SEC Raises “Qualified Client” Net Worth Threshold
June 21, 2021
Effective as of August 16, 2021, the dollar amount tests specified in the definition of “qualified client” in Rule 205-3 will increase.
In an order dated June 17, 2021, the Securities and Exchange Commission (the “SEC”) adopted its prior proposal to (i) increase the net worth threshold for “qualified clients” under Rule 205-3 of the Investment Advisers Act of 1940, as amended (the “Advisers Act”), from $2.1 million to $2.2 million and (ii) to increase the dollar amount of the assets-under-management test from $1 million to $1.1 million.1 These adjustments are being made pursuant to a five-year indexing adjustment required by section 205(e) of the Advisers Act and section 419 of the Dodd-Frank Act.2 The effective date of the increase is August 16, 2021. Clients that enter into advisory agreements in reliance on the net worth test prior to the effective date will be “grandfathered” in under the prior net worth threshold.
Rule 205-3 of the Advisers Act permits investment advisers to receive performance-based compensation only when the client is a “qualified client,” which may capture performance fees or distributions of carried interest.
After giving effect to the increase, a qualified client will be a client that:
(i) has at least $1.1 million in assets under management with the investment adviser immediately after entering into the advisory contract; or
(ii) has a net worth (together, in the case of a client that is a natural person, with assets held jointly with a spouse) that the investment adviser reasonably believes to be in excess of $2.2 million immediately prior to entering into the advisory contract (“net worth test”).3
A qualified client also includes both a “qualified purchaser” as defined in section 2(a)(51)(A) of the Investment Company Act of 1940, as amended (the “Investment Company Act”), and an investment adviser’s “knowledgeable employees.”
As a practical matter, the increased thresholds will affect managed accounts and private funds that rely on the exception to the definition of an investment company provided in section 3(c)(1) of the Investment Company Act, which are required to “look through” to each investor of such fund to determine such investor’s qualified client status.
Clients that enter into advisory agreements in reliance on the net worth test prior to the effective date will be “grandfathered” in under the prior net worth threshold.4 However, sponsors of section 3(c)(1) funds should update their current offering documents to conform to the new qualified client threshold. The updated net worth threshold should be reflected in prospective investor net worth representations in subscription agreements for any section 3(c)(1) funds with closings on or after the effective date and representations in any documents used in effectuating secondary transfers of ownership interests in existing section 3(c)(1) funds following the effective date.
1 Order Approving Adjustment for Inflation of the Dollar Amount Tests in Rule 205-3 under the Investment Advisers Act of 1940, Release No. 5756 (June 17, 2021), available at: https://www.sec.gov/rules/other/2021/ia-5756.pdf.
2 Section 205(e) of the Advisers Act and section 418 of the Dodd-Frank Act require the SEC to issue an order every five years to adjust for inflation the dollar amount thresholds in Rule 205-3’s assets-under-management and net worth tests based on the Personal Consumption Expenditures Chain-Type Price Index (“PCE Index,” published by the United States Department of Commerce), rounded to the nearest $100,000.
3 While a natural 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 be excluded as a liability (subject to limitations in the case of recently acquired debt). Additionally, indebtedness that is secured by the person’s primary residence in excess of the estimated fair market value of the residence also must be included as a liability.
4 The transition rules set forth in Rule 205-3(c)(1) provide that, if an investment adviser entered into an advisory agreement prior to the effective date with an investor that satisfied the qualified client status rule in effect at the time the advisory agreement was entered into, the qualified client rule will be considered satisfied; however, if an investor that was not a party to the advisory agreement becomes a party to it on or after August 16, 2021 (including an investor coming into a 3(c)(1) fund on or after August 16, 2021), the new standard would apply (i.e., if the new investor is relying on the net worth test, it would need to meet the new $2.2 million net worth threshold and if the new investor is relying on the asset-under-management test, it would need to meet the new $1.1 million of assets- under-management threshold).
This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Alicja Biskupska-Haas, an O’Melveny partner licensed to practice law in New York, Tracie Ingrasin, an O’Melveny partner licensed to practice law in New York, Marina G. Richter, an O’Melveny counsel licensed to practice law in New York and Russia, and Chani Gatto-Bradshaw, an O’Melveny associate licensed to practice law in New York, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.
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