'' and are subject to the transition provisions 
of the rule. See, e.g., 2021 Order, supra footnote 12. The 
transition provisions state, for example, that if a registered 
investment adviser entered into a contract and satisfied the 
conditions of rule 205-3 that were in effect when the contract was 
entered into, the adviser will be considered to satisfy the 
conditions of the rule; if, however, a natural person or company 
that was not a party to the contract becomes a party, the conditions 
of the rule in effect at the time such natural person or company 
becomes a party will apply to that person or company. See rule 205-
3(c)(1) through (3).
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    We are also adopting an amendment to rule 205-3 to update from 
``May 1, 2016'' to ``May 1, 2026'' the reference point of a specific 
date in paragraph (e). Paragraph (e) currently provides that the dollar 
amount thresholds of the assets-under-management and net worth tests 
will be adjusted for inflation by Commission order ``issued on or about 
May 1, 2016 and approximately every five years thereafter.'' \15\ By 
amending the rule to refer to a date in the future, the rule will 
establish clearly the next expected date for issuance of a Commission 
order, while retaining the five-year period between such orders that 
was established by the Commission in 2012. We believe that referring in 
the rule text to a specific date will be useful to market participants 
in determining approximately when the Commission will issue and the 
Federal Register will publish an order for purposes of the amended 
rule's definition of ``most recent order.''
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    \15\ Rule 205-3(e).
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B. Procedural and Other Matters

    Under the Administrative Procedure Act (``APA''), notice of 
proposed rulemaking is not required: (1) For interpretive rules, 
general statements of policy, or rules of agency organization, 
procedure, or practice; or (2) when the agency for good cause finds 
(and incorporates the finding and a brief statement of reasons therefor 
in the rules issued) that notice and public procedure thereon are 
impracticable, unnecessary, or contrary to the public interest.\16\ 
Given that the amendments to rule 205-3 do not substantively change the 
methodology for calculating the dollar amount thresholds or the amount 
of those thresholds, and instead merely add a reference in the rule to 
the Commission's ``most recent order'' adjusting the dollar amount 
thresholds and update the reference point of a specific date in 
paragraph (e), the Commission finds that good cause exists to dispense 
with public notice and comment pursuant to the notice and comment 
provisions of the APA. In accordance with the APA, the Commission also 
finds that there is good cause to establish an effective date less than 
30 days after publication of rule 205-3.\17\ The Commission finds there 
is good cause for the amendments to rule 205-3 to take effect upon 
publication in the Federal Register because the current rule's dollar 
thresholds do not conform to the dollar thresholds adopted pursuant to 
the most recent order. The Commission believes that establishing an 
effective date less than 30 days after publication of rule 205-3 is 
necessary to remove the outdated dollar thresholds in the rule by 
making the text consistent with the thresholds adopted pursuant to the 
most recent order. Furthermore, the amendments to rule 205-3 under the 
Advisers Act do not contain any ``collection of information'' 
requirements as defined by the Paperwork Reduction Act of 1995, as 
amended (``PRA'').\18\ Accordingly, the PRA is not applicable.
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    \16\ 5 U.S.C. 553(b). The amendments to rule 205-3 do not 
require analysis under the Regulatory Flexibility Act (``RFA'') 5 
U.S.C. 601(2) (for purposes of RFA analysis, the term ``rule'' 
generally means any rule for which the agency publishes a general 
notice of proposed rulemaking). In addition, pursuant to the 
Congressional Review Act, the Office of Information and Regulatory 
Affairs has designated the amendments to rule 205-3 as not a ``major 
rule'' as defined by 5 U.S.C. 804(2). See 5 U.S.C. 801 et seq.
    \17\ 5 U.S.C. 553(d)). This finding also satisfies the 
requirements of 5 U.S.C. 808(2), allowing the amendment to rule 205-
3 to become effective notwithstanding the requirement of 5 U.S.C. 
801 (if a Federal agency finds that notice and public comment are 
impracticable, unnecessary or contrary to the public interest, a 
rule shall take effect at such time as the federal agency 
promulgating the rule determines). Therefore, the amendments to rule 
205-3 shall take effect on November 10, 2021.
    \18\ 44 U.S.C. 3501-3520.
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III. Economic Analysis

    The Commission is sensitive to the economic effects that could 
result from the amendments to rule 205-3. Investment advisers who 
charge, or may charge, performance fees and clients who meet, or may 
meet, the definition of ``qualified client'' in the rule could be 
affected by the amendments. As of August 2021, of the approximately 
14,543 investment advisers registered with the Commission, 5,251 (36%)

[[Page 62475]]

currently report that they are compensated with performance-based 
fees.\19\
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    \19\ This analysis is based on adviser responses to Item 5.E.6 
of Part 1A on Form ADV. This Item requests that an adviser note 
whether it receives performance-based fees.
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    We do not, however, expect that the amendments to rule 205-3 will 
result in substantial costs or benefits to these market participants. 
As described above, rule 205-3 currently references specific dollar 
amount thresholds in the rule's net worth and assets-under-management 
tests in paragraph (d)(1) and, separately, specifies that these 
thresholds will be adjusted for the effects of inflation by order of 
the Commission in paragraph (e). The amendments replace the specific 
dollar amount thresholds with references to the ``most recent order'' 
issued by the Commission containing the specific dollar amount 
thresholds adjusted for inflation, consistent with existing paragraph 
(e) of the rule. The amendments do not themselves change the dollar 
amount thresholds used in the definition, and, as a result, will not 
have any effect on the number of clients that meet the rule's 
definition of ``qualified client.'' Further, we do not believe the 
amendments will affect the number of advisers charging clients 
performance fees. The amendments also update the date from ``May 1, 
2016'' to ``May 1, 2026'' in paragraph (e) to indicate when the next 
adjustment will occur, with future adjustments every five years 
thereafter, although this update does not reflect any change in process 
or timing from the existing rule.
    The amendments to rule 205-3 could help investment advisers and 
clients more easily identify the current thresholds in the ``qualified 
client'' definition to the extent that the text of rule 205-3 is 
inconsistent with the most recent order issued by the Commission or to 
the extent that investment advisers and clients are unaware of such 
inconsistency. Relatedly, the updated date in paragraph (e) may help 
investment advisers and clients more easily determine approximately 
when the Commission will next issue an order and set expectations for 
future changes. These effects could incrementally reduce compliance 
costs; however, we do not expect any such reductions to be substantial.
    Similarly, we do not expect any changes to efficiency, competition, 
or capital formation in the investment adviser industry as a result of 
the amendments to rule 205-3. While the amendments may make the 
identification of ``qualified clients'' incrementally easier by 
clarifying that the current thresholds in the ``qualified client'' 
definition may be found in the most recent order issued by the 
Commission, we do not believe that these changes will substantially 
affect an adviser's ability to identify ``qualified clients'' or raise 
capital from such clients.

IV. Statutory Authority

    The Commission is adopting amendments to rule 205-3 under the 
Advisers Act pursuant to the authority set forth in section 205(e) of 
the Investment Advisers Act of 1940 [15 U.S.C. 80b-5(e)].

List of Subjects in 17 CFR Part 275

    Reporting and recordkeeping requirements, Securities.

Text of Rules

    For the reasons set out in the preamble, title 17, chapter II of 
the Code of Federal Regulations is amended as follows:

PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940

0
1. The authority citation for part 275 continues to read, in part, as 
follows:

    Authority: 15 U.S.C. 80b-2(a)(11)(G), 80b-2(a)(11)(H), 80b-
2(a)(17), 80b-3, 80b-4, 80b-4a, 80b-6(4), 80b-6a, and 80b-11, unless 
otherwise noted.
* * * * *
    Section 275.205-3 is also issued under 15 U.S.C. 80b-5(e).
* * * * *

0
2. Section 275.205-3 is amended by:
0
a. Revising paragraphs (d)(1)(i) and (d)(1)(ii)(A) introductory text;
0
b. Adding paragraph (d)(5); and
0
c. Revising paragraph (e) introductory text.
    The revisions and addition read as follows:


Sec.  275.205-3  Exemption from the compensation prohibition of section 
205(a)(1) for investment advisers.

* * * * *
    (d) * * *
    (1) * * *
    (i) A natural person who, or a company that, immediately after 
entering into the contract has, under the management of the investment 
adviser, at least the applicable dollar amount specified in the most 
recent order;
    (ii) * * *
    (A) Has a net worth (together, in the case of a natural person, 
with assets held jointly with a spouse) of more than the applicable 
dollar amount specified in the most recent order. For purposes of 
calculating a natural person's net worth:
* * * * *
    (5) The term most recent order means the most recently issued 
Commission order in accordance with paragraph (e) of this section and 
as published in the Federal Register.
    (e) Inflation adjustments. Pursuant to section 205(e) of the Act, 
the dollar amounts referenced in paragraphs (d)(1)(i) and (d)(1)(ii)(A) 
of this section shall be adjusted, by order of the Commission, issued 
on or about May 1, 2026, and approximately every five years thereafter. 
The adjusted dollar amounts established in such orders shall be 
computed by:
* * * * *

    By the Commission.

    Dated: November 4, 2021.
Vanessa A. Countryman,
Secretary.
[FR Doc. 2021-24525 Filed 11-9-21; 8:45 am]
BILLING CODE 8011-01-P