On February 15, 2012, the SEC announced the final adoption of amendments to Rule 205-3 of the Investment Advisers Act of 1940 (“Advisers Act”). The amendment results from the Dodd-Frank Wall Street Reform and Consumer Protection Act’s change to section 205 of the Advisers Act, which requires the SEC to make inflationary adjustments to any dollar amount thresholds used to exempt investors from the provision’s prohibition on registered investment advisers collection of performance based fees. Section 205(a)(1) of the Advisers Actwas originally enacted in 1940 to protect advisory clients from compensation arrangements that Congress believed would encourage advisers to take undue risks with client’s funds to increase their own fees. The law was later amended to authorize the SEC 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 subsection (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, [and] relationship with a registered investment adviser….” 15 U.S.C.§80b-5. As a result, in 1985 the SEC adopted Rule 205-3, which allowed advisers to charge performance fees to certain qualified investors who had at least $500,000 of assets under management with the adviser or if the adviser reasonably believed the client had a net worth of more than $1 million at the time the contract was entered into. In 1998 these amounts were adjusted upwards by the Commission to $750,000 and $1.5 million, respectively. The new amendment to Rule 205-3 adjusts the dollar thresholds for the assets under management test to $1 million and the net worth test to $2 million. The rule also is amended to: (1) state that the SEC will adjust the thresholds for inflation every five (5) years; (2) exclude the value of a person’s primary residence from the net worth test just as it has done for the definition of accredited investors (although not required by Dodd-Frank); and (3) institute grandfathering provisions to allow investment advisers charging performance fees to clients who were qualified under the prior thresholds to maintain those agreements. Perhaps the biggest impact of the new rule will be on previously unregistered private fund managers who, as a result of Dodd-Frank’s mandate, must register as investment advisers and are subject to Advisers Act requirements. Such managers, who previously could solicit investments from accredited investors (with a net worth requirement of only $1 million), are now restricted to soliciting investments from qualified clients (with assets under management of $1 million or a net worth above $2 million) pursuant to Rule 205-3. In sum, the amended rule may now result in the reduction of the number of potential investors who are eligible to invest in private funds that charge a performance-based fee. For additional information please contact Jacko Law Group at (619) 298-2880.