SEC Increases Net Worth Threshold of “Qualified Client” Test
Client Alerts | July 7, 2016 | Securities and Corporate Finance | Hedge Funds
On June 14, 2016, the SEC issued an order increasing the net worth prong of the “qualified client” test from $2.0 million to $2.1 million, reflecting an adjustment for inflation. This change will become effective on August 15, 2016.
Section 205(a)(1) of the Investment Advisers Act of 1940, as amended (the “Advisers Act”), and Rule 205-3 thereunder prohibit investment advisers from receiving performance-based compensation (i.e., performance fees or distributions of carried interest) from any client that is not a “qualified client”. As a result of this action by the SEC , a “qualified client is generally a client that has either:
1) at least $1 million (unchanged by this SEC action) in assets under management with the investment advisor immediately after entering into the investment advisory contract (the “assets under management test”); or
2) a net worth of more than $2.1 million (increased from $2.0 million), based on the reasonable belief of the investment adviser, immediately prior to entering into the investment advisory contract (the “net worth test”).
Any advisory agreements entered into with clients in reliance on the net worth test prior to August 15, 2016 will be grandfathered and will not have comply with the new net worth threshold. However, new investors in 3(c)(1) funds are not grandfathered and will be subject to the increased net worth test beginning on August 15, 2016. Accordingly, managers of the 3(c)(1) funds should amend the subscription agreements prior to this date.
 The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) amended Section 205(e) of the Advisers Act to provide that, by July 21, 2011 and every five years thereafter, the SEC adjust for inflation the dollar amount thresholds included in the definition of “qualified client”, rounded to the nearest $100,000.
 Each investor in a 3(c)(1) fund is considered to be a client of the investment adviser for this purpose and must satisfy the qualified client test in order for the manager of the fund to receive performance-based compensation with respect to such investor.
 As adjusted for inflation, this amount did not round up to the next $100,000.