piggy bank, chart, wallet, money, graph showing increaseThe SEC gave notice of intent to issue an order that would increase the minimum assets under management or net worth that a client must have before an investment adviser may charge performance-based fees. Section 205(a)(1) of the Advisers Act prohibits an adviser from being compensated by a client based on capital gains or capital appreciation of the client’s funds. Congress put this protection in place in 1940 to protect against advisers taking undue risks with client money in hopes of increasing the adviser’s fee. Performance-based fees were characterized as “heads I win, tails you lose.” These fees incentivize adviser’s to take risks to increase the adviser’s fee with little or nothing at stake for the adviser. 

Congress and the SEC later created exemptions to the prohibition. Under the exemptions, if a client has at least a minimum amount of assets under management or minimum net worth, the prohibition against performance-based fees no longer applies. The theory behind these exemptions is that client sophistication and financial experience increases with the amount of assets under management and net worth and that wealthy clients are able to bear the risks of performance-based fees. In many cases, merely because someone has assets under management of $500,000, $1,000,000, or some other arbitrary threshold, this has little or nothing to do with financial sophistication or risk tolerance.

The SEC now intends to increase the thresholds where the prohibitions against performance-based fees no longer apply to $1,100,000 in assets under management or $2,200,000 in net worth.

The SEC’s notice is available here.