The Board of Directors of the North American Securities Administrators Association, Inc. (“NASAA”) has authorized release for public comment the following proposed changes to Model Rule 102(f)-3 under the Uniform Securities Act of 1956 and Model Rule  502(c) under the Uniform Securities Act of 2002 (“the performance fee model rules” or “the Model Rules”).

Public Comment Period

The public comment period will remain open to December 10, 2012.  To facilitate consideration of comments from the public, please send comments to Greg Abram (greg.abram@state.ma.us), Chair of the Investment Adviser Section Regulatory Policy and Review Project Group, and Joseph Brady (jb@nasaa.org) and A.Valerie Mirko (vm@nasaa.org), NASAA Legal Department. We encourage, but do not require, comments to be submitted by e-mail.  Hard copy comments can be submitted at the address below. We also welcome any general comments on Model Rules 102(f)-3 and 502(c). 

NASAA Legal Department
Joseph Brady, General Counsel
A.Valerie Mirko, Assistant General Counsel
NASAA
750 First Street, NE, Suite 990
Washington, DC  20002

Background on 2012 Amendments to the NASAA Performance Fee Model Rules

The “performance fee” rule is designed to limit the type of clients that may be charged a fee based on capital gains.  Section 205(a)(1) of the Investment Advisers Act of 1940 (“Investment Advisers Act”) generally prohibits the assessment of these fees by most federally registered investment advisers.  SEC Rule 205-3(“Rule 205-3”) under the Investment Advisers Act establishes an exemption, which allows for the assessment of performance fees to qualified clients.  Rule 205-3 has undergone a few amendments since it was first established, with the most recent amendment becoming effective May 22, 2012.  The various amendments have accounted for inflation and have also removed substantive requirements of the exemption.

The 1956 and 2002 Model Rules each contain a rule that allows investment advisers to charge certain clients a performance based fee.  However, both performance fee model rules have not been updated in tandem with Rule 205-3, and as a result need to be amended to account for inflation and changes in federal law.

In general, the proposed changes to the performance fee model rules are intended to more closely align them to Rule 205-3.  Immediately below are hyperlinks to both Model Rules with proposed revisions.  Proposed changes are summarized below the hyperlinks.

Download 1956 Model Rule with Proposed Revisions

Download 2002 Model Rule with Proposed Revisions

Proposed Changes to the 1956 Version – Model Rule 102(f)-3

Section 102(c)(1) of the Uniform Securities Act of 1956 contains a general prohibition related to performance based fees.  An exemption to this prohibition is found in Rule 102(f)-3. 

First, Rule 102(f)-3 has been amended structurally to mirror Rule 205-3.  In this regard, the definitions have been moved to the end of the rule.

Subsection (a)

Subsection (a) now lists the requirements of the exemption.  Notably, this subsection has been amended extensively.  The rule now specifically states that an adviser can charge performance fees if either: (1) the adviser is not registered and not required to be registered or (2) the requirements of new (a)(2)(A) and (a)(2)(B) are complied with.  The purpose for clarifying that an adviser that is not required to be registered may charge performance fees originates from the fact that the federal prohibition on performance based fees is limited to advisers that are registered or required to be registered.  As the prohibition under the 1956 Uniform Act is not limited to registered/required to be registered advisers, the rule creates a specific exemption for those advisers that are not registered and do not need to be registered.  This will be especially significant in jurisdictions that adopt an exemption from registration for advisers to private funds (i.e. whether exempt reporting adviser status or other exempt status). 

Subsection (a)(2) of the prior version of Rule 102(f)-3 listed specific requirements with respect to the computation of a performance fee.  The Rule is being amended to remove those specific requirements primarily because they were previously removed from the federal Rule 205-3.  Furthermore, removing these requirements will allow parties to an advisory contract more flexibility in negotiating the fee.  Given the changes to the definition of a “qualified client” and the ongoing applicability of the anti-fraud provisions, it seems appropriate to remove the specific requirements from the rule.

Subsection (a)(2)(A) is similar to the Rule 205-3 requirement.  It should be noted that the definition of “qualified client” is tied directly to the federal definition.  Notably, the Rule 205-3 amendment that became effective on May 22, 2012 (1) codifies changes to the dollar amount thresholds [$2 million net worth or $1 million under management with the adviser]; (2) creates a requirement to exclude a person’s primary residence value from the net worth computation for the qualified client definition; and (3) requires the SEC to adjust the dollar thresholds every 5 years to account for inflation.  The new structure of Rule 102(f)-3 will ensure that states adopting the Model Rule will be able to account for inflation without having to modify their respective rule. 

The requirements listed under (a)(2)(B) as modified are not in Rule 205-3.  Of note, Rule 205-3 contained similar disclosure requirements until it was amended in 1998.  At that point, the SEC reasoned that the rule did not need to contain the specific disclosure items because the specificity was inhibiting “the flexibility of advisers and their clients” and the anti-fraud provisions would still require disclosure of all material information regarding performance fee arrangements. 

Nonetheless, the disclosures have not been removed from the Model Rule in order to emphasize the importance of the information and to provide direct notice to investment advisers about the necessary disclosures.  While, as the SEC notes, even if the rule didn’t specify these disclosures, a failure to disclose such information could subject an investment adviser to a fraud claim, retaining the disclosures within the Model Rule provides emphasis.  Furthermore, while emphasizing the importance of the disclosures, the Model Rule also makes it clear that an investment adviser may make these disclosures through Part 2 of the Form ADV.  This clarification will facilitate advisers’ efforts to comply with the disclosure requirements.

Subsection (b)

This subsection was added to the Model Rule to make it clear that an investor in a private fund must be a “qualified client” before the adviser can charge such investor a performance fee.  The adviser can’t justify charging performance fees to all investors in a fund by relying on the fact that the fund is the advisers “client” and the fund is a “qualified client”.  A fund can be composed of investors that are qualified clients and non-qualified, in which case the adviser must look-through to the ultimate client and assess performance fees solely if the client is a qualified client.  SEC Rule 205-3 contains the same specification, which in practice requires that each “tier” of entities must be subject to a look-through to determine whether performance fees may be charged. The SEC addressed this issue in SEC Release IA-3372,[1] the Adopting Release for the most recent amendments to SEC Rule 205-3: “rule 205-3(b) specifies that the requirement to look through to each investor of a private investment company applies to each tier of a funds-of-funds structure.”[2]

Subsection (c)

This is a new addition to the Model Rule and it is also included in Rule 205-3.  The current (and anticipated future) amendments to the performance fee rule, specifically the definition of “qualified client”, would require advisers to re-assess which existing clients could be charged a performance fee anytime they extend or renew a contract with the client.  These changes could impact both the adviser’s business plan as well as the adviser-client relationship.  Because of this subsection, such impact would be avoided to the extent that the adviser was in compliance with the performance fee rule effective when the contract was most recently entered into, extended, or otherwise renewed. 

Subsection (d)

The definitions portion has been amended to only retain terms relevant to the amended rule.

Proposed Changes to the 2002 Version – Model Rule 502(c)

The 2002 version of the performance fee rule is structured differently than the 1956 version.  Most significantly, Rule 502(c) establishes both the prohibition on assessing a performance fee and the exemption from such prohibition.  It should also be noted that Rule 502(c) is not limited solely to the performance fee issue as this Model Rule also specifies several other requirements related to investment advisory contracts. 

Nonetheless, as with the amendments to Rule 102(f)-3 of the 1956 Rules, the primary focus of the amendments to Rule 502(c) was to closely align the Model Rule to Rule 205-3.

Subsection (a)

Subsection (a) establishes four requirements with respect to the terms of an investment advisory contract.  Subsection (a)(3) specifically establishes the general prohibition related to the assessment of performance fees.  The primary change to subsection (a) was the deletion of references to “investment adviser representative” and “federally covered investment adviser”. 

The reference to “investment adviser representative” did not seem necessary because the investment advisory contract would be established between the investment adviser and the client.  That said, subsection (a)(1) was slightly modified to make clear that an investment advisory contract must indicate if the investment adviser “or any of its” investment adviser representatives was being granted discretionary authority.

References to “federally covered investment adviser” were deleted from subsection (a) because state jurisdiction related to federally covered investment advisers is limited to fraud matters.  To the extent that the contractual items discussed in subsection (a) are not per se fraud, the deletion of federally covered investment adviser appears appropriate.  Of course, the deletion is not intended to indicate that failure to adhere to the contractual terms discussed in subsection (a) could not be fraudulent in certain cases.  But, the deletion simply acknowledges that where such conduct is fraudulent, a state could rely on its general anti-fraud prohibitions.

Subsection (b)

Subsection (b) was left unchanged, primarily because this subsection did not have any relation to performance fee items.  However, in the future, it may be worth considering whether references to investment adviser representative and federally covered investment adviser should be removed for the reasons discussed in connection with subsection (a).

Subsections (c), (d), and (e)

Subsections (c), (d), and (e) have been modified to match USA 1956 Rules 105(f)-3(a), (b), and (c). See above discussion under 1956 version.

With respect to (c), the rule now specifically states that an adviser can charge performance fees if either: (1) the adviser is not registered and not required to be registered or (2) the requirements of (c)(2)(A) and (c)(2)(B) are complied with.  The purpose for clarifying that an adviser that is not required to be registered may charge performance fees originates from the fact that the federal prohibition on performance based fees is limited to advisers that are registered or required to be registered.  As the prohibition under the 2002 Model Rule, just as under the 1956 Uniform Act, is not limited to registered/required to be registered advisers, subsection (c) creates a specific exemption for those advisers that are not registered and do not need to be registered.  This will be especially significant in jurisdictions that adopt an exemption from registration for advisers to private funds (i.e. whether exempt reporting adviser status or other exempt status). 

However, unlike the 1956 version, the performance based fee prohibition is actually contained within the Model Rule. See subsection (a). So, the Group considered amending subsection (a) to limit the prohibition to those advisers that are registered or need to be registered.  But, because there are other prohibitions under subsection (a), it was decided to avoid making changes that could impact issues beyond the performance fee.

Old Subsections (f) and (g) – Deleted

These subsections were deleted as unnecessary restatements of established legal principles.  The inclusion of these subsections does not appear to enhance investor rights or protections.

New subsection (f)

This subsection is now the definitions portion of Rule 502(c).  It has been modified by deleting the terms that were no longer necessary as a result of the other amendments to Rule 502(c).  The deleted terms include: “affiliate”; “client’s independent agent”; “executive officer”; “interested person”; and “qualified client”.