As discussed in our prior alert, the Securities and Exchange Commission (SEC) previously issued notice of its intent to increase for inflation the dollar amount thresholds under Rule 205-3 of the Investment Advisers Act of 1940 (the Advisers Act) that determine whether a person is a "qualified client" eligible to be charged performance-based compensation. The SEC has now issued a formal order increasing such thresholds, effective as of June 29, 2026.
Background
Section 205(a)(1) of the Advisers Act generally prohibits investment advisers from entering into advisory contracts that provide for compensation based on a share of capital gains or capital appreciation of a client's account (i.e., performance fees or carried interest). Rule 205-3 under the Advisers Act provides an exemption from this prohibition where the client is considered a "qualified client." A "qualified client" is defined by reference to two financial tests: the assets-under-management test (the client has at least a specified minimum dollar amount under management with the adviser immediately after entering into the advisory contract) and the net worth test (the adviser reasonably believes, immediately prior to entering into the advisory contract, that the client has a net worth exceeding a specified minimum threshold, excluding the value of the client's primary residence).
The Formal Order (Release No. IA-6961)
On April 28, 2026, the SEC issued its formal order confirming the new thresholds, which have been adjusted as follows:
Test
|
Current Threshold
|
New Threshold (Effective June 29, 2026)
|
| Assets Under Management Test |
$1,100,000 |
$1,400,000 |
| Net Worth Test |
$2,200,000 |
$2,700,000 |
Consistent with prior adjustment orders, the new thresholds will not apply retroactively to contractual relationships entered into prior to the effective date, subject to the transition rules incorporated in Rule 205-3.
Action Items for Investment Advisers
In light of the formal order, advisers charging carried interest or other performance-based compensation should take the following steps prior to the June 29, 2026, effective date:
Review advisory agreements and subscription documents: Confirm that representations and warranties relating to qualified client status accurately reference the applicable threshold and consider whether updates are needed for ongoing or future offerings.
Update investor eligibility questionnaires: Ensure that suitability and eligibility questionnaires and side letter representations are consistent with the new thresholds for investors subscribing on or after the effective date.
Confirm fund offering documents: Private placement memoranda, limited partnership agreements, and related documents for 3(c)(1) funds should be reviewed to confirm accurate references to the qualified client definition.
Implement investor tracking procedures: Advisers should track the effective date carefully and ensure that compliance procedures distinguish between investors who subscribed before the effective date (generally grandfathered) and those subscribing on or after (subject to new thresholds).
Assess state law implications: State-registered investment advisers should note that Rule 205-3 by its terms applies only to SEC-registered advisers. State-registered advisers should confirm applicable state law requirements regarding performance-based compensation.
For any questions regarding the SEC's order increasing the "qualified client" threshold, please contact Paul J. Foley, Cole Beaubouef, Kiki Scarff, or John M. Faust.