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Susan Grant
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Thank you for your kind review of my article. Below is a general answer to your question: Although the Investment Advisers Act contains a prohibition against RIAs charging a client a performance fee, based upon the belief that such a fee could encourage the RIA to make riskier investments, there are a number of exceptions, which are set forth in Rule 205-3 under that law. The exceptions are generally applicable for sophisticated clients, because the SEC believes that they could adequately protect themselves from that risk. One of those exceptions is a performance fee based upon a stated percentage of appreciation in the account’s assets, which is what you seem to be asking about. First, clear, prominent disclosure of all of the relevant aspects of the performance fee is a must. In terms of what type of client could be charged a performance fee, Rule 205-3 requires the client to be a “qualified client.” Thus the client, which could be a natural person or a company (but not a private fund relying on the registration exemption contained in Section 3(c)(1) of the Investment Company Act, a registered investment company [mutual fund] or a business development company), would have to meet one of the following three criteria: (1) the client has to have a minimum of $750,000 under management with the RIA right after signing the advisory contract with the RIA; (2) the RIA must reasonably believe that the client either has a net worth of over $1.5 million at the time the contract is executed or is a “qualified purchaser” under Section 2(a)(51)(A) of the Investment Company Act; or (3) the client is a natural person who, immediately before signing the advisory contract, is a senior person of the RIA or is involved with the investment activities of the RIA or another company. If the client is a company, there may be a need to look to the owner, if that, too is a company, to determine if it also meets one of these criteria. In addition, there may be state laws or rules, ERISA requirements and FINRA requirements, depending on the RIA and client involved. As to whether charging a performance fee increases an adviser’s liability/exposure in any fashion, there is no definitive answer to that, but my opinion is that, with all other things being equal in the business of two RIAs, a regulator would likely opt to examine the one that charges a performance fee over the one that charges a more standard fee based upon AUM.
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Aug 17, 2010