The SEC’s Rule concerning the compensation prohibition based on performance fees is included in the Investment Advisers Act of 1940 in section 205(a)(1). The exemptions to the prohibition are included in section 205-3. So what we learn from this is that there are circumstances that will allow an adviser to charge a performance fee. Ironically some advisers who never intended to charge a performance fee may have done so based on the definition of a performance fee that reads “… an investment advisory contract that provides for compensation to the investment adviser on the basis of a share of the capital gains upon, or the capital appreciation of, the funds, or any portion of the funds, of a client,…”.
On May 16, 1980 the SEC published an interpretive release of the Investment Advisers Act that in essence stated that any contract which provides that advisory fees are waived or refunded if a client’s account does not meet a specified level of performance then the management fees are contingent or in effect based on a share of capital gains or appreciation of the funds. All RIA firms should review the following examples to see if the firm has mistakenly created a performance fee contract with a client:
- The advisory contract does not charge a client any management fees until the account makes money.
- The advisory contract waives all management fees until the account has grown by 3%.
- The advisory contract does not charge a management fee if the account loses money.
- The advisory contract waives the management fee if the management fee causes the value of the client account to decrease below its originally deposited value.
In each of the above examples, the advisory firm may be charging or not charging a management fee based on the capital gains or capital appreciation of the client account even if that was not the original intention of the fee arrangement. Regardless, it’s possible that the compensation has become based upon the gains of the account.
It’s important to note that SEC registered investment advisers can generally only charge performance fees to qualified investors. Many state registered investment advisers are similarly only allowed to charge performance fees to qualified or accredited investors. There are also a number of states that do not allow state-registered investment advisory firms to charge performance fees to any type of client.
It’s also important to note that there have been some No Action letters released by the SEC that have allowed, under certain circumstances, performance fees to be waived or reduced. The overriding concern of the SEC as it relates to advisory fees being charged, reduced or waived is will it create a situation in which the adviser is going to be taking undue risk in the client’s account or over trading? Recently Amerivest Investment Management, LLC requested No Action from the SEC in August 18, 2014 and received a response from the SEC that it would not recommend action against them (No Action) on August 19, 2014.
As RIA compliance consultants, we strongly recommend that the Chief Compliance Officer (CCO) of all SEC and state-registered RIA firms carefully review all investment advisory contracts to ensure that no unintended performance fee situation has been created.