Proposed Rule2026-20474
Investment Adviser Performance-Based Compensation Modernization
Primary source
Metadata and text below are from the Federal Register, a public-domain U.S. government work. Always verify the official published version before relying on it for any legal matter.
Published
October 6, 2026
Effective
October 6, 2026
Issuing agencies
Securities and Exchange Commission
Abstract
The Securities and Exchange Commission (the "Commission") is proposing to amend the rule under the Investment Advisers Act of 1940 that provides an exemption from the statutory prohibition on registered investment advisers receiving compensation on the basis of a share of capital gains in or capital appreciation of an advisory client's account. Specifically, the proposed amendments would expand the ability of investment advisers to receive this compensation from clients that are registered management investment companies and business development companies (collectively, "regulated funds"), subject to certain conditions. The proposal would relatedly amend certain regulated fund registration and reporting forms to require separate disclosure of all performance-based compensation paid by regulated funds to their investment adviser. The proposed rule amendments would also allow investment advisers to receive this compensation from additional clients by revising the rule's "qualified client" definition to include investors that meet the "accredited investor" definition in Regulation D under the Securities Act of 1933. The proposal would relatedly make conforming amendments to certain other rules under the Investment Advisers Act of 1940 whose provisions reference the "qualified client" definition.
Full Text
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<title>Federal Register, Volume 91 Issue 192 (Tuesday, October 6, 2026)</title>
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[Federal Register Volume 91, Number 192 (Tuesday, October 6, 2026)]
[Proposed Rules]
[Pages 63676-63745]
From the Federal Register Online via the Government Publishing Office [<a href="http://www.gpo.gov">www.gpo.gov</a>]
[FR Doc No: 2026-20474]
[[Page 63675]]
Vol. 91
Tuesday,
No. 192
October 6, 2026
Part II
Securities and Exchange Commission
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17 Part 239, 249, 274, et al.
Investment Adviser Performance-Based Compensation Modernization;
Proposed Rule
Federal Register / Vol. 91, No. 192 / Tuesday, October 6, 2026 /
Proposed Rules
[[Page 63676]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 239, 249, 274, and 275
[Release Nos. 33-11443; 34-106533; IA-7022; IC-36350; File No. S7-2026-
28]
RIN 3235-AN59
Investment Adviser Performance-Based Compensation Modernization
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rule.
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SUMMARY: The Securities and Exchange Commission (the ``Commission'') is
proposing to amend the rule under the Investment Advisers Act of 1940
that provides an exemption from the statutory prohibition on registered
investment advisers receiving compensation on the basis of a share of
capital gains in or capital appreciation of an advisory client's
account. Specifically, the proposed amendments would expand the ability
of investment advisers to receive this compensation from clients that
are registered management investment companies and business development
companies (collectively, ``regulated funds''), subject to certain
conditions. The proposal would relatedly amend certain regulated fund
registration and reporting forms to require separate disclosure of all
performance-based compensation paid by regulated funds to their
investment adviser. The proposed rule amendments would also allow
investment advisers to receive this compensation from additional
clients by revising the rule's ``qualified client'' definition to
include investors that meet the ``accredited investor'' definition in
Regulation D under the Securities Act of 1933. The proposal would
relatedly make conforming amendments to certain other rules under the
Investment Advisers Act of 1940 whose provisions reference the
``qualified client'' definition.
DATES: This release was published in the Federal Register on October 6,
2026. Comments should be received on or before December 7, 2026.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
<bullet> Use the Commission's internet comment form (<a href="https://www.sec.gov/comments/s7-202628/investment-adviser-performance-based-compensation-modernization">https://www.sec.gov/comments/s7-202628/investment-adviser-performance-based-compensation-modernization</a>); or
<bullet> Send an email to <a href="/cdn-cgi/l/email-protection#9fedeaf3fab2fcf0f2f2faf1ebecdfecfafcb1f8f0e9"><span class="__cf_email__" data-cfemail="ef9d9a838ac28c8082828a819b9caf9c8a8cc1888099">[email protected]</span></a>. Please include
File Number S7-2026-28 on the subject line.
Paper Comments
<bullet> Send paper comments to Vanessa A. Countryman, Secretary,
Securities and Exchange Commission, 100 F Street NE, Washington, DC
20549-1090.
All submissions should refer to File Number S7-2026-28. This file
number should be included on the subject line if email is used. To help
the Commission process and review your comments more efficiently,
please use only one method of submission. The Commission will post all
comments on the Commission's website (<a href="https://www.sec.gov/comments/s7-202628/investment-adviser-performance-based-compensation-modernization">https://www.sec.gov/comments/s7-202628/investment-adviser-performance-based-compensation-modernization</a>). Do not include personally identifiable information in
submissions; you should submit only information that you wish to make
available publicly. The Commission may redact in part or withhold
entirely from publication submitted material that is obscene or subject
to copyright protection.
Studies, memoranda, or other substantive items may be added by the
Commission or staff to the comment file during this rulemaking. A
notification of the inclusion in the comment file of any such materials
will be made available on the Commission's website. To ensure direct
electronic receipt of such notifications, sign up through the ``Stay
Connected'' option at <a href="http://www.sec.gov">www.sec.gov</a> to receive notifications by email.
A summary of the proposal of not more than 100 words is posted on
the Commission's website (<a href="https://www.sec.gov/comments/s7-202628/investment-adviser-performance-based-compensation-modernization">https://www.sec.gov/comments/s7-202628/investment-adviser-performance-based-compensation-modernization</a>).
FOR FURTHER INFORMATION CONTACT: Daniel Levine, Neema Nassiri, Lawrence
Pace, Senior Counsels; Robert Holowka, Assistant Director, at (202)
551-6787, Investment Adviser Regulation Office; Pamela Ellis, Senior
Counsel; Blair Burnett, Branch Chief; Brian McLaughlin Johnson,
Assistant Director, at (202) 551-6792, Investment Company Regulation
Office, Division of Investment Management, Securities and Exchange
Commission, 100 F Street NE, Washington, DC 20549-8549.
SUPPLEMENTARY INFORMATION: The Commission is proposing for public
comment amendments to the following rules and forms:
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\1\ 15 U.S.C. 77a et seq.
\2\ 15 U.S.C. 80a et seq.
\3\ 15 U.S.C. 78a et seq.
\4\ 15 U.S.C. 80b et seq.
[GRAPHIC] [TIFF OMITTED] TP06OC26.000
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Table of Contents
I. Introduction and Background
A. Overview of Section 205 and Rule 205-3
1. Section 205: 1940 Enactment and 1970 Amendments
2. Initial Rule 205-3 Adoption and Subsequent Section 205
Amendments
3. Current Rule 205-3
B. Performance-Based Compensation: Current Practices
II. Discussion
A. Expansion of the Ability of Investment Advisers To Charge
Performance-Based Compensation to RICs and BDCs
1. Scope of Amended Exception
2. Conditions
3. Disclosure Related to Performance-Based Compensation
B. Additional Amendments to the ``Qualified Client'' Definition
1. Incorporation of the ``Accredited Investor'' Definition
2. Removal of the Assets Under Management Test
3. Amending References to the ``Qualified Client'' Definition in
Rule 203A-3, Rule 204-3 and Form ADV
C. Client Look-Through
D. Compliance Period
III. Economic Analysis
A. Introduction
B. Economic Baseline
1. Regulatory Baseline
2. Affected Parties
3. Performance-Based Compensation: Current Market Practices
C. Benefits and Costs
1. Changes to the Qualified Client Definition
2. Amending References to the Qualified Client Definition
3. Performance Fee Disclosure for Regulated Funds
4. Aggregate Monetized Benefits and Costs
D. Effects on Efficiency, Competition, and Capital Formation
1. Efficiency
2. Competition
3. Capital Formation
E. Reasonable Alternatives Considered
1. Performance Fees Only on Realized Capital Gains
2. Performance Fee on Capital Gains for Contracts With a Subset
of Regulated Funds
3. Additional Conditions for the Fund Board Channel
4. Disclosure Alternatives
F. General Request for Comment
IV. Paperwork Reduction Act Analysis
A. Summary of the Collections of Information
B. Summary of the Proposed Amendments' Estimated Effects on the
Collections of Information
1. Form N-1A PRA Estimates
2. Form N-2 PRA Estimates
3. Form N-CSR PRA Estimates
C. Changes in Paperwork Burdens Under the Proposed Amendments
D. Request for Comments
V. Initial Regulatory Flexibility Analysis
A. Reasons for and Objectives of the Proposed Actions
1. Proposed Amendments to Rule 205-3
2. Proposed Amendments to Forms N-1A, N-2, and N-CSR
B. Legal Basis
C. Small Entities Subject to the Rule Amendments
D. Projected Reporting, Recordkeeping, and Other Compliance
Requirements
1. Proposed Rule 205-3 Amendments
2. Proposed Disclosure and Reporting Requirements
E. Duplicative, Overlapping, or Conflicting Federal Rules
1. Proposed Amendments to Rule 205-3
2. Proposed Amendments to Forms N-1A, N-2, and N-CSR
F. Significant Alternatives
G. Request for Comment
VI. Congressional Review Act
VII. Other Matters
Statutory Authority
I. Introduction and Background
The asset management industry has expanded significantly in recent
decades, driven by evolving investor demands and the availability of a
broader range of investment opportunities across public and private
markets. Asset managers today employ an increasingly wide array of
investment strategies and offer those strategies through multiple
investment products, including, among others, regulated funds, private
funds, separately managed accounts, and direct advisory recommendations
to individual clients.
As the variety of investment products and their delivery channels
have grown, both institutional and individual investors have
increasingly sought to access alternative investment assets and to
construct more diversified investment portfolios than in the past. The
Commission is committed to identifying ways to reduce unnecessary
regulatory obstacles to investment product innovation, allowing for the
broadening of investor choice available in today's asset management
industry while appropriately addressing risks associated with
increasingly diverse portfolio compositions and operations.
As part of this commitment, the Commission is proposing amendments
to the ``qualified client'' definition and other provisions in rule
205-3 under the Advisers Act that would expand the ability of
registered investment advisers and certain of their clients, including
regulated funds under certain conditions and investors that meet the
``accredited investor'' definition in Regulation D under the Securities
Act, to enter into performance-based compensation arrangements
calculated on the basis of a share of capital gains in or capital
appreciation of an advisory client's account. We anticipate that such
expansion would allow a wider range of advisers to offer regulated
funds, enable the introduction of more investment strategies into
regulated funds, and separately expand the availability of investment
opportunities to accredited investors in pools or separately managed
accounts. In addition, the proposal would amend certain forms under the
Investment Company Act to require disclosure of all performance-based
compensation to shareholders of regulated funds, including compensation
based on interest, ordinary income, or dividends. As the ``qualified
client'' definition is also referenced in the definition of
``investment adviser representative'' in rule 203A-3 and the exceptions
to a registered investment adviser's brochure supplement delivery
requirement in rule 204-3 under the Advisers Act, we also propose
conforming amendments to these rules.\5\
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\5\ See also infra section II.B.3.c. (noting that the proposed
amendments to the qualified client definition would expand the
meaning of ``high net worth individual'' as defined in Form ADV).
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The use of performance-based compensation has long been a common
and defining characteristic of investment strategies that are
associated with private funds, such as hedge fund, private equity, and
venture capital strategies, which generally include private market
strategies as well as complex or differentiated public market
strategies.\6\ Because registered investment advisers and their private
fund clients are largely able to enter into and tailor performance-
based compensation arrangements, these types of alternative investment
strategies have, as a practical matter, been limited to the private
fund industry, reducing access to a limited group of eligible
investors. Therefore an adviser may be incentivized to allocate its
potentially higher performing investment strategies and opportunities
to this limited group of investors. This situation results in a
structural disadvantage for retail investors, as it may disincentivize
capable advisers from allocating potentially higher performing
strategies to regulated funds or, in some cases, from launching or
maintaining regulated funds altogether.
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\6\ Performance-based compensation has in practice also been
used in the context of separately managed accounts of eligible
clients, including for advisory services with respect to more
traditional investment strategies.
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Performance-based compensation can offer a rational and effective
means to define and align adviser and investor goals, especially as
arrangements have evolved over time through commercial practice to
commonly include features and terms designed to more closely
[[Page 63678]]
align adviser and investor interests.\7\ Expanding the ability for
advisers to charge performance fees could incentivize advisers
currently operating in the private markets to bring diverse strategies
to a wider group of clients and investors, including investors in
regulated funds. Accordingly, the proposed amendments are designed to
modernize the regulatory framework related to performance-based
compensation, facilitate capital formation in the public and private
markets by promoting innovation in regulated fund structures, and
expand investor choice, while maintaining appropriate investor
protections and safeguards.
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\7\ See infra section I.B. for examples of these features and
terms.
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As discussed below, Congress amended the Advisers Act in 1970 to
authorize the Commission to exempt any person or transaction (or class
of persons or transactions) from any provision of the Advisers Act, if
and to the extent such exemption is necessary or appropriate in the
public interest and consistent with the protection of investors and the
purposes fairly intended by the policy and the provisions of the
Advisers Act.\8\ In granting such authority to the Commission, Congress
specifically contemplated its potential application to the performance
fee prohibition in section 205 under the Advisers Act.\9\ Congress also
amended the Advisers Act in 1996 to authorize the Commission to exempt
any person or transaction (or class thereof) specifically from the
performance fee prohibition in section 205, provided that the exemption
relates to an advisory contract with ``any person that the Commission
determines does not need the protections'' of the prohibition ``on the
basis of such factors as financial sophistication, net worth, knowledge
of and experience in financial matters, amount of assets under
management, relationship with a registered investment adviser, and such
other factors as the Commission determines are consistent with''
section 205.\10\ Over decades, the Commission has used these
authorities to expand the use of performance fees by registered
investment advisers, and this proposal continues on that path.
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\8\ Investment Company Act Amendments of 1970, Public Law 91-
547, Sec. 26, 84 Stat. 1413 (1970) (codified at 15 U.S.C. 80b-6a).
\9\ See Investment Company Amendments of 1969: Analysis of S.
34, 91st Cong., 1st Sess. 29 (1969) (``Under proposed section 206A,
the Commission would in appropriate cases be able to exempt persons
from the registration requirements of proposed section 203 and from
the ban on performance-based advisory compensation in proposed
section 205(1) of the Advisers Act if and to the extent such action
is appropriate in the public interest and consistent with the
protection of investors and the policy of the [A]ct.''); S. Rep. No.
184, 91st Cong., 1st Sess. 46 (1969); H.R. Rep. No. 1382, 91st
Cong., 2d Sess. 42 (1970).
\10\ National Securities Markets Improvement Act of 1996, Public
Law 104-290, Sec. 210, 110 Stat. 3416 (1996) (``NSMIA'') (codified
at 15 U.S.C. 80b-5(e)).
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A. Overview of Section 205 and Rule 205-3
Section 205(a)(1) of the Advisers Act generally prohibits an
investment adviser registered or required to be registered with the
Commission from receiving compensation on the basis of a share of
capital gains in or capital appreciation of an advisory client's
account.\11\ These restricted performance-based compensation
arrangements are commonly referred to as ``performance fees'' because
they compensate advisers based on the investment performance of a
client's account rather than on another basis, such as the aggregate
value of the assets in a client's account.\12\ For example, an advisory
fee calculated as a percentage of the investment gains in a client's
account over a period of time (e.g., twenty percent of an account's
gains over the last year) is a performance fee, while an advisory fee
calculated as a percentage of the total value of a client's account
(e.g., two percent of such client's assets) is not a performance fee.
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\11\ 15 U.S.C. 80b-5(a)(1).
\12\ Unless otherwise specified, the term ``performance fee'' is
used herein to refer to those types of compensation arrangements
based on capital gains or capital appreciation that are prohibited
by section 205(a)(1) under the Advisers Act. Compensation
arrangements based on other measures of performance--such as, for
example, interest, ordinary income, or dividends--are not prohibited
by section 205(a)(1) and are not referred to as or otherwise within
the meaning of ``performance fees'' as used herein.
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Although performance fees can be structured in various amounts and
forms, section 205(a)(1) functions to broadly prohibit a registered
investment adviser from entering into, extending, renewing, or in any
way performing an investment advisory contract that provides for any
performance fees to the adviser, however that performance fee is
expressed or calculated, unless that advisory contract qualifies for an
exception or exemption to the prohibition on performance fees.
Statutory exceptions to the prohibition are provided in sections
205(b)(1) through (b)(5) of the Advisers Act,\13\ and the Commission
has authority to promulgate exemptions to the prohibition under
sections 205(e) and/or 206A thereof. Pursuant to these authorities, the
Commission previously adopted and amended rule 205-3 as a generally
available exemption to the statutory performance fee prohibition set
forth in section 205(a)(1).
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\13\ Per the statutory exceptions set forth in sections
205(b)(1) through (b)(5), section 205(a)(1)'s general prohibition
against performance fees does not apply to: (1) advisory contracts
that provide for compensation based on the total value of a fund's
account averaged over a definite period, or as of definite dates or
taken as of a definite date; (2) provided that an appropriate
``fulcrum fee'' (as discussed below) is used in each instance, (A)
advisory contracts with registered investment companies and (B)
advisory contracts relating to the investment of assets in excess of
$1,000,000 with persons other than trusts, governmental plans,
collective trust funds, or separate accounts as referred to in
section 3(c)(11) of the Investment Company Act; (3) advisory
contracts involving business development companies, subject to
certain conditions; (4) advisory contracts with a company that
exempted is from the definition of an investment company under
section 3(c)(7) of the Investment Company Act; and (5) advisory
contracts with persons who are not residents of the United States.
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1. Section 205: 1940 Enactment and 1970 Amendments
The prohibition on performance fees in section 205(a)(1) has been
part of the Advisers Act since its original enactment by Congress in
1940 (originally as section 205(1) thereof). Legislative history
indicates that the prohibition was included because of Congressional
concern that performance fee arrangements (then typically called
``profit-sharing'' arrangements) would by their nature incentivize
investment advisers to take inappropriate risks with their clients'
funds, rather than because of evidence of actual abuse or misconduct in
the advisory industry related to performance fees at that time.\14\
Specifically, because performance fee arrangements generally provided
an adviser with additional fees when its client had investment gains
but did not decrease the adviser's compensation when the client had
investment losses, performance fees were viewed by some as encouraging
advisers to speculate excessively with their clients' funds.\15\
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\14\ See H.R. Rep. No. 2639, 76th Cong., 3d Sess. 29 (1940); S.
Rep. No. 1775, 76th Cong., 3d Sess. 22 (1940).
\15\ See SEC, Investment Trusts and Investment Companies, H.R.
Doc. No. 477, 76th Cong., 2d Sess. 30 (1939) (summarizing an
industry survey and a public conference held by the Commission on
February 11, 1938, in which an industry representative asserted that
performance fees encourage advisers to recommend a degree of risk
that investors themselves would not knowingly undertake, as advisers
have ``everything to gain . . . and nothing to lose''); see also
Investment Trusts and Investment Companies: Hearings on S. 3580
before a Subcomm. of the Senate Comm. on Banking and Currency, 76th
Cong., 3d Sess. 319-320 (1940) (``1940 Senate Hearings'') (testimony
from Director Schenker of the then-SEC Investment Company Division
that ``it was virtually . . . the unanimous consensus of the
industry that what you ought to abolish is these profit-sharing
abuses in the industry: `If you make any money, you turn part of it
over to me; but if you lose, I don't lose anything.' ''); S. Rep.
No. 1775, 76th Cong., 3d Sess. 22 (1940) (``Individuals assuming to
act as investment advisers at present can enter profit-sharing
contracts which are nothing more than `heads I win, tails you lose'
arrangements.'').
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[[Page 63679]]
Although the performance fee prohibition for registered investment
advisers has been in the Advisers Act since its enactment in 1940, the
prohibition was, in practice, narrow in scope for two reasons:
<bullet> First, the Advisers Act provided a registration exemption
for investment advisers whose only clients were registered investment
companies, and the performance fee prohibition did not extend to
advisers that were not required to register with the Commission.
<bullet> Second, for advisers that were registered, or required to
register, with the Commission, the Advisers Act excepted from the
performance fee prohibition advisory contracts with investment
companies registered under the Investment Company Act.
These were intentional decisions. The original bill did not include
these exceptions, but the final Advisers Act excepted contracts with
investment company clients from the performance fee prohibition, with
legislative history suggesting Congress ultimately responded to
industry input that performance fees closely linked the interests of
investment company investors and advisers ``throughout the life of the
investment,'' and that the basis of advisory compensation should not be
limited by statute if clearly and adequately disclosed to
investors.\16\
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\16\ See 1940 Senate Hearings, supra note 15, at 664, 1055.
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In the decades following the enactment of the Investment Company
Act and the Advisers Act, the registered investment company industry
grew dramatically from under $450 million in assets and 300,000
investors in 1940 to over $45 billion in assets and 4 million investors
by the end of 1966.\17\ This dramatic growth and accompanying
perceptions of prevalent excessive fee and expense practices in the
industry, especially related to the then-popular ``go-go funds'' that
aggressively sought short-term gains with high portfolio turnover and
related transaction costs, prompted both Congress and the Commission to
take a hard look at the registered fund industry and investor
protections under the securities laws more broadly.\18\ Congress
directed the Commission to comprehensively review and conduct a study
on the registered fund industry, and the Commission in turn requested
the securities research unit of the Wharton School of Finance and
Commerce to broadly examine the industry in 1958.
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\17\ See SEC, Report on the Public Policy Implications of
Investment Company Growth, H.R. Rep. No. 2337, 89th Cong., 2d Sess.
2 (1966) (``PPI Report''); Mutual Fund Legislation of 1967: Hearings
before the Comm. on Banking and Currency on S. 1659, 90th Cong., 1st
Sess. 125 (1967) (``1967 Senate Hearings'').
\18\ See, e.g., Securities Act Amendments of 1964, Public Law
88-467, 78 Stat. 565 (1964). Cf. Chairman Manuel S. Cohen, SEC,
Address at the 1968 Conference on Mutual Funds: The ``Mutual'' Fund
(Mar. 1, 1968) (``Chairman Cohen Address'') (``The regulatory scheme
devised in 1940, when the industry was in its infancy, reached the
grosser forms of abuses, such as embezzlement and the more obvious
form of overreaching. It seems evident that it is now important to
deal with more subtle abuses which may flow from overcharging and
overreaching which traditional disclosure techniques are ineffective
to reach.'').
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This examination resulted in the transmittal to the Commission in
1962 of Wharton's ``A Study on Mutual Funds,'' which generally found
that advisory fees paid by registered funds often bore little relation
to the actual cost of the advisory services provided or to investment
performance.\19\ The Wharton report was immediately followed by a
special study by the Commission's staff that focused its attention on
problematic distribution practices and excessive sales charges in the
registered fund industry.\20\
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\19\ See Wharton School of Finance and Commerce, A Study of
Mutual Funds, H.R. Rep. No. 2274, 87th Cong., 2d Sess. (1962).
\20\ See SEC, Report of Special Study of the Securities Markets,
H.R. Doc. No. 95, 88th Cong., 1st Sess. (1963). Staff reports and
other staff documents (including those cited herein) represent the
views of Commission staff and are not a rule, regulation, or
statement of the Commission. Furthermore, the Commission has neither
approved nor disapproved these documents and, like all staff
statements, they have no legal force or effect, do not alter or
amend applicable law, and create no new or additional obligations
for any person.
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This review effort culminated in the Commission's submission to
Congress in 1966 of its Report on the Public Policy Implications of
Investment Company Growth (the ``PPI Report''), which recommended,
among a broader package of comprehensive reforms to fee and expense
practices, the extension of the Advisers Act's performance fee
prohibition to advisory contracts with registered investment
companies.\21\ Although the PPI Report did not contain any specific
examples of abuse or misconduct relating to performance fees at
registered investment companies, the Commission nonetheless recommended
that Congress amend the Advisers Act to remove its exceptions for
advisers to registered investment companies, and explained that doing
so with respect to the performance fee prohibition would complement the
Commission's primary recommendation at the time to incorporate a
general standard of reasonableness into the Investment Company Act for
advisory compensation paid by registered investment companies.\22\
Combined with this reasonableness standard, the extension of the
performance fee prohibition to advisory contracts with registered
investment companies would, according to the Commission, permit
``capital gains and appreciation of a registered investment company
[to] be taken into account as a factor in setting the amount of the fee
of its investment adviser, [notwithstanding that] such fee could not be
tied directly to such gains or appreciation.'' \23\
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\21\ See PPI Report, supra note 17, at 344-45.
\22\ See id. (``This amendment would complement the Commission's
recommendations . . . that the Investment Company Act be amended to
incorporate a standard of reasonableness for compensation paid by
investment companies for services furnished by those who occupy a
fiduciary relationship to such companies.'').
\23\ Id. at 345.
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Shortly afterward, bills were introduced in Congress that would
largely implement the Commission's recommendations discussed above,
including the extension of the performance fee prohibition to
investment advisory contracts with registered investment companies.\24\
In Congressional hearings on these bills, it was generally acknowledged
that the types of performance fee arrangements ``that would be barred
by section 205(1) . . . are not common in the investment company
industry, but some do exist, and the number of [such] contracts appears
to be increasing.'' \25\
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\24\ 1967 Senate Hearings, supra note 17, at 897.
\25\ S. Rep. No. 1351, 90th Cong., 2d Sess. 43-45 (1967). The
Commission's views at the time that performance fee arrangements at
registered investment companies were increasing was based on an
increase in the registration of such companies, which coincided with
litigation where a federal court found that a New York Stock
Exchange rule prohibiting advisory services ``based on the profits
realized'' did not apply to registered investment companies. SEC,
35th Annual Report, 14-15, 141-42 (1969) (``1969 SEC Annual
Report''). The Commission subsequently furnished Congress with
information that, out of 137 registered investment companies with
performance fee arrangements, 48 allowed the adviser to earn a bonus
for good performance without imposing a penalty for poor
performance, and another 45 had performance fee arrangements where
the potential rewards were substantially greater than the penalties.
Mutual Fund Amendments: Hearings before the Subcomm. on Commerce and
Finance of the House Comm. on Interstate and Foreign Commerce on
H.R. 11995, S. 2224, H.R. 13754 and H.R. 14737, 91st Cong., 1st
Sess. 207 (1969).
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Notwithstanding the view that performance fees were generally
uncommon for investment companies and the fact that the Commission's
1966 PPI Report had not included any specific examples of abuse, there
was an effort to justify the extension of the performance fee
prohibition by broadly
[[Page 63680]]
referencing the legislative history from the Investment Company Act's
and Advisers Act's original enactments.\26\ The Commission's Chairman
at the time echoed the earlier characterization of performance fees as
a `heads, I win; tails, you lose' arrangement and opined that
performance fees inherently lead to excessive risk-taking by investment
advisers, such that Congress should act to ``protect fund clients'' in
the growing investment company industry and ``insulate investment
company shareholders from arrangements that give investment managers a
direct pecuniary interest in pursuing high risk investment policies.''
\27\
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\26\ Cf. Chairman Cohen Address, supra note 18 (``[F]ee
structure has provided a real opportunity for the exercise of the
ingenuity for which fund managers have established an enviable
reputation. . . . A current and developing fashion seems to be the
performance fee. An appealing case can be made for the proposition
that the man who does well for the fund he manages is entitled to
extra compensation measured by the quality of his performance. But,
apart from the problem of establishing appropriate yardsticks
against which to measure performance, a difficult problem which has
not as yet been resolved, we must not overlook the dangers inherent
in certain types of incentive fees which led the Congress in the
Investment Advisers Act of 1940 to prohibit compensation for
investment advisers based on a percentage of the gains achieved by
their clients. These considerations are equally matters of concern
in the investment company area today.'').
\27\ See 1967 Senate Hearings, supra note 17, at 111. Because
advisory contracts with private clients were not excepted under
section 205 at the time, the Commission also characterized the
extension as making applicable to advisers of registered investment
companies the prohibition on performance fees then-applicable to
advisers of private clients. 1969 SEC Annual Report, supra note 25,
at 15.
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The proposed extension of the performance fee prohibition to
advisory contracts with registered investment companies was met with
some scrutiny and skepticism by the investment advisory industry and
other stakeholders, including criticism that the proposal had received
insufficient deliberation and that prohibiting performance-based
compensation was inconsistent with the Commission's recognition in
other contexts that the quality of investment advisory services is
ultimately reflected by performance. One investment adviser objected
that ``[a]s far as we can determine little or no attention has been
directed to the proposed amendments [to the performance fee
prohibition] either during the hearings, in the press or otherwise.''
\28\ After discussions with the Investment Company Institute and other
industry representatives, Congress added a narrow exception for a
limited type of performance-based fee (commonly called a ``fulcrum
fee'') to the pending extension of the performance fee prohibition to
registered investment companies.\29\
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\28\ Investment Company Amendments Act of 1969: Hearings before
the Comm. on Banking and Currency, 91st Cong., 1st Sess. 421 (1969)
(``1969 Senate Hearings''). Cf. 1967 Senate Hearings, supra note 17,
at 253 (``The Commission . . . indicates that in the securities
field, the quality of service means performance. . . . Despite this
recognition of the significance of relating compensation to
performance the Commission apparently is reluctant to put this
relationship into practice. It has recommended that the Investment
Advisers Act be amended to outlaw compensation on the basis of a
share of capital gains or appreciation of the funds--although such a
fee clearly would be most directly tied to performance. This
suggests an odd discrepancy between recommended theory and
recommended practice.'') (from ``Implications of the Rate-Making
Proposals of the SEC in the Mutual Fund Industry'' by Sidney
Robbins, Professor of Finance, Graduate School of Business, Columbia
University).
\29\ See Investment Company Act Amendments of 1967: Hearings
before the Subcomm. on Commerce and Finance of the House Comm. on
Interstate and Foreign Commerce on H.R. 9510, H.R. 9511, 90th Cong.,
1st Sess. 79 (1968) (noting that the shift from an absolute
prohibition on performance fees to permitting a fulcrum fee occurred
subsequent to discussions with the Investment Company Institute).
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Under the new fulcrum fee exception, advisory contracts that based
any part of the adviser's compensation on a percentage of a company's
(or other client's) capital gains or appreciation would be prohibited,
but fulcrum fees that increased and decreased proportionately on the
basis of the company's investment performance (over a specified period
and measured against an appropriate securities index or other
appropriate measure of performance) would be permissible. Using a
fulcrum fee, an adviser would thus be permitted to receive its
``baseline'' fee only at the point that the fund's performance equaled
the index or other appropriate measure. Fulcrum fees were intended to
address the notion that an adviser with a performance fee arrangement
did not face any downside and share in the otherwise excessive risk
that might be incentivized by performance-based compensation.
Despite further objections from some stakeholders,\30\ Congress
enacted a version of the bill extending the prohibition on performance
fees to advisory contracts with registered investment companies, with a
narrow exception for fulcrum fees.\31\ However, Congress also amended
the Advisers Act to include new section 206A, which authorized the
Commission, by rulemaking on its own motion or by order upon
application, to exempt conditionally or unconditionally any person or
transaction (or class or classes of persons or transactions) from any
provision in the Advisers Act, if and to the extent such exemption is
necessary or appropriate in the public interest and consistent with the
protection of investors and the purposes fairly intended by the policy
and the provisions of the Advisers Act.\32\ This broad exemptive
authority was intended to provide the Commission with greater
flexibility to appropriately administer the Advisers Act in light of
the broader coverage of the Advisers Act to investment advisers of
registered investment companies, and it accordingly mirrored the
general exemptive authority that the Commission already had with
respect to the Investment Company Act under section 6(c) thereof.\33\
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\30\ See, e.g., 1969 Senate Hearings, supra note 28, at 422
(``[T]he real problem today should not be fear of the `heads I win,
tails you lose' investment adviser, since even without prohibitory
legislation, the present competitive nature of the business would
make it hard for such an adviser to survive. The real danger is that
a misunderstanding of the fundamental problem and a lack of interest
on the part of much of the mutual fund industry could effectively
destroy the incentives available to the `put your money where your
mouth is' type of money manager, the investment adviser who is not
afraid to tie his fees to his investment results. There is no
question that such type of adviser poses a competitive threat to the
more traditional fund manager whose fees depend solely upon the
amount of money managed. It is understandable, therefore, that the
Investment Company Institute and many other spokesmen for the
industry might not be overly concerned with the proposed amendments
to section 205.'') (statement of John M. Hartwell, President of
Hartwell Management Co.).
\31\ Investment Company Act Amendments of 1970, Public Law 91-
547, 25, 84 Stat. 1413 (1970) (codified at 15 U.S.C. 80b-5(b)(1)).
The exception for appropriate fulcrum fees is available with respect
to an advisory contract with a client that is a registered
investment company or any person ``except a trust, governmental
plan, collective trust fund, or separate account referred to in
section 3(c)(11) of [the Investment Company Act],'' provided that
the advisory contract with such a person relates to the investment
of assets in excess of $1 million.
\32\ Id. at Sec. 26 (codified at 15 U.S.C. 80b-6a).
\33\ See, e.g., H.R. Rep. No. 1351, 90th Cong., 2d Sess. 43-45
(1967); Investment Company Amendments of 1969: Analysis of S. 34,
91st Cong., 1st Sess. 29 (1969) (``The proposed amendment [to add
new section 206A] would be the counterpart of section 6(c) of the
Investment Company Act, which gives the Commission broad power to
exempt any person, transaction, or security from any provision of
that statute. The flexibility which this amendment would introduce
into the administration of the Advisers Act is appropriate in view
of the broader coverage provided for by this bill.'').
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Congress specifically contemplated the potential application of
section 206A's exemptive authority to exempt persons in appropriate
circumstances from the registration requirements of section 203 and
from the performance fee prohibition in section 205, each of which were
newly being applied to advisers of registered investment companies.\34\
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\34\ See id. (``Under proposed section 206A, the Commission
would in appropriate cases be able to exempt persons from the
registration requirements of proposed section 203 and from the ban
on performance-based advisory compensation in proposed section
205(1) of the Advisers Act if and to the extent such action is
appropriate in the public interest and consistent with the
protection of investors and the policy of the [A]ct.''); S. Rep. No.
184, 91st Cong., 1st Sess. 46 (1969); H.R. Rep. No. 1382, 91st
Cong., 2d Sess. 42 (1970).
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[[Page 63681]]
Over the next decade, the Commission used its exemptive authority
under section 206A to issue several orders conditionally exempting
certain performance fee arrangements in advisory contracts with certain
clients.\35\ These conditional exemptions were generally subject to
objective client eligibility requirements relating to both minimum
client income or net worth and minimum amounts invested with the
adviser.
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\35\ See, e.g., Foster Management Company, Investment Advisers
Act Rel. Nos. 646 (Nov. 1, 1978), 43 FR 52313 (Notice of
Application) and 651 (Nov. 28, 1978), 16 SEC Docket 316 (Order);
Weiss, Peck & Greer, Investment Advisers Act Rel. Nos. 623 (Mar. 28,
1978), 43 FR 14193 (Notice of Application) and 625 (Apr. 25,1978),
14 SEC Docket 946 (Order); Connecticut Mutual Life Ins. Co.,
Investment Advisers Act Rel. Nos. 459 (May 7, 1975), 40 FR 20992
(Notice of Application) and 461 (June 5, 1975), 16 SEC Docket 316
(Order).
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In 1980, Congress added another statutory exception to the
performance fee prohibition, permitting advisers to business
development companies (``BDCs'') to include performances fee
arrangements in their advisory contracts, provided that the fee did not
exceed 20% of the BDC's net realized capital gains over a defined
period and the BDC did not have other incentive compensation structures
in place.\36\ This exception was part of broader legislation to
incentivize venture capital investing in small businesses and
accordingly allowed BDCs, which were engaged in that type of
investment, to receive performance-based compensation similar to that
charged by advisers to private venture capital funds, subject to
meaningful structural constraints designed to align adviser and
investor interests.
---------------------------------------------------------------------------
\36\ See section 205(b)(3) of the Advisers Act; see also Small
Business Investment Incentive Act of 1980, Public Law 96-477, 94
Stat. 2275 (1980).
---------------------------------------------------------------------------
2. Initial Rule 205-3 Adoption and Subsequent Section 205 Amendments
Based partly on its experience using its authority under section
206A to approve individual exemptive orders related to performance
fees, the Commission used its rulemaking authority thereunder in 1985
to propose and adopt a generally applicable exemptive rule to the
performance fee prohibition as rule 205-3 under the Advisers Act.\37\
As originally adopted, rule 205-3 permitted an adviser to charge
performance fees to a client that had at least $500,000 in assets under
management with the adviser or had a net worth of at least $1,000,000,
departing from some of the Commission's earlier orders that had
required both a minimum client net worth and a minimum investment
amount as conditions for exemptive relief.\38\ If the client was a
private or registered investment company or business development
company, rule 205-3 required the adviser to ``look through'' the
company and apply these net worth and investment minimums to each of
its equity owners. This requirement expressly covered clients that were
registered investment companies, which were thus provided with their
first alternative to the statutory fulcrum fee exception for
performance fee arrangements with their advisers.\39\ The Commission
``concluded that it is consistent with the protection of investors and
the purposes of the [Advisers] Act to permit clients who are
financially experienced and able to bear the risks associated with
performance fees to have the opportunity to negotiate compensation
arrangements which they and their advisers consider appropriate.'' \40\
To provide ``alternate safeguards to the statutory prohibition,''
however, rule 205-3 at the time also required that performance fee
contracts include certain provisions concerning the appropriate
calculation of performance fees, and that advisers provide certain
disclosures to their clients regarding potential conflicts of interest,
the periods and any index used to measure performance for purposes of
the fee, and, if relevant to the fee's calculation, the valuation of
unrealized appreciation of securities for which market quotations are
not readily available.\41\
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\37\ See Conditional Exemption to Allow Registered Investment
Advisers to Charge Fees Based Upon a Share of the Capital Gains or
Capital Appreciation of a Client's Account, Investment Advisers Act
Rel. No. 961, March 15, 1985 [50 FR 11718 (March 25, 1985)] (``1985
Proposal''); Exemption to Allow Registered Investment Advisers to
Charge Fees Based Upon a Share of the Capital Gains or Capital
Appreciation of a Client's Account, Investment Advisers Act Rel. No.
996 (Nov. 14, 1985) [50 FR 48556 (Nov. 28, 1985)] (``1985
Adoption'').
\38\ See 1985 Proposal, supra note 37, at n.15.
\39\ Original rule 205-3(b)(2).
\40\ 1985 Adoption, supra note 37, at 48558.
\41\ Id.
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In 1992, the staff of the Commission's Division of Investment
Management (the ``Division'') issued a report recommending that the
existing exemptions from the performance fee prohibition be expanded to
generally permit performance fees in advisory contracts with
institutions or otherwise financially sophisticated clients, as well as
with foreign clients, whether sophisticated or unsophisticated.\42\ In
the report, the Division acknowledged that the ``existing exemptions .
. . preclude the use of performance fees in advisory contracts in a
number of situations, even where the clients are institutions and
otherwise sophisticated.'' \43\ In particular, whereas the fulcrum fee
exception requires advisers to ``structure their performance fee
arrangements to increase and decrease proportionately[, m]any
institutional investors, however, prefer to structure performance fee
arrangements with a low base fee, with satisfactory performance
resulting in additional compensation,'' which arrangement ``does not
qualify as a fulcrum fee.'' \44\ In this regard, the Division expressed
its view that, ``where a client appreciates the risk of performance
fees and is in a position to protect itself from overreaching by the
adviser, the determination of whether such fees provide value is best
left to the client.'' \45\ With respect to sophisticated and
unsophisticated foreign clients, the Division stated its belief that
the Advisers Act's performance fee prohibition ``likely reduce[s] the
ability of domestic advisers to compete effectively with foreign
advisers in foreign markets'' where performance fees may not be
restricted.\46\
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\42\ Division of Investment Management, SEC, Protecting
Investors: A Half Century of Investment Company Regulation 237-250
(1992) (``Protecting Investors Report'').
\43\ Id. at 245.
\44\ Id. at 246.
\45\ Id. at 245.
\46\ Id. at 247.
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The Division explained these views by acknowledging various
criticisms of the performance fee prohibition, noting that the
prohibition ``always has been controversial.'' \47\ These included
criticisms that performance fee arrangements rationally align advisory
and client interests by linking adviser compensation to client
investment performance, encourage the establishment of new and smaller
advisory firms, incentivize advisers to service smaller client accounts
that may otherwise not have access to advisory services, and function
to reduce advisory costs during periods of market decline.\48\ The
Division concluded that it ``believe[d] that some of the criticisms of
the performance prohibition [were] valid and that modification of the
[[Page 63682]]
prohibition is warranted.'' \49\ Consequently, the Division recommended
that Congress amend section 205 to specifically authorize the
Commission to unconditionally exempt advisory contracts with any person
whom the Commission determines to not need the protections of the
prohibition and contracts with foreign clients.
---------------------------------------------------------------------------
\47\ Id. at 239.
\48\ Id. at 239-40. The Protecting Investors Report also
acknowledged views in support of the performance fee prohibition,
noting, for instance, that ``supporters of the prohibition . . .
challenge whether there is any basis, theoretical or actual, for
believing that performance fees will improve performance.''
\49\ Id. at 240.
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Four years later, in 1996, Congress amended the Advisers Act to add
new statutory exceptions for advisory contracts with clients that are
companies excepted from the definition of ``investment company'' by
section 3(c)(7) of the Investment Company Act or that are foreign
residents, as well as new section 205(e).\50\ Following the Division's
earlier recommendation, section 205(e) provides that the Commission may
conditionally or unconditionally exempt any person or transaction (or
class or classes of persons or transactions) from the performance fee
prohibition in section 205(a)(1), provided that the exemption relates
to an advisory contract with ``any person that the Commission
determines does not need the protections'' of the prohibition ``on the
basis of such factors as financial sophistication, net worth, knowledge
of and experience in financial matters, amount of assets under
management, relationship with a registered investment adviser, and such
other factors as the Commission determines are consistent with''
section 205.\51\ As the Commission has noted, the definition of
``person'' under section 202 of the Advisers Act includes companies,
which in turn includes investment companies, for purposes of section
205.\52\
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\50\ NSMIA, supra note 10 (codified at 15 U.S.C. 80b-5(b)(4),
(b)(5) and (e)). With respect to excepting section 3(c)(7) private
funds, the Commission noted that ``[t]he level of sophistication of
the investors in a qualified purchaser pool suggests that this kind
of issuer should be allowed to enter into a fee arrangement that is
not a fulcrum fee.'' The Securities Investment Promotion Act of
1996: Hearing before the Comm. on Banking, Housing, and Urban
Affairs on S. 1815, 104th Cong., 2d Sess. 42 (1996).
\51\ 15 U.S.C. 80b-5(e).
\52\ See Exemption to Allow Investment Advisers to Charge Fees
Based Upon a Share of Capital Gains Upon or Capital Appreciation of
a Client's Account, Investment Advisers Act Rel. No. 1682 (Nov. 13,
1997) [62 FR 61882 (Nov. 19, 1997)] (``1997 Proposal''), at n.13;
Investment Advisers Act Rel. No. 1731 (July 15, 1998) [63 FR 39022
(July 21, 1998)], at n.9 (``1998 Adoption'').
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3. Current Rule 205-3
Shortly following the addition of section 205(e) to the Advisers
Act in 1996, the Commission used its expanded rulemaking authority to
propose (in 1997) and adopt (in 1998) amendments to rule 205-3, giving
shape to the rule in its current form.\53\ These amendments eliminated
the specific contractual and disclosure requirements relating to
performance fees that were previously explained in 1985 as
``alternative safeguards'' to the statutory prohibition, because the
Commission ultimately viewed these requirements as in practice
``hav[ing] inhibited the flexibility of advisers and their clients in
establishing performance fee arrangements beneficial to both parties''
and, moreover, as unnecessary in light of the other protections
provided by the Advisers Act.\54\ The amendments also expanded the
eligibility criteria for clients to which investment advisers could
charge performance fees, with clients that satisfied the new
eligibility criteria referred to by the rule as ``qualified clients.''
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\53\ See 1997 Proposal and 1998 Adoption, supra note 52.
\54\ See 1997 Proposal, supra note 52, at n.21 and accompanying
text; 1998 Adoption, supra note 52, at 39023.
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Under rule 205-3 as amended in 1998, qualified clients to which an
investment adviser may charge a performance fee include: (1) clients
that meet a minimum net worth or assets-under-management requirement,
with the threshold amounts from original rule 205-3 inflation-adjusted
from $1,000,000 to $1,500,000 for the net worth test and from $500,000
to $750,000 for the assets-under-management test; \55\ (2) clients that
are ``qualified purchaser[s]'' under section 2(a)(51)(A) of the
Investment Company Act; and (3) clients that are certain executive
officers or employees of the adviser who actively participate in the
investment activities of the adviser, similar to the category of
``knowledgeable employees'' eligible to invest in section 3(c)(1) and
3(c)(7) companies in accordance with rule 3c-5 under the Investment
Company Act.\56\ With respect to the addition of qualified purchasers
as a category of clients eligible for performance fees, the Commission
explained that, although persons that have the $5,000,000 in
investments required to be a qualified purchaser under section
2(a)(51)(A) generally should separately satisfy the lower minimum net
worth or minimum assets-under-management thresholds under rule 205-3,
they may in certain cases not meet the lower thresholds because of
different approaches to accounting for indebtedness between these
provisions.\57\ In light of the 1996 amendments' addition of section
3(c)(7) companies (i.e., privately-offered qualified purchaser pools)
to the statutory exceptions for the performance fee, the addition of
qualified purchasers themselves to rule 205-3 filled an eligibility gap
to provide qualified purchasers and their advisers with the flexibility
to enter into performance fee contracts outside of the context of a
section 3(c)(7) private fund.\58\ Regarding the addition of certain
knowledgeable employees as a category of qualified clients, the
Commission stated that an adviser's officers and ``employees who
actively participate in the investment activities of the adviser are
likely to be sophisticated financially and do not need the protections
of the performance fee prohibition,'' \59\ consistent with its
authority under section 205(e) to consider ``whether a client may not
need the protections of the performance fee prohibition by virtue of
the client's relationship with the adviser,'' in addition to other
criteria.\60\
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\55\ See discussion of later inflation adjustments infra at
notes 64-65 and accompanying text.
\56\ Rule 205-3(d)(1)(i)-(iii); see also 1998 Adoption, supra
note 52, at 39025. Similar to the definition of ``knowledgeable
employee'' in rule 3c-5 under the Investment Company Act, this
category of ``qualified client'' includes an executive officer,
director, trustee, general partner, or person serving in a similar
capacity, of the investment adviser, as well as certain other
employees who participate in investment activities and have
performed such functions for at least 12 months.
\57\ See 1997 Proposal, supra note 52, at n.28; 1998 Adoption,
supra note 52, at n.22.
\58\ See 1998 Adoption, supra note 52, at n.23 and accompanying
text.
\59\ Id. at text following n.27.
\60\ See id. at n.24 and accompanying text.
---------------------------------------------------------------------------
The Commission retained ``look-through'' treatment for clients that
are private or registered investment companies or business development
companies, requiring each equity owner thereof that would be charged a
performance fee to fall into one of the three categories of qualified
client in order for the company itself to be a qualified client under
the rule.\61\ Some commenters objected to the application of the look-
through requirement in contexts where the financial sophistication of
an independent fund representative could be expected to adequately
protect investors' interests by enabling the negotiation of performance
fees at arm's length with the adviser, consistent with the exemption
provided by rule 205-3.\62\ Although the Commission did not expressly
disagree with this view, the Commission determined ``not to eliminate
the look through provision of the rule at this time'' but clarified
that it would still ``entertain requests for relief from the
application of the look through provision in circumstances where the
policies and purposes of
[[Page 63683]]
section 205 of the Advisers Act would not be served by its
application.'' \63\
---------------------------------------------------------------------------
\61\ Rule 205-3(b).
\62\ See 1998 Adoption, supra note 52, at n.32.
\63\ See 1998 Adoption, supra note 52, at n.32 and accompanying
text.
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In 2011, 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
Commission shall, by order, adjust for the effects of inflation the
dollar amount thresholds included in rules issued under section 205(e),
rounded to the nearest multiple of $100,000.\64\ As of June 29, 2026,
the dollar amount threshold of the assets-under-management test is
$1,400,000, and the dollar amount threshold for the net worth test is
$2,700,000.\65\
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\64\ Public Law 111-203, 418, 124 Stat. 1376 (2010).
\65\ Order Approving Adjustment for Inflation of the Dollar
Amount Tests in Rule 205-3 under the Investment Advisers Act of
1940, Investment Advisers Act Rel. No. 6961 (April 28, 2026) [91 FR
23520 (May 1, 2026)] (``2026 Inflation Adjustment Order'').
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B. Performance-Based Compensation: Current Practices
The current exceptions to and exemptions from the performance fee
prohibition have led to a patchwork of permitted performance fee
arrangements and practices in the asset management industry. As
detailed above, current section 205 and rule 205-3 under the Advisers
Act operate to permit certain performance fee arrangements largely
conditioned on the relevant advisory client's legal type or form (e.g.,
the legal classification of a client fund managed by the adviser),
rather than on an investor's ability to evaluate and bear the risks of
an investment product with performance fees.\66\ Specifically, the
current use of performance fees can depend on the following
classifications:
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\66\ As noted above, compensation arrangements based on measures
of performance other than capital gains or capital appreciation are
also not prohibited, such as with respect to investment strategies
where gains are sought primarily in the form of interest, ordinary
income, or dividends. See supra note 12.
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<bullet> whether the client is a registered investment company or
any person (other than a trust, governmental plan, collective trust
fund, or separate account referred to in section 3(c)(11) of the
Investment Company Act, which covers most employee benefit plans) with
at least $1 million in assets managed by the adviser, provided that in
each instance an appropriate fulcrum fee is used;
<bullet> whether the client is a BDC, provided that the performance
fee is structured to meet specific statutory conditions;
<bullet> whether the client is a section 3(c)(7) qualified-
purchaser private fund;
<bullet> whether the client is a non-U.S. resident; or
<bullet> whether the client (or its equity owners, as applicable)
is a ``qualified client,'' e.g., a high net worth individual with a
separately managed account.
These exceptions to and exemptions from the performance fee
prohibition conditioned on a client's legal classification have in
practice confined the use of performance fees behind the requirements
for such classifications, including applicable investor eligibility
requirements. Particularly, the use of performance fees has long been a
defining characteristic of the private fund industry, which has
experienced tremendous asset growth over the last decades.\67\
Investors that do not meet the eligibility requirements for these
performance-fee investment products have had limited opportunities for
exposure to their underlying investment strategies and for
participation in their asset growth.\68\
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\67\ Based on Form ADV reporting data, as of the end of 2025,
private fund assets have increased from $11.9 trillion to $36.8
trillion in the preceding ten years alone.
\68\ Cf. Democratizing Access to Alternative Assets for 401(k)
Investors, E.O. 14330 (Aug. 7, 2025) [90 FR 38921 (Aug. 12, 2025)]
(stating that the vast majority of investors in employer-sponsored
defined-contribution plans ``do not have the opportunity to
participate, either directly or through their retirement plans, in
the potential growth and diversification opportunities associated
with alternative asset investments'' and directing the Commission to
``facilitate access to investments in alternative assets,''
including ``consideration of revisions to existing SEC regulations
and guidance relating to accredited investor and qualified purchaser
status'').
---------------------------------------------------------------------------
However, performance fee arrangements have come to reflect a
matured industry practice that can offer a rational and effective means
of aligning adviser and investor interests, as well as incentivizing
outperformance and rewarding specialized advisory expertise. This is
particularly true as performance fees have evolved over time through
commercial negotiations to commonly include features designed to
mitigate the prospect of conflicted or otherwise excessive risk-taking
and more closely align adviser and investor interests (e.g.,
distribution waterfalls with preferred return and high-water mark
rates, catch-ups, and agreed-upon valuation procedures, as applicable
to the particular investment strategy). Although initially developed
through negotiations between advisers and sophisticated institutional
investors, these features have since become commonly adopted across
performance fee arrangements offered to private fund investors.\69\
---------------------------------------------------------------------------
\69\ Cf. Institutional Limited Partners Association, ILPA
Principles 3.0: Fostering Transparency, Governance and Alignment of
Interests for General and Limited Partners (June 2019).
---------------------------------------------------------------------------
Private funds that are offered exclusively to investors that are
``qualified purchasers'' with generally at least $5,000,000 in
investments in accordance with section 3(c)(7) of the Investment
Company Act fall under the broad statutory exception to the performance
fee prohibition set forth in section 205(b)(4) of the Advisers Act. As
such, performance fee arrangements are most commonly and freely used in
section 3(c)(7) qualified-purchaser private funds, causing investment
strategies generally associated with performance fees, such as private
equity, hedge fund, and venture capital strategies, to be offered
largely through these types of clients (and hence through some of the
most investor eligibility-restricted investment products).
Unlike section 3(c)(7) private funds, private funds that are
offered to fewer than one hundred persons in accordance with section
3(c)(1) of the Investment Company Act do not generally qualify for a
statutory exception under section 205(b) of the Advisers Act. Instead,
a section 3(c)(1) private fund and its adviser can rely on the client-
identification or ``look-through'' provision in rule 205-3(b) to enter
into a performance fee arrangement if each of the fund's relevant
equity owners is a ``qualified client'' under the rule (e.g., a person
with at least $1,400,000 managed by the adviser or a net worth of at
least $2,700,000, or a knowledgeable employee of the adviser).\70\
Similar to section 3(c)(1) private funds, a regulated fund and its
investment adviser may likewise currently enter into a performance fee
arrangement if each of the regulated fund's relevant equity owners is a
``qualified client'' under rule 205-3.
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\70\ Investors that are qualified clients by virtue of their
status as qualified purchasers are eligible to invest in a section
3(c)(7) qualified-purchase private fund rather than a section
3(c)(1) private fund.
---------------------------------------------------------------------------
Because section 3(c)(1), like section 3(c)(7), requires that a
relying fund ``is not making and does not presently propose to make a
public offering of its securities,'' section 3(c)(1) funds are
generally privately offered to U.S. investors in reliance on section
4(a)(2) of the Securities Act and the non-exclusive safe harbors and
exemptions provided by Regulation D.\71\ Private
[[Page 63684]]
offerings to U.S. investors in reliance on rule 506(b) of Regulation D
may be made to up to 35 non-accredited investors (in any 90-calendar-
day period) and to an unlimited number of ``accredited investors,'' a
definition that includes, among other qualifying criteria, entities
with over $5,000,000 in assets or investments and individuals with net
worths of over $1,000,000 (excluding their primary residence) or
incomes of over $200,000 (individually) or $300,000 (with a spouse or
spousal equivalent).\72\ Some private funds have also begun to rely on
rule 506(c) of Regulation D, which requires that the issuer take
reasonable steps to verify accredited investor status of all investors
and does not permit any non-accredited investors. Section 3(c)(1)
private funds that rely on Regulation D and seek to enter into
performance fee arrangements are thus generally subject to separate
qualified client and accredited investor asset tests to determine
investor eligibility. In addition to these distinct investor
eligibility requirements, the requirement that a section 3(c)(1) fund
have not more than one hundred beneficial owners necessarily limits the
potential scale of these funds, which may limit the incentive for
investment advisers to sponsor investment products that utilize them
and, in turn, the ultimate availability of these investment products to
investors.
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\71\ 17 CFR 230.500-508 (``Regulation D'').
\72\ Rule 501(a) of Regulation D. In addition to the net worth
and income criteria, the current accredited investor definition
includes individuals who are directors, executive officers, or
general partners of the issuer; are a ``family client'' of a
``family office''; hold certain professional certifications; or are
``knowledgeable employees'' of the issuer (if the issuer is a
private fund). See Rule 501(a)(4), (10), (11), and (13). For
entities, in addition to entities with over $5,000,000 in assets or
investments, certain financial institutions, certain insurance
companies, business development companies, entities in which all of
the equity owners are accredited investors, and ``family offices''
are also accredited investors. See Rule 501(a)(1), (2), (8), and
(12).
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The option to use a fulcrum fee in accordance with section
205(b)(2)(B) of the Advisers Act may be available with respect to
section 3(c)(1) private funds (if their advisory contracts relate to
assets of at least $1,000,000) and regulated funds. However, the
inflexibility of the fulcrum fee model and its concomitant operational
risks have contributed to its lack of substantial adoption in the
industry. Based on available industry data, in 2026 only approximately
1% of registered funds used a fulcrum fee, indicating the model's
limited appeal as a practical matter.\73\
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\73\ This approximation is derived from an assessment of data
obtained from Morningstar Direct as of June 10, 2026.
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Specifically, the symmetrical nature of the fulcrum fee model can
lead to unanticipated operational consequences for an adviser and its
fund client. The model requires that the fulcrum fee ``provide for
increases and decreases in compensation which are proportionate to each
other,'' so that the potential upside performance adjustment must equal
the potential downside performance adjustment in absolute terms.\74\ As
a result, the potential for unpredictable changes in a fund's net
assets (upon which a fulcrum fee must be calculated) because of factors
other than its relative performance (e.g., due to a general declining
or rising asset environment that impacts the fund's portfolio to a
different extent than it does its chosen benchmark or due to fund
redemptions or purchases over the period) can in practice make the
total advisory fees paid by the fund unpredictable.\75\ Accordingly,
fund advisers may face pressure to increase their fulcrum fee's base
fee (i.e., the fee earned when performance is equivalent to the fund's
benchmark index) and/or limit the possible extent of their upside and
downside performance adjustments in order to ensure more reliably that
they receive a level of compensation adequate to continue their
advisory operations in an economically feasible manner. Otherwise, they
risk receiving a minimal level of compensation--or even zero or
negative compensation, depending on the applicable fulcrum fee and
performance adjustment schedule--that could be inadequate to meet an
adviser's own ongoing expenses necessary for its continued operation
and provision of services to its client funds, which can in turn
precipitate their closures and liquidations. Although unpredictable
changes in a client fund's net assets can impact the compensation level
of any fund adviser with an asset-based fee, including advisory fees
that are not performance fees, the fulcrum fee's requirement for
strictly proportional performance adjustments can exacerbate these
impacts and heighten the risk of receiving inadequate compensation to
address operational challenges.\76\
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\74\ S. Rep. No. 184, 91st Cong., 1st Sess. 45 (1969).
\75\ See, e.g., Redmond Growth Fund, Inc., SEC No-Action Letter
(pub. avail. Apr. 30, 1974) (granting no-action letter to a fund in
connection with its transition to a fulcrum fee arrangement, where
its adviser would not receive any advisory fee and would pay monies
to the fund, if the performance adjustment resulted in a total
advisory fee of less than zero). See also Andrew J. Donohue, Speech
by Staff: Keynote Address at the Independent Directors Council
Investment Company Directors Conference (Nov. 12, 2009) (``What
advisers sometimes fail to realize, however, is that when the base
fee is calculated on current level net assets, the adviser runs the
risk of having to reimburse the fund when there is a significant
decline in assets coupled with poor performance'').
\76\ See J. W. Murphy et al., Mutual Fund Performance Fees:
Perspectives After More Than 40 Years, The Investment Lawyer, Vol.
26, No. 5 (May 2019) (discussing some of the practical issues faced
by advisers and fund boards that seek to implement fulcrum fees).
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Additionally, the frequency of compensation under a fulcrum fee
model can likewise cause operational difficulties, as the fulcrum fee
exception generally requires that the period used for calculating the
base fee must be the same as the period used for purposes of
calculating the performance adjustment.\77\ This can cause a mismatch
between the operational needs of the adviser to receive compensation
more regularly (e.g., quarterly) than may be desired for a meaningful
performance period (e.g., yearly). Although rule 205-2(c) under the
Advisers Act provides some flexibility in this respect to use a rolling
performance period for purposes of calculating the performance
adjustment while using the most recent subperiod of that performance
period for purposes of calculating the base fee,\78\ the use of two
different periods can in practice result in actual fees that greatly
differ from the predictable advisory fees that advisers and funds may
anticipate.
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\77\ See section 205(b)(2)(B) and rule 205-2(b).
\78\ See rule 205-2(c). In effect, rule 205-2(c) provides that
the periods for calculating the fulcrum fee's base fee and its
performance adjustment may differ if: (1) the performance-related
portion of the fee is computed on the basis of net asset value
averaged over a rolling period (e.g., 12, 24 or 36 months); (2) the
base fee is computed on the basis of net asset value averaged over
the most recent subperiod of the performance period (e.g., a month,
quarter or semi-annual period); and (3) the total advisory fee
(i.e., both the base fee and the performance adjustment) is paid at
the end of each subperiod.
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In sum, the fulcrum fee model's inflexibility has limited its
adoption among regulated funds. More broadly, as a result of the
general statutory prohibition on performance fees paired with the
rigidity of the fulcrum fee exception, the regulated fund industry has
been prevented from developing more competitive fee structures,
including, for instance, adapting features from performance fee
arrangements that have evolved in the private fund industry to address
the prospect of conflicted or otherwise excessive risk-taking that
originally animated the performance fee prohibition. Instead, advisory
fees for registered investment companies are
[[Page 63685]]
generally based solely on their net asset value, where an adviser's
compensation is principally a function of their client funds' size,
which, while reflecting asset accumulation that can result from strong
performance, may not isolate investment performance as a direct driver
of compensation.
Allowing other kinds of performance fees for registered investment
companies would provide investors with the opportunity to select funds
where adviser compensation is more directly tied to investment
performance and ultimately the returns generated for shareholders. For
instance, allowing advisers to be compensated commensurate with the
investment gains they generate for shareholders rather than solely
based on accumulated assets may promote capital formation in capacity-
constrained strategies, where advisers limit assets under management to
preserve investment efficacy, but where meaningful return opportunities
nonetheless exist.\79\
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\79\ For example, advisers pursuing investments in public market
small- or micro-capitalization companies may limit the total assets
deployed in such strategies, as large inflows can impair execution.
Under a fee structure based solely on net asset value, an adviser's
compensation in such a strategy would be inherently constrained by
the capacity limitation, potentially rendering the strategy
economically unattractive to offer in a regulated fund
notwithstanding its return potential. A performance fee would allow
the adviser to be compensated in proportion to the returns generated
for shareholders, independent of the strategy's asset ceiling.
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II. Discussion
A. Expansion of the Ability of Investment Advisers To Charge
Performance-Based Compensation to RICs and BDCs
The proposal would amend the qualified client definition in rule
205-3 to expand the ability of investment advisers to regulated funds
to enter into investment advisory contracts with performance-based
compensation arrangements, provided the following conditions are
satisfied:
<bullet> The performance-based compensation does not exceed 20% of
the regulated fund's net gains over a specified period;
<bullet> The regulated fund satisfies rule 0-1(a)(7) under the
Investment Company Act (the ``fund governance standards''); and
<bullet> The regulated fund's board, including a majority of
independent directors, determines that the performance-based
compensation arrangement is in the best interest of the regulated fund
and its shareholders and makes specific findings regarding the
arrangement's appropriateness, structure, and investor protection
features.
As discussed above, the prohibition in section 205(a)(1) of the
Advisers Act was primarily designed to protect investors who lack the
sophistication and bargaining power to evaluate performance fees from
the prospect of excessive risk-taking by investment advisers.\80\
Regulated funds operate within a comprehensive regulatory framework
that provides for a number of investor protections, including, among
other features, board oversight, shareholder approval rights, leverage
limits, and mandatory disclosure and reporting obligations. Notably,
with respect to advisory compensation, the Investment Company Act
requires regulated fund boards to annually evaluate and approve the
reasonableness of the advisory fees paid to the regulated fund's
adviser.\81\ The proposed amendments would leverage the existing
investor protection framework under the Investment Company Act and the
Advisers Act and incorporate conditions tailored to mitigate the risks
associated with performance-based compensation arrangements.
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\80\ See supra section I.A.
\81\ See section 15(c) of the Investment Company Act.
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1. Scope of Amended Exception
The proposed rule amendments would apply to investment advisers of
a registered management investment company or BDC.\82\ The amended rule
would therefore apply to investment advisers of open-end management
investment companies (``registered open-end funds''), such as exchange-
traded funds and mutual funds, as well as registered closed-end
management investment companies, such as interval funds and tender
offer funds. The proposed amendments would apply to investment advisers
of regulated funds that are listed for trading on an exchange and those
that are unlisted.
---------------------------------------------------------------------------
\82\ See proposed rule 205-3(c)(5).
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We are not, however, proposing to include contracts with unit
investment trusts (``UITs'') within the scope of the proposed
amendments. Unlike management investment companies and BDCs, UITs are
organized under a trust indenture or similar instrument and do not have
a board of directors or other governing body responsible for ongoing
management of the trust. Because the proposed amendments are premised
on the existence of a board of directors capable of exercising ongoing
oversight, we have not proposed to extend the scope of the amendments
to contracts with UITs. In addition, we are not proposing to include
within the scope of the rule amendments contracts with separate
accounts that are registered management investment companies offering
variable annuity contracts registered on Form N-3 because such separate
accounts typically function as pass-through vehicles that allocate
contract holder assets to underlying management investment companies
registered on Form N-1A, where active portfolio management occurs and
to which the proposed amendments would already apply.
Although section 205(b)(3) of the Advisers Act provides an
exception to the prohibition on charging performance-based compensation
for certain contracts with BDCs, our proposal would allow investment
advisers of BDCs to rely on the amended rule. We do not see a basis to
differentiate between contracts with BDCs and contracts with registered
management investment companies for purposes of the proposed
amendments, as BDCs employ investment strategies similar to those of
many registered management investment companies and are subject to a
substantially similar regulatory framework, which includes the
requirement to have a board of directors.
We are not proposing to limit the availability of performance-based
compensation arrangements to contracts with registered closed-end funds
or BDCs that focus their investments in private markets. Currently,
performance-based compensation arrangements are most closely associated
with private market-oriented strategies, such as private equity,
private credit, hedge fund strategies, or other alternative asset
approaches. Registered closed-end funds and BDCs, rather than
registered open-end funds, typically have been perceived as better
suited to holding relatively less-liquid private market assets because
the liquidity and daily valuation and redeemability requirements for
registered open-end funds restrict their ability to allocate a
significant portion of their portfolio to less-liquid private market
assets. There are varying degrees of liquidity associated with exempt
offering products, however. For example, hedge fund strategies, which
typically charge both management and performance fees, tend to be more
liquid relative to private equity fund strategies, which also commonly
charge performance fees.\83\
[[Page 63686]]
Similarly, innovative regulated funds formed as registered open-end
funds could offer complex and differentiated strategies that rely
heavily on manager skill, warranting performance-based compensation
paid to the adviser. Accordingly, we are proposing to expand the
ability of investment advisers to include performance fees in
investment advisory agreements with all regulated funds, including
registered open-end funds.
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\83\ See 17 CFR 279.9 (Form PF) (defining ``hedge fund,'' in
part, to mean ``[a]ny private fund . . . with respect to which one
or more investment advisers (or related persons of investment
advisers) may be paid a performance fee or allocation calculated by
taking into account unrealized gains. . .'').
---------------------------------------------------------------------------
We request comment on the scope of the proposed rule amendments
that would expand the ability of investment advisers to regulated funds
to enter into investment advisory contracts with performance-based
compensation arrangements.
1. Should the proposed rule amendments apply to contracts with all
regulated funds, or just some subset of regulated funds? For example,
should we explicitly exclude registered open-end funds from the amended
rule and limit the scope of the proposed amendments to investment
advisory agreements with registered closed-end funds and BDCs,
considering that these regulated fund types are currently most
associated with investing in private markets? Should the proposed
amendments apply both to exchange-listed and unlisted regulated funds?
Should the rule exclude regulated funds employing passive or index-
tracking strategies?
2. Are there operational or administrative challenges unique to
registered open-end funds that would make compliance by their advisers
with the proposed amendments difficult or impracticable? For example,
given that registered open-end funds continuously issue and redeem
shares on a daily basis, are there structural or operational
characteristics of registered open-end funds that present particular
difficulties in implementing or administering performance fee
arrangements? If so, how should the proposed rule amendments account
for these challenges, and should the Commission consider alternative
compliance frameworks or exemptions tailored to the operational
realities of registered open-end fund structures?
3. Is there a basis to exclude investment advisers of BDCs from
relying on the amended rule? Why or why not?
4. Should the proposed rule amendments apply to UITs? If so, how
should the proposed amendments be modified to account for the
structural differences between UITs and management investment companies
and BDCs?
5. The proposed rule amendments would not apply to contracts with
separate accounts that are registered management investment companies
offering variable annuity contracts registered on Form N-3. These
separate accounts typically allocate contract holder assets to
underlying management investment companies where the active portfolio
management occurs, and thus do not generally have an investment adviser
whose managerial skills are relevant to the strategy. Should contracts
with separate accounts that are registered management investment
companies be included in the proposal? Why or why not? Are there any
special considerations that would be important to address if such
registered management investment companies were included in the
proposal?
6. Should the Commission provide guidance on ``capital gains'' or
``capital appreciation'' or any other terms used in section 205(a) or
rule 205-3 or define those terms by rule? Are there ways in which
performance-based compensation calculated using risk-adjusted, market-
relative returns (such as alpha) could be structured in a manner that
falls outside the statutory scope of capital gains and capital
appreciation under section 205(a)(1)? If so, what specific
methodological, contractual, or economic features would distinguish
such metrics from capital gains and capital appreciation?
2. Conditions
The proposed rule amendments would expand the ability of investment
advisers to include performance fees in investment advisory agreements
with regulated funds, permitting the adviser to align its economic
incentives with the interests of the regulated fund and its
shareholders by linking a portion of the adviser's compensation to the
fund's investment performance. The proposed rule amendments would
subject the adviser to certain conditions that are designed to protect
regulated funds and their shareholders.\84\ By conditioning compliance
on limiting the maximum level of performance fees, mandating
independent board oversight, and requiring a board determination that
the compensation arrangement serves the best interests of the fund and
its shareholders, the proposed rule amendments are intended to mitigate
the potential for excessive risk-taking and speculation that prompted
Congress to apply the general prohibition in section 205 of the
Advisers Act to advisory agreements with regulated funds. We discuss
each of the conditions below.
---------------------------------------------------------------------------
\84\ See proposed rule 205-3(c)(1)(iv).
---------------------------------------------------------------------------
a. The Performance-Based Compensation Does Not Exceed 20% of the
Regulated Fund's Net Gains Over a Specified Period
The current statutory exception on the performance fee prohibition
for BDCs reflects a congressional judgment that investment advisers to
certain investment vehicles should be permitted to receive performance
fees, subject to certain conditions that protect investors from
excessive fees.\85\ Specifically, Section 205(b)(3) permits an
investment adviser to a BDC to receive compensation based on a share of
capital gains, not to exceed 20% of realized capital gains upon the
funds of the BDC over a specified period or as of definite dates
(computed net of all realized capital losses and unrealized capital
deprecation). Congress calibrated the 20% ceiling to the then-
prevailing market practice for private equity and venture capital
funds, while providing investors with a statutory limit above which
performance fees could not be increased by contractual negotiation.\86\
In addition, considering that venture capital and private equity funds
typically compensate managers through performance fees triggered upon
the realization of portfolio gains, Congress designed section 205(b)(3)
to apply only to the realized gains of BDCs.\87\
---------------------------------------------------------------------------
\85\ See supra note 36 and accompanying text.
\86\ H.R. Rep. No. 96-1341, at 21-22 (1980) (stating that the
establishment of the BDC in the Small Business Investment Incentive
Act of 1980 ``seeks to remove burdens on venture capital activities
that create unnecessary disincentives to the legitimate provision of
capital to small businesses'').
\87\ Id.
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The proposal draws on this statutory framework as the conceptual
foundation for a new condition in the amended rule, which would allow
compensation to the investment adviser on the basis of a share of the
capital gains upon, or the capital appreciation of, the funds of a
regulated fund, subject to a ceiling of 20% of net capital gains or net
capital appreciation over a specified period or as of definite
dates.\88\ Unlike section 205(b)(3), as applicable to BDCs, the
proposed rule amendments would allow an investment adviser to calculate
performance fees on net realized and net unrealized capital
appreciation. This modification allows flexibility for investment
advisers to align their compensation with the total-return experience
of investors who typically
[[Page 63687]]
redeem (or tender shares for repurchase) from regulated funds at net
asset value (a price that reflects current unrealized appreciation and
depreciation on a mark-to-market basis).\89\
---------------------------------------------------------------------------
\88\ See proposed rule 205-3(c)(1)(iv)(A).
\89\ See infra section II.A.2.c. (discussing the regulated fund
board's responsibility to make written findings addressing the basis
upon which any performance-based compensation is determined with
reference to realized gains, unrealized gains, or both).
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The clause ``over a specified period or as of definite dates,''
which appears in section 205(b)(3) and which we propose to incorporate
into the amended rule's exemptive conditions, requires that the
advisory contract specify a defined measurement period or reference
dates over which net capital appreciation is calculated and against
which the adviser's entitlement to performance-based compensation is
determined. This measurement window can be a rolling period, such as
the fiscal year, a cumulative period calculated from a specified
inception date, or discrete valuation dates at periodic intervals. The
rule does not propose to mandate a minimum measurement period,
consistent with the flexibility afforded by the statutory text in
section 205(b)(3).\90\
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\90\ See proposed rule 205-3(c)(1)(iv)(C)(2); see also infra
note 108 and accompanying text (discussing a proposed requirement
for the board to make written findings related to the measurement
period over which performance fees are assessed).
---------------------------------------------------------------------------
We request comment on the proposed condition that the performance-
based compensation to an adviser for a regulated fund does not exceed
20% of the fund's net capital gains or net capital appreciation over a
specified period or as of definite dates.
7. Should the amended rule allow advisers to regulated funds to
enter into advisory agreements that include performance fees that
exceed 20% of the fund's net capital gains? Conversely, should the
proposal include a lower cap (e.g., 10% or 15% of a regulated fund's
net capital gains)? Why or why not?
8. Should the amended rule allow advisers to regulated funds to
charge performance fees on unrealized gains in addition to realized
gains or should the proposed rule permit advisers to regulated funds to
charge performance fees on realized gains only? Why or why not?
9. Should investment advisers to BDCs be permitted to charge
performance-based compensation on net unrealized capital gains,
consistent with the proposed amendments to rule 205-3, or should they
be limited to charging performance-based compensation only on net
realized gains, as provided by the statutory exception in section
205(b)(3) of the Advisers Act?
10. The proposed amendments would require that performance fees for
regulated funds be calculated over ``a specified period'' or ``as of
definite dates,'' but do not prescribe a minimum measurement period or
minimum interval between measurement dates. Should the amended rule
require a specific time period or minimum measurement period over which
net capital appreciation is calculated? For instance, should the rule
mandate a quarterly, semi-annual, or annual measurement period? Would a
mandated minimum measurement period better protect investors by
preventing advisers from structuring short measurement windows that
obscure volatility or diminish the practical effect of high-water mark
and loss carryforward protections? Are those investor protection
benefits outweighed by any reduction in flexibility for regulated funds
with structural or liquidity reasons to assess performance on a shorter
cadence? For regulated funds that currently pay performance fees to
their advisers on capital gains or capital appreciation, what
measurement periods are typically used in practice, and would a
required annual minimum measurement period be consistent with or
disruptive to those existing arrangements?
b. Compliance With the Fund Governance Standards
Regulated funds are typically organized and operated by an
investment adviser that is responsible for the day-to-day operations of
the fund. The adviser is a separate and distinct entity from the
regulated fund it advises. This framework presents inherent conflicts
of interest and potential for abuses that the Investment Company Act
and the Commission have addressed in different ways. The primary manner
in which the Investment Company Act and the rules thereunder address
this conflict is by giving regulated fund boards, in particular
disinterested or ``independent'' directors, an important role in fund
governance to look after the interests of regulated fund shareholders
and provide an independent check upon the fund's adviser.\91\ This
framework encourages directors to bring to the boardroom a high degree
of rigor and skeptical objectivity to the evaluation of management and
its plans and proposals. Certain exemptive rules under the Investment
Company Act include a condition that requires regulated funds to comply
with rule 0-1(a)(7) under the Investment Company Act, a set of
requirements intended to reinforce board independence (the ``fund
governance standards'').\92\ The fund governance standards require
that:
---------------------------------------------------------------------------
\91\ See Burks v. Lasker, 441 U.S. 471, 484 (1979); see also
Protecting Investors Report, supra note 42, at pp. 255-256.
\92\ See rule 0-1(a)(7); see also Role of Independent Directors
of Investment Companies, Investment Company Act Rel. No. 24816 (Jan.
2, 2001) [66 FR 3734 (Jan. 16, 2001)] (``2001 Independent Directors
Adopting Release'') at text following n.20 (stating that the
``amendments are designed to increase the ability of independent
directors to perform their important responsibilities under each of
these [exemptive] rules''). Investment Company Governance Technical
Amendment, Investment Company Act Rel. No. 36282 (Aug. 4, 2026) [91
FR 50707 (Aug. 6, 2026)] (adopting technical amendments to rule 0-
1(a)(7) under the Investment Company Act that reflect the 2006
vacatur by a Federal court of appeals of certain 2004 amendments to
the fund governance standards).
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<bullet> A majority of a regulated fund's board is made up of
independent directors;
<bullet> The independent directors of the regulated fund select and
nominate any other independent directors;
<bullet> Any person who acts as legal counsel for the independent
directors of the regulated fund is an independent legal counsel as
defined in the fund governance standards;
<bullet> The board of directors evaluates at least once annually
the performance of the board of directors and the committees of the
board of directors, which evaluation must include a consideration of
the effectiveness of the committee structure of the fund board and the
number of funds on whose boards each director serves;
<bullet> The independent directors meet at least once quarterly in
a session at which no directors who are interested persons of the fund
are present; and
<bullet> The independent directors have been authorized to hire
employees and to retain advisers and experts necessary to carry out
their duties.
These fund governance standards, collectively, are designed to
enhance the independence and effectiveness of independent directors and
currently are conditions to commonly used exemptive rules under the
Investment Company Act that rely on the independent judgment and
scrutiny of directors, including independent directors, in overseeing
activities that involve inherent conflicts of interest between the
funds and their managers.\93\ Section 205 of the Advisers Act generally
prohibits investment advisers from receiving compensation based on a
share of capital gains or capital appreciation of a client's funds. The
proposed amendments to rule 205-3 would expand the exemption from this
[[Page 63688]]
prohibition. Consistent with our practice of applying the fund
governance standards to other exemptive rules that rely on independent
director oversight to address conflicts of interest between regulated
funds and their management, we propose to apply the fund governance
standards as a condition of the proposed expansion of relief to
regulated funds. Compliance with the fund governance standards is
appropriate in the context of the negotiation and review of a
performance fee arrangement between a regulated fund and its investment
adviser that is subject to the proposed amendments to rule 205-3
because a board with a majority of independent directors is better
positioned to represent the interest of the fund by more effectively
mitigating the potential conflicts of interest inherent in performance
fee arrangements. Therefore, proposing to require a regulated fund's
board to satisfy the fund governance standards as a condition to the
fund being a ``qualified client'' is intended to help ensure
appropriate board oversight of any conflicts of interest associated
with a performance fee arrangement proposed by the adviser.
---------------------------------------------------------------------------
\93\ See 2001 Independent Directors Release, supra note 92, at
n.20 and accompanying text.
---------------------------------------------------------------------------
We request comment on the proposed requirement that a regulated
fund satisfy the fund governance standards as a condition to meeting
the definition of a qualified client under the amended rule.
11. Would requiring the regulated fund's board to satisfy the fund
governance standards, as a condition to being treated as a qualified
client, enhance the independence and effectiveness of the board in
negotiating any performance fee arrangement with the fund's adviser?
12. Is the proposed condition that a regulated fund comply with the
fund governance standards appropriate? Would it be appropriate to
remove reference to the fund governance standards and simply rely on
the current requirement that the board of directors, including a
majority of disinterested directors, approve the investment advisory
contract?
13. Are there certain requirements in the fund governance standards
that the proposal should exclude? For instance, should the rule require
that disinterested directors meet at least once quarterly in a session
at which no directors who are interested persons of the fund are
present, as is currently required in the fund governance standards?
Alternatively, are there additional fund governance standards we should
require in light of the specific conflicts involved in negotiating a
performance fee arrangement?
c. Determination by the Board of Directors
The final condition in the proposed rule amendments would require a
regulated fund's board of directors to determine, as part of its
approval and annual review of an investment advisory contract required
under section 15(c) of the Investment Company Act, that the
performance-based compensation arrangement is in the best interest of
the regulated fund and its shareholders, and to make specific findings
regarding the arrangement's appropriateness, structure, and investor
protection features.\94\
---------------------------------------------------------------------------
\94\ See proposed rule 205-3(c)(1)(iv)(C).
---------------------------------------------------------------------------
Section 15(c) of the Investment Company Act requires that the
initial approval, and any annual continuance, of an investment advisory
contract by a regulated fund be approved by a majority of the fund's
board, including a majority of directors who are not interested persons
of the adviser.\95\ In discharging this responsibility, the board must
request and evaluate such information as may be reasonably necessary to
evaluate the terms of the advisory contract.\96\
---------------------------------------------------------------------------
\95\ Sections 15(a) through (c) of the Investment Company Act.
\96\ Section 15(c); see also Commission Interpretation Regarding
Standard of Conduct for Investment Advisers, Advisers Act Rel. No.
5248 (June 5, 2019) [84 FR 33669 (July 12, 2019)] (stating that
under section 206 of the Advisers Act, an investment adviser has an
affirmative, independent obligation to disclose to its client all
material information regarding conflicts of interest, including any
conflict that may arise from the structure of advisory compensation
arrangements).
---------------------------------------------------------------------------
Courts and Commission guidance have stated that this evaluation
should encompass what are commonly referred to as the Gartenberg
factors, which include the nature, extent, and quality of services
provided by the investment adviser; the investment performance of the
regulated fund and the investment adviser; the costs of the services
and the profitability of the advisory relationship to the adviser;
economies of scale; and comparisons of advisory fees and services with
those of other advisers to similarly situated funds.\97\ This annual
evaluation process is further reinforced by section 36(b) of the
Investment Company Act, which imposes a fiduciary duty on an investment
adviser of a regulated fund with respect to the receipt of compensation
for services paid by the fund or its shareholders.\98\ Because
performance-based compensation is a component of the total advisory fee
paid to an investment adviser, it is necessarily within the board's
existing obligations under both sections 15(c) and 36(b). To the extent
applicable, boards already consider performance fees as part of their
review of the adviser's total compensation under these provisions.
---------------------------------------------------------------------------
\97\ Gartenberg v. Merrill Lynch Asset Mgmt., Inc., 694F.2d 923
(2d Cir. 1982); Jones v. Harris Assocs. L.P., 559 U.S. 335, 348
(2010) (``Jones''); see also Disclosure Regarding Approval of
Investment Advisory Contracts by Directors of Investment Companies,
Securities Act Rel. No. 8433 (June 23, 2004) [69 FR 39797 (June 30,
2004)], at n 31.
\98\ See 15 U.S.C. 80a-35(b); see also Jones, 559 U.S. at 348.
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Section 15(c) contemplates that a fully informed board,
particularly its non-interested directors, will scrutinize the
regulated fund's advisory relationship on an annual basis, supported by
all information reasonably necessary to evaluate the terms of the
advisory agreement.\99\ For purposes of actions under section 36(b),
courts are instructed to give a board's approval of a particular
advisory fee arrangement under section 15(c) such consideration as is
deemed appropriate under all the circumstances, which may include
considerable weight where the board has engaged in a fully informed
process in which it requested and considered all material information
bearing on the relevant factors identified in Gartenberg.\100\ Our
proposal builds on this framework. By requiring that the board's
findings related to the performance fee arrangement be made as part of
its section 15(c) review, we are anchoring the timing of the board's
review of performance-based compensation to its established section
15(c) process as a matter of practical expediency and to promote
coherent, integrated board oversight of the advisory relationship and
compensation. This integrated review framework would help ensure that
the board evaluates the performance-based compensation within the same
deliberative framework that governs all other material terms of the
advisory contract, and would help ensure that the appropriateness of a
performance fee arrangement will be reassessed annually as the
regulated fund's performance, strategy, portfolio composition, and
valuation complexity evolve over time. In addition, this approach would
allow the board's evaluation of any performance fee arrangement to also
include the evaluation of the aggregate
[[Page 63689]]
advisory fee burden on fund shareholders, considering that the total
cost borne by shareholders reflects the combined effect of any
performance fee and base management fee, among other expenses.\101\
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\99\ Jones, 559 U.S. at 348 (quoting Burks v. Lasker, 441 U.S.
471, 482 (1979)). Section 15(c) requires that such approval come by
the vote of a majority of directors, who are not parties to such
contract or agreement or interested persons of such party.
\100\ Jones, 559 U.S. at 351 (``Where a board's process for
negotiating and reviewing investment-adviser compensation is robust,
a reviewing court should afford commensurate deference to the
outcome of the bargaining process.'').
\101\ Regulated funds have an existing obligation to retain any
documents or written information considered by the board in
approving the terms of an investment advisory contract under section
15(c) of the Investment Company Act, including board meeting minutes
memorializing the directors' consideration of the contract. See
rules Sec. 270.31a-1(b)(4) and Sec. 270.31a-2(a)(6). This also
would include materials related to the board's findings related to
performance fees under the proposed amendments to rule 205-3.
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The findings required by the proposed amendments to rule 205-3,
however, are not simply a restatement of what sections 15(c) and 36(b)
already require, nor are they intended to be redundant with those
existing obligations. Rather, the proposed rule 205-3 conditions are
designed to operate independently of, and in addition to, the board's
existing statutory duties, by requiring findings that are more
particularized to the specific features of the performance fee
arrangement. For example, the proposed rule amendments would require
the board to make specific written findings regarding adequacy of
investor protection features in the compensation arrangement, such as
considerations of a preferred return or a high-water mark. These are
targeted findings about the design of the performance fee itself and go
beyond the general assessment of whether the adviser's total
compensation is excessive or the product of arm's-length bargaining,
which is the focus of the Gartenberg analysis under section 15(c) and
the judicial standard under section 36(b). In other words, while
sections 15(c) and 36(b) require a regulated fund's board to evaluate
whether the adviser's compensation, considered as a whole, is
reasonable and not excessive, the conditions in proposed rule 205-3
require the board, as part of the 15(c) process, to determine whether
the features of the performance fee arrangement are appropriately
designed and the arrangement is in the best interests of the regulated
fund and its shareholders.
The proposed condition requiring that a regulated fund's board,
including a majority of independent directors, determines that a
performance-based compensation arrangement is in the best interests of
the fund and its shareholders provides important investor protections.
Unlike an asset-based advisory fee, a performance-based fee could
create an economic incentive for an investment adviser to pursue
strategies or assume portfolio risks that it might not otherwise take
in the absence of the contingent compensation opportunity. This
asymmetric incentive structure, where the adviser participates in
upside gains but does not share in the downside losses, has the
potential to misalign the interests of the adviser with those of fund
shareholders. To the extent an adviser would like to rely on the
exemptive rule, requiring an affirmative best-interest finding by the
board, grounded in written findings addressing certain factors relevant
to the evaluation of performance fees, is designed to provide a check
against the regulated fund being managed on behalf of the adviser or
other affiliated persons of the regulated fund rather than on behalf of
its shareholders.
The proposed best interest determination requirement reflects the
Commission's view that the board is best positioned to assess whether
the specific contours of a proposed compensation arrangement are
appropriate for a given regulated fund. This condition is not intended
to operate as a basis for Commission staff to substitute their judgment
for that of a diligently engaged board. Just as with the section 15(c)
process, to the extent that directors have meaningfully considered the
relevant factors and obtained sufficient information to evaluate the
performance fee arrangement, their approval of the arrangement is
entitled to considerable weight. Separately, the ``best interests of
the regulated fund and its shareholders'' in this context is not
intended to apply to each regulated fund shareholder individually, but
rather to the shareholders generally.
The proposed best interest finding by the board would be required
to include a written finding addressing the appropriateness of a
performance-based compensation arrangement considering such factors as
the regulated fund's investment strategy and valuation practices.\102\
With respect to a fund's investment strategy, a board would generally
need to consider whether the adviser is managing the fund's assets in a
manner consistent with the fund's stated strategies, and should be
attentive to whether the compensation structure may be incentivizing
the adviser to take on excessive risk in pursuit of higher fees to the
detriment of fund shareholders. Boards generally also would need to
consider whether an adviser may be increasing the volatility of the
fund's portfolio beyond what is consistent with the fund's stated
investment objectives and strategies, whether to enhance the prospect
of exceeding a performance threshold or to influence the timing of when
performance fees are earned or crystallized, and whether the
arrangement could harm shareholders by exposing them to risks that may
not be reflected in the fund's disclosures. Under the proposed best
interests finding, a board would need to consider, for example, whether
the adviser's portfolio construction, use of leverage, or concentration
of positions has materially shifted in a manner that appears
inconsistent with the fund's investment strategy, particularly during
periods proximate to performance fee measurement dates.
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\102\ See proposed rule 205-3(c)(1)(iv)(C)(1).
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Performance-based compensation arrangements are most closely
associated with private market-oriented strategies or other complex or
differentiated strategies, such as private equity, private credit, or
liquid strategies employing relative value, long/short equity, market
arbitrage, or other active management techniques. Because these
strategies aim to generate risk-adjusted outperformance and rely
heavily on manager skill, compensation contingent on investment results
may be reasonably justified. Unlike asset-based management fees, which
compensate an adviser based solely on the size of assets under
management and may therefore incentivize growth of a fund without
regard to investment outperformance of a benchmark, a performance fee,
if properly structured, can align the interests of the adviser and fund
shareholders by tying a portion of the adviser's compensation to
returns that genuinely exceed a meaningful benchmark or create risk-
adjusted outperformance. By contrast, fund board approval of a
performance fee arrangement in connection with the fund tracking a
broad-based securities market index, where the investment strategy is
passive or formulaic in nature and where excess returns above a market
benchmark are neither the stated objective nor a realistic expectation,
would generally seem unjustifiable.
The proposal's requirement that the board make written findings
assessing the appropriateness of the compensation arrangement
considering the regulated fund's valuation practices is important. For
instance, where a fund holds assets for which there are no readily
available market quotations, such as many private market investments,
the risk that performance-based compensation would be calculated on
valuations that depend on subjective inputs is elevated, and the board
would need to assess the appropriateness of a performance fee, or the
design of any proposed performance fee, given the inherently subjective
[[Page 63690]]
nature of the valuation of such private market portfolio securities.
This obligation is familiar to boards of regulated funds, as the
Investment Company Act and rules thereunder currently require regulated
fund boards to oversee a fund's valuation process.\103\ The Commission
has made clear that this oversight obligation is not passive.\104\
Boards are expected to apply a level of scrutiny commensurate with the
degree to which the fair value of the regulated fund's portfolio
depends on subjective inputs and assumptions rather than objective
market-based measures.\105\ Accordingly, a regulated fund that invests
primarily in private market assets for which no readily available
market quotation exists should demand more intensive board oversight of
the valuation process relative to a fund whose portfolio consists
principally of exchange-traded or other readily marketable securities.
The proposed rule condition is designed to complement the existing
valuation oversight framework in rule 2a-5 under the Investment Company
Act, with particular emphasis on the risks that could arise when fair
value of portfolio assets serves as the basis for calculating
performance-based compensation.
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\103\ See rule 2a-5 under the Investment Company Act.
\104\ See Good Faith Determination of Fair Value, Investment
Company Act Rel. No. 34128 (Dec. 3, 2020) [86 FR 748 (Jan. 6.
2021)], at text following n.209.
\105\ See id., at text accompanying n.213 (stating that ``[a]s
the level of subjectivity increases and the inputs and assumptions
used to determine fair value move away from more objective measures,
we expect that the board's level of scrutiny would increase
correspondingly.'').
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In addition, the proposed amendments would require the board's
written findings to address the basis upon which performance fees are
calculated and, specifically, whether fees are determined with
reference to realized gains, unrealized gains, or both.\106\ This
distinction is of material significance to fund shareholders and
implicates fairness considerations that the board should evaluate with
reference to the particular structural characteristics of the fund:
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\106\ See proposed rule 205-3(c)(1)(iv)(C)(2).
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<bullet> On one hand, calculating performance fees on unrealized
appreciation and depreciation may better align the investment adviser's
compensation with the actual economic experience of fund shareholders,
because shareholders in many types of regulated fund structures
purchase and redeem shares at net asset value and therefore benefit or
suffer from changes in portfolio value that include unrealized
components. For these types of regulated funds, a strictly realized-
gains-only performance fee could create a misalignment between when the
adviser is compensated and when shareholders actually experience the
economic results being compensated. Moreover, limiting performance fees
to realized gains could create incentives for investment advisers to
prematurely dispose of higher performing positions to achieve a higher
performance fee, potentially to the detriment of fund shareholders who
might otherwise benefit from continued appreciation in those positions.
<bullet> On the other hand, the inclusion of unrealized
appreciation in the performance fee base could introduce meaningful
risks to shareholders. For instance, when a portfolio asset lacks a
readily available market quotation, upward movements in the fair value
of the illiquid asset could inflate a performance fee base without
corresponding economic realization. This risk of such an asset could be
compounded in the near term, as shareholders may bear asymmetric
performance fees on unrealized appreciation that is subsequently
reversed, eroding net asset value without any mechanism for recovery
absent contractual protections. Boards should be alert to valuation
practices that inflate the performance fee base without corresponding
economic substance. For example, a regulated fund's acquisition of
private fund interests at a discount to net asset value, followed by an
immediate mark to full net asset value calculated by the private fund,
can artificially accelerate reported returns and, by extension,
performance fee accrual.\107\
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\107\ This typically involves a fund relying on the practical
expedient to use net asset value to estimate fair value, subject to
certain criteria. See Financial Accounting Standards Board
(``FASB'') Accounting Standards Codification (``ASC'') Topic 820-10-
35-59 through 35-62. This practice is sometimes referred to as ``NAV
squeezing.''
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The proposed board oversight conditions are intended to provide a
framework to guide boards in evaluating whether a regulated fund's
valuation practices produce performance fee outcomes that are truly
reflective of fund performance and are in the best interests of the
fund and its shareholders.
The board's evaluation of the basis upon which performance fees are
calculated would also need to account for the structural relationship
between the regulated fund's net asset value and any price at which
shareholders are able to transact in fund shares, if different from a
price based on net asset value. For instance, the board's evaluation
may be more complex for exchange-listed regulated funds, whose shares
trade on a secondary market at prices that may diverge materially from
net asset value. In many cases, such secondary market trading is the
only way investors are able to buy and sell the fund's shares. Where a
listed regulated fund's shares trade at a persistent discount to net
asset value (common for many exchange-listed registered closed-end
funds), a performance fee calculated on net asset value may impose a
fee burden on fund shareholders that is disconnected from the economic
experience of those shareholders in the secondary market. A shareholder
who purchased shares at a discount to net asset value and continues to
hold at a discount has not realized, and may never realize, the net
asset value appreciation on which the performance fee is based. Boards
of exchange-listed regulated funds should therefore consider whether
performance fee calculations based on net asset value are appropriately
calibrated to the actual returns experienced by shareholders
transacting in the secondary market, and whether additional structural
protections, such as a discount-adjusted fee calculation or enhanced
hurdle rate, would be warranted to address this potential misalignment.
While the Commission does not prescribe a single approach, in
evaluating whether a performance fee arrangement is in the best
interests of the regulated fund and its shareholders, the board would
have to consider, and therefore its written findings would have to
reflect, an evaluation of the relevant structural features of the
regulated fund and their relationship to the performance fee
arrangement and the extent to which the proposed performance fee
arrangement equitably aligns adviser compensation with shareholder
outcomes across the range of circumstances in which shareholders may
transact.
A regulated fund's board also would be required to make written
findings addressing the measurement period over which performance is
assessed.\108\ The length of the performance fee measurement period can
have a significant impact on the alignment of adviser compensation with
fund performance and the interests of shareholders. The measurement
period that may be appropriate for a given fund may depend, among other
things, on the fund's investment strategy and the time horizon over
which the fund's returns are anticipated. A fund's liquidity profile
and portfolio turnover, among other factors, may bear on whether a
[[Page 63691]]
shorter or longer measurement period is consistent with the nature of
the fund's investments and the interests of its shareholders.\109\
Boards should evaluate the length of the measurement period
holistically and in connection with other investor protection features
that are incorporated into the performance fee arrangement and could
mitigate some of the risks associated with shorter measurement periods
(e.g., high-water marks or loss carryforward mechanisms). Accordingly,
the board's written findings should reflect a considered assessment of
whether the measurement period, viewed in the context of the overall
fee arrangement, is appropriate for the fund and consistent with the
best interests of its shareholders.
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\108\ See proposed rule 205-3(c)(1)(iv)(C)(2).
\109\ Cf. Alt. Inv. Mgmt. Ass'n, AIMA Global Investor Board
Perspectives: Alignment of Interests and Fee Preferences (Oct. 7,
2022) (noting that most investors in hedge funds surveyed prefer
that performance fees be paid no more frequently than annually,
while acknowledging that ``there can be considerable differences in
the crystallisation frequencies applied by different hedge fund
strategies--mainly due to the variety of fund liquidity terms used
across the universe of hedge fund strategies.'').
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Lastly, the proposed amendments would require the board's written
findings to address the adequacy of any investor protection features
embedded in the performance-based compensation arrangement to protect
the interests of shareholders, including, where no investor protection
features are present, the basis for concluding that the compensation
arrangement is adequate to protect the interests of shareholders.\110\
Common investor protection features in performance arrangements include
preferred returns, hurdles, high-water marks, and/or loss carryforward
mechanisms. These structural protections are well-established features
of private fund performance fee arrangements and have been refined over
decades of negotiations between institutional investors and private
fund managers. The development of many of these features postdates the
prohibition on performance-based compensation in section 205 of the
Advisers Act, and therefore Congress may not have considered these
tools when contemplating the prohibition as applied to advisory
contracts with regulated funds. Preferred returns and hurdle rates
establish a minimum return threshold that must be achieved before any
performance-based compensation accrues to the manager. They operate as
a floor that is designed to ensure investors receive a baseline return
on their investment before the manager participates in profits.\111\
High-water mark provisions and/or loss carryforward mechanisms require
that any prior losses be fully recovered before additional performance
fees may be charged, thereby preventing an adviser from repeatedly
extracting performance fees during periods of volatile performance
without regard to the investors' cumulative experience. \112\
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\110\ See proposed rule 205-3(c)(1)(iv)(C)(3).
\111\ The board should consider whether the arrangement employs
a ``hard hurdle,'' under which the performance fee is calculated
only on returns in excess of the threshold or a ``soft hurdle,''
which permits the adviser to earn a performance fee on all profits
once the threshold is cleared.
\112\ Boards should consider incorporating features within the
performance fee arrangement that are common in contracts between
institutional investors and private fund managers, to the extent
applicable or useful for the fund structure/strategy. For example,
including a provision in the investment advisory agreement that
accrued performance fees be held in escrow rather than distributed
immediately to the adviser would preserve the adviser's ability to
satisfy any loss recovery obligations or clawbacks if subsequent
fund performance deteriorates.
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The implementation of one or more of these features would protect
the interest of shareholders because these features would directly
counteract the most acute forms of investment adviser overreach that
performance-based compensation can generate (e.g., payment of
performance fees attributable to unrealized gains that are never
realized, fee layering across volatile performance cycles, and the
misalignment of adviser compensation with shareholder capital
accumulation over time). The Commission recognizes, however, that no
single mechanism is universally appropriate for all regulated fund
strategies and structures. Accordingly, the proposed amendments do not
mandate the use of any particular feature or mechanism in all
circumstances. The board is best positioned to evaluate the benefits
and drawbacks of any investor protection feature as applied to the
individual strategy and structure of the regulated fund. If no investor
protection features are included in the performance-based compensation
arrangement, the proposed amendments would require that the board's
determination include written findings that address the basis for
concluding that the compensation arrangement is adequate to protect the
interests of shareholders without such investor protection features.
In aggregate, the proposed conditions are designed to permit the
adviser to align its economic incentives with shareholders' interests,
while mitigating the risks that led Congress to include the general
prohibition on performance-based compensation in section 205 of the
Advisers Act, namely, that such compensation arrangements would
incentivize investment advisers to take excessive risks with client
funds to the detriment of fund shareholders. The proposed conditions
create a structured, board-centered governance process through which
advisers to regulated funds may access performance-based compensation
arrangements in a manner that is consistent with investor protection
and the purposes of the Advisers Act. The principles-based approach in
the proposed amendments draws on the accumulated market experience that
has shaped performance fee practices in the private fund context for
decades but is also designed to ensure that regulated fund boards have
the tools to evaluate and accommodate future innovation in performance
fee structures.
We request comment on the proposed condition requiring that the
regulated fund's board determine that the performance-based
compensation arrangement is in the best interest of the regulated fund
and its shareholders and make specific findings regarding the
arrangement's appropriateness, structure, and investor protection
features.
14. Should the proposal explicitly require that the board conduct a
comparative analysis, such as requiring that the board determine that
the performance fee structure is more beneficial to shareholders than a
conventional asset-based only fee arrangement?
15. The proposed rule amendments would require that the board's
written findings be made as part of the regulated fund's annual review
and approval of an investment advisory contract under section 15(c) of
the Investment Company Act. Should the rule instead require that the
board's written findings be made more frequently than annually, for
example, on a semi-annual or quarterly basis? Are there circumstances
where a more frequent determination by the board would be warranted to
protect the interests of fund shareholders; for instance, where a
regulated fund's performance fee is calculated over a shorter
measurement period?
16. Should a regulated fund's initial approval and any annual
continuance of a performance fee arrangement be subject to heightened
procedural requirements, such as a supermajority vote of the
independent directors or a shareholder vote? Should the proposed rule
amendments require the board to retain independent fee consultants or
financial advisors when evaluating performance fee arrangements?
[[Page 63692]]
17. Should the rule affirmatively enumerate categories of fund
strategies for which an adviser would be categorically ineligible to
charge performance fees under the exemption, rather than leaving this
determination to the discretion of the regulated fund's board? For
example, should the rule exclude regulated funds employing passive or
index-tracking strategies? Alternatively, should the Commission define
or offer further guidance on the boundary between complex and
differentiated strategies that may rely heavily on manager skill and
passive or formulaic strategies where performance fees may be less
appropriate?
18. To what degree should the proposed rule amendments specifically
address performance fees for regulated funds investing in strategies
with highly heterogeneous or mixed asset compositions? For example, a
regulated fund that invests most of its assets in private market
investments but also maintains a liquidity sleeve of money market
instruments or large-capitalization equity securities. Should the
proposed condition require that performance-based compensation be
calculated only with respect to the portion of the regulated fund's
portfolio attributable to private market or alternative asset
strategies? Is a blended or sleeve-based performance fee structure
administratively workable for regulated funds and their service
providers, including funds with multi-manager structures?
19. Should the rule require that portfolio investments subject to
unrealized gain-based performance fee calculations be independently
valued by a qualified independent third-party valuation agent prior to
any payment of performance fees to the adviser attributable to such
portfolio investments? Alternatively, should the rule condition payment
of any performance fee based on unrealized gains on the board's
affirmative finding that the fund's valuation methodology is
sufficiently objective and verifiable to support performance fee
calculations?
20. In cases where the performance fee base includes unrealized
appreciation on assets for which no readily available market quotation
exists, is there a heightened risk that the adviser's application of
the fair value determination framework established under rule 2a-5
under the Investment Company Act, including its use of FASB ASC Topic
820 methodologies, would fail to sufficiently address the conflicts of
interest introduced by charging performance fees on capital gains or
capital appreciation? Are there specific aspects of the FASB ASC Topic
820 framework, such as its reliance on unobservable inputs or its use
of management assumptions and estimates commonly applied to private
market investments, that, when coupled with the risks inherent in
charging a performance fee, give rise to particular conflicts of
interest that may negatively impact the reliability of fair value
estimates as a basis for performance fee calculations? Are there
certain incremental safeguards that advisers should be required to put
in place to address such conflicts? Alternatively, should the proposed
rule amendments condition the ability of an investment adviser to
charge performance fees to a regulated fund on the regulated fund's
portfolio consisting entirely of assets for which readily available
market quotations exist, or, more broadly, on the regulated fund's
entire portfolio consisting of assets classified as level 1 or level 2
assets under the FASB ASC Topic 820 fair value hierarchy?
21. The proposed rule amendments would require the board's written
findings to address the adequacy of investor protection features
embedded in the performance-based compensation arrangement, such as
preferred return, hurdles, high-water marks, and/or loss carryforward
mechanisms. Should the rule mandate the inclusion of one or more of
these investor protection features as a categorical requirement for
reliance on the proposed rule, rather than leaving their inclusion to
board discretion subject to a written findings requirement?
22. The proposed rule amendments would require that the board's
written findings address the adequacy of investor protection features
in the performance-based compensation arrangement but would not
prescribe a specific form or level of detail for those written
findings. Should the Commission provide additional guidance, or
establish minimum content requirements, regarding the form and
substance of the board's written findings, such as by requiring that
the findings specifically identify and respond to any material
conflicts of interest identified by the board in connection with its
evaluation of the performance fee arrangement?
23. Should the amendments include specific provisions governing the
treatment of accrued or anticipated performance fees in the event of
the board's termination of an adviser? If so, what form should such
provisions take, and how should they be structured to appropriately
balance the board's fiduciary obligations to fund shareholders with the
adviser's interest in receiving earned compensation? For example, where
a board terminates an adviser for cause (such as for fraud, willful
misconduct, or a material breach of the advisory agreement), should the
amended rule provide that the adviser forfeit some or all accrued but
unpaid performance fees, or should the rule distinguish between fees
that have already crystallized and those that are merely anticipated?
Conversely, where a board terminates an adviser without cause (e.g., as
part of a strategic management decision, to transition to a different
adviser, or following a change in the fund's investment mandate), the
adviser may have a stronger claim to compensation reflecting value it
has already created for the regulated fund even if that value has not
yet been realized or crystallized into a payable fee. Should the
Commission provide guidance identifying factors boards should consider
when evaluating adviser termination in light of accrued or anticipated
performance fee obligations, or are these matters better left to
private contract between the regulated fund and the adviser?
3. Disclosure Related to Performance-Based Compensation
a. Prospectus Disclosure
Currently, regulated funds are required to disclose in their
prospectuses information about the investment advisory fees paid to the
fund's adviser, including any performance-based compensation. Unlike
section 205 of the Advisers Act and rule 205-3 thereunder, the scope of
the prospectus disclosure requirements related to performance-based
compensation are not limited to compensation based solely on capital
gains or appreciation. They also encompass fees based on other
performance measures, such as interest, ordinary income, or dividends.
We are proposing to maintain this approach.\113\ The proposal would
require a regulated fund to provide more particularized prospectus
disclosure in two locations about any performance-based compensation
paid to the investment adviser:
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\113\ Accordingly, the use of ``performance-based compensation''
or ``performance fees'' in this section II.A.3.a includes fees paid
to the adviser based on all performance measures, consistent with
the existing disclosure requirements in Form N-1A and Form N-2.
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<bullet> Fee table: the proposal would add a distinct line item
regarding any performance-based compensation paid to the adviser or its
affiliates, while also alerting the investor about the variability of
the performance fees and providing a cross-reference to the more
[[Page 63693]]
complete discussion about the performance fees provided later in the
prospectus.\114\ In addition, the proposal would require that the
expense example reflect any performance fees; \115\ and
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\114\ See proposed Instruction 3(b) to Item 3 of Form N-1A;
proposed Instruction 7.c. to Item 3 of Form N-2.
\115\ See proposed Instruction 4(f) to Item 3 of Form N-1A;
proposed Instruction 12.d. to Item 3 of Form N-2.
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<bullet> Management discussion: the proposal would require a
detailed description of the performance fee arrangement, including a
graphical representation illustrating the calculation of the
performance fee across a range of hypothetical performance
scenarios.\116\
---------------------------------------------------------------------------
\116\ See proposed Item 10(a)(1)(ii)(B) of Form N-1A; proposed
Instruction 2. to Item 9.1.b.(3) of Form N-2.
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To help implement the proposal's investor protection goals and
safeguards discussed above, the proposed disclosure would augment the
current registration form requirements that require that a regulated
fund provide disclosure in its prospectus and statement of additional
information about the compensation of its investment advisers,
including performance-based compensation.\117\ These amendments are
designed to enhance transparency for investors about performance fees
paid to the adviser and to complement our proposed amendments to rule
205-3 under the Advisers Act by providing disclosure regarding the
expanded ability for regulated funds to pay performance fees based on
capital gains or appreciation.\118\ Without the amendments, as
discussed below, it may be difficult for an investor to easily
determine that the adviser is paid a performance fee, which is a
material part of the cost structure of the advisory fee, as the
performance fee would not be disclosed separately in the regulated
fund's fee table.\119\ Requiring separate disclosure about the fees
that the regulated fund may pay to its adviser would assist an investor
in making an informed investment decision as well as enhance the
ability of an investor to compare regulated funds.
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\117\ See Items 10 and 19 of Form N-1A; Items 9 and 20 of Form
N-2; see supra sections II.A.1 and II.A.2. This disclosure would
complement information regulated funds currently provide on
performance fees, including the current requirement for a regulated
fund that charges a performance fee to disclose, in notes to the
fund's financial statements, how the performance fee was calculated
and the amount of the performance fee that was paid during the
reporting period. See, e.g., FASB ASC Topic 850-10-50-1; rule 4-
08(k) of Regulation S-X [17 CFR 210.4-08].
\118\ Unlike the disclosure required in the initial adoption of
rule 205-3 in 1985 and subsequently removed from the 1998 amendments
to rule 205-3, our proposed disclosure requirements would be
applicable only to performance fee arrangements with regulated funds
and are designed to provide retail investors with the information
necessary to understand the performance fee arrangement. See supra
section I.A.3.
\119\ See infra note 122 and accompanying text.
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Fee Table Disclosure
Regulated funds are currently required to disclose certain key
information about the funds' fees and expenses in a standardized fee
table in their prospectus. The fee table is designed to help investors
understand the costs associated with investing in a regulated fund and
to facilitate comparisons across funds. The instructions to the fee
table require funds to disclose ``management fees,'' as a line item
that encompasses all fees paid to the investment adviser for managing
the fund's portfolio, including any fees that are based on the fund's
performance.\120\ The instructions to the prospectus fee table do not
currently require a regulated fund to separately identify, as a
distinct line item or caption within the fee table, the portion of
management fees attributable to performance-based compensation as
distinguished from asset-based advisory fees. As a result, if such fees
are not separately identified, investors in regulated funds that could
charge performance fees may not be able to readily discern from the fee
table the extent to which the total management fees they bear reflect
asset-based charges exclusively versus fees that would vary with fund
performance, potentially obscuring a material aspect of the fund's cost
structure and limiting investors' ability to make fully informed
investment decisions and to fully compare funds. Some regulated funds
where the adviser receives performance fees have developed a practice
of including separate disclosure in their fee tables about such
fees.\121\ The practice of separating performance fees from management
fees results in enhanced transparency to investors about performance
fees, and thus we are proposing to require separate line-item
disclosure in the fee table about performance fees paid to a regulated
fund's adviser, to the extent applicable.
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\120\ See Instruction 3(a) to Item 3 of Form N-1A; Instruction
7.a. to Item 3 of Form N-2. These instructions apply to fulcrum fees
and any other compensation arrangements based on measures of
performance.
\121\ See, e.g., Blackstone Private Multi-Asset Credit and
Income Fund (Investment Company Act File No. 811-23996); Carlyle
Tactical Private Credit Fund (Investment Company Act File No. 811-
23319); Hamilton Lane Private Assets Fund (Investment Company Act
File No. 811-23509).
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Specifically, we are proposing to require that a regulated fund add
a caption to its prospectus fee table titled ``performance fees.'' This
caption would disclose that the regulated fund has an investment
advisory agreement that includes performance-based compensation which
may be payable to the investment adviser or its affiliates.\122\ The
performance fees caption would be located directly below and indented
equally to the ``management fees'' caption in the fee table. The
regulated fund would be required to disclose the performance fee paid
to the adviser during the prior fiscal year as a percentage of the
value of the shareholder's investment, for Form N-1A disclosure, or as
a percentage of net assets attributable to common shares, for Form N-2
disclosure.
---------------------------------------------------------------------------
\122\ See proposed Instruction 3(b) to Item 3 of Form N-1A;
proposed Instruction 7.c. to Item 3 of Form N-2.
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A regulated fund that may pay its adviser performance fees under
its investment advisory agreement also would be required to add a
footnote to the fee table that would provide concise information about
the performance fees with a cross-reference to where the investor could
find additional information about the performance fees. Specifically,
the footnote would explain briefly the basis on which performance fees
are imposed and that performance fees may be substantially higher or
lower because these fees are based on the performance of the
registrant, which may fluctuate over time.\123\ Performance fees are
variable, and the footnote disclosure would alert the investor to this
variability. In addition, consistent with the Commission's layered
disclosure framework, the footnote would include a cross-reference to
the more complete disclosure about the performance fees which would be
provided later in the prospectus.\124\ The proposed prospectus fee
table amendments also would address New Funds, as defined in each
registration statement form, that will pay their advisers performance
fees and existing regulated funds that newly determine to pay their
advisers performance fees.\125\
[[Page 63694]]
The proposed amendments would provide that a New Fund, as defined in
Form N-1A and Form N-2, would be able to show zero performance fees
paid to the investment adviser or its affiliates.\126\ A New Fund has
no or a limited track record and therefore would not have performance
information on which to base its disclosure of performance fees paid to
the adviser. Following the regulated fund's first fiscal year, however,
a regulated fund with a performance fee arrangement would be required
to disclose in the fee table the performance fee paid to the investment
adviser or its affiliates during the prior fiscal year.\127\ Further,
if there are any changes to the annual fund operating expenses
disclosure in the fee table that would materially affect the
information disclosed in the fee table, which would include the
performance fee disclosure for an existing regulated fund that newly
determines to pay its adviser performance fees, the regulated fund
would be required to restate the expense information using the current
fees as if they had been in effect during the previous fiscal
year.\128\ Accordingly, existing funds (i.e., funds that do not qualify
as ``New Funds'' as defined in Form N-1A and Form N-2) that adopt a
performance fee arrangement, would disclose in the fee table the
performance fee that would have been payable to their investment
adviser had the performance fee arrangement been in place during the
previous fiscal year and would disclose in a footnote to the fee table
that the expense information in the table has been restated to reflect
current fees.\129\
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\123\ See proposed Instruction 3(b) to Item 3 of Form N-1A;
proposed Instruction 7.c. to Item 3 of Form N-2.
\124\ See, e.g., Tailored Shareholder Reports for Mutual Funds
and Exchange-Traded Funds; Fee Information in Investment Company
Advertisements, Investment Company Act Rel. No. 34731 (Oct. 26,
2022) [87 FR 72758 (Nov. 25, 2022)] at section I.A.2.; see also
proposed Instruction 3(b) to Item 3 of Form N-1A; proposed
Instruction 7.c. to Item 3 of Form N-2.
\125\ See Instruction 6 to Item 3 of Form N-1A (defining a new
fund as a ``Fund that does not include in Form N-1A financial
statements reporting operating results or that includes financial
statements for the Fund's initial fiscal year reporting operating
results for a period of 6 months or less'') and proposed Instruction
13. to Item 3 of Form N-2.
\126\ See id. Further, a regulated fund that is subject to a
performance fee but that did not pay a performance fee to its
adviser in the prior fiscal year would show zero performance fees
paid in the line item disclosure and would include the note to the
fee table required by proposed Instruction 3(b) to Item 3 of Form N-
1A and proposed Instruction 7.c. to Item 3 of Form N-2.
\127\ See proposed Instruction 6(c) to Item 3 of Form N-1A and
proposed Instruction 7.c. to Item 3 of Form N-2.
\128\ See renumbered Instruction 3(e)(ii)(A) to Item 3 of Form
N-1A; see also proposed Instruction 11.b.1 to Item 3 of Form N-2.
\129\ See proposed renumbered Instruction 3(e)(ii)(B) to Item 3
of Form N-1A; see also proposed Instruction 11.b.2 to Item 3 of Form
N-2. As in proposed renumbered Instruction 3(e)(iii) to Item 3 of
Form N-1A, proposed Instruction 11.c to Item 3 of Form N-2 would
explain that a change in ``Annual Fund Expense'' means either an
increase or a decrease in expenses that occurred during the most
recent fiscal year or that is expected to occur during the current
fiscal. A change in ``Annual Fund Expenses'' would not include a
decrease in annual expenses as a percentage of assets due to
economies of scale or breakpoints in a fee arrangement resulting
from an increase in the Registrant's assets.
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To implement our proposed performance fees line-item disclosure, we
are proposing to amend the definition of ``Management Fees'' in the fee
table instructions to exclude any fees based on the fund's
performance.\130\ Therefore, the regulated fund's base management fees
would be presented separately from any performance-based compensation
in the fee table.
---------------------------------------------------------------------------
\130\ See proposed Instruction 3(a) to Item 3 of Form N-1A;
proposed Instruction 7.a. to Item 3 of Form N-2.
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Further, we are proposing to require that the fee table expense
example include performance fees, to the extent applicable.\131\ We
recognize that the expense example currently includes management fees,
which are defined to include any performance fees. Our proposed
requirement is designed to ensure the expense example would reflect the
performance fees shown in the fee table line item and would parallel
that disclosure requirement.\132\
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\131\ See proposed Instruction 4(f) to Item 3 of Form N-1A;
proposed Instruction 12.d. to Item 3 of Form N-2.
\132\ Because the examples in Form N-1A and Form N-2 require
registrants to assume a 5 percent annual return, there may be
circumstances in which a regulated fund would not reflect a
performance fee in the example. For instance, if a New Fund, for
which past performance does not exist and the performance fee is
only payable on returns exceeding a hurdle rate or benchmark return
that is greater than 5 percent, the assumed 5 percent annual return
would not trigger a performance fee obligation, and therefore no
performance fee would be reflected in the example.
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Requiring separate disclosure regarding performance fees in the
prospectus fee table would alert an investor in an easily accessible
location and reader-friendly format that performance fees may be
payable to the regulated fund's adviser. In addition, because regulated
funds already are required to tag their fee tables using the Inline
eXtensible Business Reporting Language (``XBRL''), fee table disclosure
about performance-based compensation, including the footnote to the fee
table and the expense example, would be included in the Interactive
Data Files that are required to be submitted to the Commission.\133\
The Commission would make taxonomy changes to reflect the disclosure
revisions. The Interactive Data Files provide a structured, machine-
readable data language, which would make the fee table disclosure about
performance fees more readily available and easily accessible for
aggregation, comparison, filtering, and other analysis.
---------------------------------------------------------------------------
\133\ See General Instruction C.3.(g) to Form N-1A; General
Instruction I. to Form N-2.
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Further, our proposed prospectus fee table disclosure about
performance fees would be included in a registered open-end fund's
summary prospectus, as applicable.\134\ A registered open-end fund may
satisfy its prospectus delivery obligations by sending or giving a
summary prospectus to investors.\135\ Most open-end funds satisfy their
prospectus delivery requirements with summary prospectuses.
---------------------------------------------------------------------------
\134\ See 17 CFR 230.498 (rule 498 under the Securities Act).
Only certain disclosure items are included in the summary
prospectus. While fee table disclosure is included in the summary
prospectus, the discussion about management, organization, and
capital structure required by Item 10 of Form N-1A is not included
in the summary prospectus.
\135\ A summary prospectus uses a layered disclosure approach
designed to provide investors with key information about the
registered open-end fund in a concise more reader-friendly
presentation, with access to more detailed information available
online, or delivered in paper or electronic format upon request. See
Enhanced Disclosure and New Prospectus Delivery Option for
Registered Open-End Management Investment Companies, Investment
Company Act Rel. No. 28584 (Jan. 13, 2009) [74 FR 4546 (Jan. 26,
2009)].
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Performance Fee/Management Discussion Disclosure
Currently, in addition to fee table disclosure, the registration
statement forms for regulated funds require a description of the
investment adviser's compensation, including whether the compensation
will be based on a percentage of average net assets.\136\ While this
disclosure is important, it is not explicitly tailored to dovetail with
the requirements of the proposed amendments to rule 205-3 discussed
above.\137\
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\136\ See Item 10(a)(1)(ii)(A) of Form N-1A; Instruction 1 to
Item 9.1.b.(3) of Form N-2. These disclosure items are not required
to be included in the interactive data files submitted to the
Commission.
\137\ See supra section II.A.2; see also proposed rule 205-
3(c)(1)(iv)(C).
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Specifically, if the investment adviser's compensation includes a
performance fee, the regulated fund would be required to disclose the
following:
<bullet> The rate of the performance fee and the basis on which it
is calculated, including whether the fee is determined with reference
to realized or unrealized gains, investment income, or any combination
thereof;
<bullet> Whether the performance fee is calculated on the fund's
total investment return before or after deducting fees, commissions or
expenses;
<bullet> The measurement period over which the performance fee is
assessed;
<bullet> A description of any features that limit or condition the
payment of a performance fee to the investment
[[Page 63695]]
adviser, including, but not limited to, any preferred return, hurdle
rate, high-watermark, loss carryforward mechanism, or any other
features that limit or condition the payment of a performance fee to
the investment adviser; and
<bullet> A graphical representation that illustrates the
calculation of the performance fee across a range of hypothetical
performance scenarios.\138\
---------------------------------------------------------------------------
\138\ See proposed Item 10(a)(1)(ii)(B) of Form N-1A; proposed
Instructions 2.a.-2.e. to Item 9.1.b.(3) of Form N-2.
---------------------------------------------------------------------------
We designed these disclosure requirements to help investors
evaluate the principal components of the performance fee
arrangement.\139\
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\139\ See proposed rule 205-3(c)(1)(iv)(C). Further, regulated
funds are currently required to disclose in Form N-CSR [17 CFR
274.128] information about the basis upon which the board approved
the advisory fee under section 15(c) of the Investment Company Act.
See Item 11 of Form N-CSR; see also Item 13 of Form N-CSR. The
disclosure on Form N-CSR also would provide investors with
information about the board's evaluation of these factors.
---------------------------------------------------------------------------
Further, while not currently required to do so by the registration
statement forms, many regulated funds include graphical representations
in their prospectuses to explain how their performance fee is
calculated. These representations are helpful in explaining the
multiple components that may be part of such fees. Our proposal would
codify this practice.\140\
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\140\ See proposed Item 10(a)(1)(ii)(B)(5) of Form N-1A;
proposed Instruction 2.e. to Item 9.1.b.(3) of Form N-2.
---------------------------------------------------------------------------
We request comment on the proposed prospectus disclosure
requirements regarding performance-based compensation.
24. Form N-1A and Form N-2 require disclosure about all types of
performance-based compensation, including compensation based on
measures other than capital gains or capital appreciation. Consistent
with section 205 of the Advisers Act, however, Form ADV defines
performance-based fees as fees based on capital gains on or capital
appreciation of the assets of the client.\141\ Should the Commission
revise the definition of performance-based fees in Form ADV to include
other measures of performance besides capital gains or capital
appreciation?
---------------------------------------------------------------------------
\141\ See section 205(a) of the Advisers Act; see Glossary of
Terms to Form ADV, definition no. 48.
---------------------------------------------------------------------------
25. Currently, management fees are defined, for purposes of the
prospectus fee table line-item disclosure, as including performance
fees. Under our proposal, the definition of management fees would be
revised to exclude performance fees for the fee table line-item
disclosure. Would our proposal to exclude performance fees from the
definition of management fees and require distinct disclosure of
performance fees in the fee table be helpful to investors and provide
transparency about the amount of any performance fees? Would there be
complications or difficulties with separating performance fees from the
management fee line-item in the prospectus fee table? Should we require
a different presentation for performance fees in the fee table instead?
Please explain.
26. We are proposing to require that the performance fees shown in
the fee table be based on the performance fees that were payable to the
investment adviser or its affiliates during the regulated fund's most
recent prior fiscal year, accompanied by disclosure about fee
variability in both a footnote to the fee table and elsewhere in the
prospectus. Is this approach appropriate, or would such an approach be
misleading to investors? Alternatively, are there other approaches to
disclosing the amount of performance fees payable to the investment
adviser or its affiliates that would be more appropriate? For example,
should the Commission instead require disclosure in the fee table of an
average of the performance fees paid over a multi-year period, such as
three years?
27. Is the proposed fee table disclosure and the accompanying
footnote to the fee table regarding performance fees necessary in light
of the information required by proposed Item 10(a)(ii)(B) of Form N-1A
and proposed Instruction 2 to Item 9.1.b.(3) of Form N-2?
28. Should we require additional particularized fee table
disclosure about fulcrum fees? For example, should we require that
regulated funds with fulcrum fee arrangements include line-item
disclosure below the performance fees that would disclose the base fee
and any performance adjustments associated with the fulcrum fee? Are
there additional ways that would facilitate investor understanding
about the fulcrum fee in the fee table?
29. We are proposing to require that the basis on which the
performance fee is imposed be disclosed briefly in a note to the fee
table. Would the proposed note about the basis on which the performance
fee is imposed help to facilitate investor understanding about the
performance fee and assist the investor in making an informed choice
about the regulated fund? Why or why not?
30. We are proposing to require that the distinct performance fees
line-item disclosure in the fee table be located directly below the
management fees line-item. Are there other places in the fee table
where the performance fees line-item should be located?
31. A New Fund, as defined in its registration statement form, that
has an investment advisory agreement under which performance fees may
be payable to investment adviser or its affiliates would be able to
show zero performance fees payable to its investment adviser or its
affiliates on the performance fees line-item in the fee table. The
proposal would require an existing registered open-end or closed-end
fund that newly adopts a performance fee arrangement to disclose in the
fee table the performance fee that would have been payable to its
investment adviser had the performance fee arrangement been in place
during the previous fiscal year. Is this approach appropriate?
Alternatively, should we permit the existing regulated fund to show
zero performance fees in the fee table, similar to the approach for a
New Fund?
32. When presenting the expense examples in Form N-1A and Form N-2,
rather than basing any performance fees included in the examples on the
amount of the performance fees reflected in the fee table, should the
examples instead include the performance fee amounts that would be paid
under the stated assumption of a 5 percent annual return and/or an
alternative or additional assumed return rate, such as the fund's
hurdle rate or another rate sufficient to trigger the performance fee,
to ensure that performance fees are captured in the example?
33. Should the Commission require that regulated funds disclose to
shareholders, in plain English and with numerical specificity, the
amount of performance fees paid or accrued during each reporting period
that are attributable to unrealized appreciation and realized gains
separately? Should this disclosure be required elsewhere, such as in
annual reports for registered open-end funds?
34. Forms N-1A and N-2 currently require that a regulated fund
submit an interactive data file to the Commission that includes the
prospectus fee table. The data file is designed to facilitate timely
availability of important information in a structured format to
investors, their investment professionals, and other data users. For
data aggregators, the data file allows them to quickly process data and
related analysis and to share the analysis with investors. Would having
an interactive data file that includes performance fees as a distinct
fee table line-item be
[[Page 63696]]
helpful to investors, investment professionals and other data users?
35. The Commission has granted exemptive relief to sponsors to
operate actively managed exchange-traded funds (``ETFs'') that do not
provide daily portfolio transparency. Under the terms of the exemptive
relief, each non-transparent ETF uses a standard risk legend in its
prospectus, fund website, and marketing materials that highlight
certain differences between non-transparent ETFs and fully transparent
ETFs. Would a similar risk legend for regulated funds that highlight
the performance fees as compared to regulated funds without performance
fees in a standard format be useful for investors, particularly
investors in registered open-end funds who may not be familiar with
performance fees? For example, this risk legend could address how a
regulated fund with performance fees may create additional risks for
investors such as the performance fee being payable even if the
regulated fund is losing money; that basing performance fees on
unrealized gains may create risks for investors in funds that invest
primarily in securities or other assets for which market quotations are
not readily available; that the performance fees may create an
incentive for the adviser to make investments on the regulated fund's
behalf that are risky or more speculative than would be the case absent
such a compensation arrangement; that the regulated fund with the
performance fees may be more expensive than a regulated fund without
performance fees; and that these additional risks may be greater in
uncertain market conditions. If so, should the legend include a cross-
reference to prospectus disclosure about the performance fee?
36. We are proposing to require that a regulated fund include a
graphical representation of the performance fee that would include the
principal components of the performance fee. Would such a graphical
representation aid investors in understanding the economic impact of
performance fee arrangements, and are there particular design
requirements or standardization elements we should mandate to ensure
comparability across registrants? For example, should we require that
the graphical representations depict standard scenarios such as a
market that has a 10% percent investment return, a negative 10%
investment return, and a no investment return? What should the design
and/or standard elements be that we mandate across registrants? For
instance, should we require that the graphical depiction be in the form
of a bar chart, or some other format? Should we require the graphical
depiction be reflected in another location in addition to the
prospectus, such as on the fund's website?
37. Should the Commission require funds to supplement the required
graphical representation with a dynamic or interactive model or
spreadsheet that would allow investors to input their own assumptions
and observe the resulting performance fee calculations in real time?
Should funds be required to provide such an interactive tool, for
example, through the fund's website with a link to the interactive tool
provided in the fund's prospectus? Would an interactive model provide
meaningful additional value to investors beyond the static graphical
representation? What are any operational, cost, or compliance burdens
associated with creating and maintaining an interactive tool?
38. Our proposed prospectus disclosure requirements about
performance fees that may be paid to a regulated fund's adviser are
designed to complement the proposed amendments to rule 205-3 under the
Advisers Act. Are there other disclosure factors that we should
consider requiring in the regulated fund's management discussion about
the performance fee that would be helpful to investors?
b. Form N-CSR Disclosure
Form N-CSR, a combined reporting form used by registered management
investment companies to transmit shareholder reports to the Commission
as well as to report corporate governance and financial data, requires
a registered management investment company to provide disclosure about
the basis for the board's approval of its investment advisory contract.
Specifically, under Item 11 of Form N-CSR, if a fund's board of
directors has approved any investment advisory contract during the
fund's most recent half-year, the fund is required to discuss in
reasonable detail the material factors and the conclusions that formed
the basis of the board's approval, including the factors relating to
the approval of the advisory fee and any other amounts paid by the
registrant to the adviser.\142\ Although the current disclosure
requirements of Item 11 of Form N-CSR require disclosure regarding a
board's approval of advisory contracts with a performance fee of any
kind, we are proposing to amend Item 11 to include more particularized
disclosure regarding the approval of performance fees based on capital
gains in or capital appreciation of a regulated fund whose investment
adviser charges the regulated fund a performance fee pursuant to the
conditions of proposed rule 205-3(c)(1)(iv).\143\ These particularized
disclosure requirements under proposed Item 11(3) of Form N-CSR would
mirror the written findings that we are proposing that the board would
be required to make when it determines that such performance fees are
in the best interests of the regulated fund under proposed Advisers Act
rule 205-3. This disclosure would be useful for investors because it
would provide them with meaningful insight into the board's reasoning
and analysis in approving a performance fee arrangement that could
impact their returns.
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\142\ See Item 11 of Form N-CSR.
\143\ See supra section II.A.2.
---------------------------------------------------------------------------
We request comment on the proposed Form N-CSR requirements
regarding performance-based compensation.
39. Would the proposed amendments to Item 11 of Form N-CSR be
helpful to investors? Why or why not? Are there additional or different
disclosure items about performance fees that registrants should be
required to disclose on Form N-CSR? If so, what are those disclosures?
40. Disclosures on Form N-CSR are available to investors through
the Commission's EDGAR website but are not required to be sent directly
to a regulated fund's shareholders. Proxy statements, however, are
required to be sent directly to a regulated fund's shareholders. Should
the Commission require that the proposed particularized disclosure
regarding the approval of performance fees based on capital gains or
capital appreciation on Form N-CSR instead be, or also be, included in
a proxy statement on Schedule 14A filed in connection with a regulated
fund's shareholder meeting? Why or why not?
B. Additional Amendments to the ``Qualified Client'' Definition
In addition to the proposed amendments expanding the qualified
client definition to include regulated funds that meet certain
conditions, the proposal would amend rule 205-3 to modernize the
``qualified client'' definition by expanding eligibility to include
investors that satisfy the ``accredited investor'' definition under
Regulation D.\144\ Specifically, the proposed changes would amend the
definition of ``qualified client'' to include natural persons or
entities that meet the ``accredited investor'' definition and relatedly
would remove the ``qualified client'' definition's
[[Page 63697]]
separate net worth test,\145\ as well as its assets-under-management
test.\146\ These amendments would harmonize the regulatory framework
governing access to private funds by enabling advisers to funds that
already limit their investors to accredited investors (e.g., section
3(c)(1) private funds that rely on Regulation D) to enter into
performance fee arrangements without needing to additionally limit
investor eligibility by applying a separate qualified client standard.
By amending the existing definition of qualified client, the proposed
amendments would provide accredited investors, intended to capture
persons whose financial sophistication renders the protections of the
Securities Act's registration process unnecessary,\147\ with greater
access to investment products that include performance fees.
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\144\ Rule 501 of Regulation D, supra note 71.
\145\ Rule 205-3(d)(1)(ii)(A).
\146\ Rule 205-3(d)(1)(i).
\147\ See Accredited Investor Definition, Securities Act Rel.
No. 10824 (Aug. 26, 2020) [82 FR 64234 (Oct. 9, 2020)], at n.7 and
accompanying text; Regulation D Revisions; Exemption for Certain
Employee Benefit Plans, Securities Act Rel. No. 6683 (Jan. 16, 1987)
[52 FR 3015 (Jan. 30, 1987)]. See also SEC v. Ralston Purina Co.,
346 U.S. 119, 125 (1953) (taking the position that the availability
of the Section 4(a)(2) exemption ``should turn on whether the
particular class of persons affected needs the protection of the
Act. An offering to those who are shown to be able to fend for
themselves is a transaction `not involving any public offering' '').
---------------------------------------------------------------------------
Because the ``qualified client'' definition is referenced in the
definition of ``investment adviser representative'' in rule 203A-3 and
in the exceptions to a registered investment adviser's brochure
supplement delivery requirement in rule 204-3 under the Advisers Act,
the proposal would include conforming amendments to these rules.
1. Incorporation of the ``Accredited Investor'' Definition
The proposal would amend the ``qualified client'' definition to
include any natural person or company (other than a ``private
investment company'') \148\ that an investment adviser reasonably
believes is an ``accredited investor'' at the time of entering into an
investment advisory contract with such person or company.\149\
Currently, the qualified client and accredited investor definitions use
distinct eligibility thresholds. The qualified client definition uses a
$1,400,000 assets-under-management test and a $2,700,000 net worth test
in the alternative, while certain prongs of the accredited investor
definition use a $1,000,000 net worth (excluding primary residence)
test and a $200,000 ($300,000 with a spouse) income test in the
alternative but does not include an assets-under-management test.\150\
The qualified client definition uses a single net worth threshold for
natural persons and entities, while the accredited investor definition
includes a net worth test for natural persons (as noted above) and
separate $5,000,000 total assets (or investments, as applicable) tests
for entities.\151\ Additionally, the dollar thresholds in the qualified
client definition are subject to periodic inflation adjustments at
five-year intervals, whereas the accredited investor definition is not
subject to inflation adjustment.
---------------------------------------------------------------------------
\148\ Current rule 205-3(d)(3) (as proposed, rule 205-3(c)(3))
defines ``private investment company'' to include companies that
would be ``investment companies'' under the Investment Company Act
but for the exception provided by section 3(c)(1) thereof. The
proposed amendments would exclude a ``private investment company''
from gaining status as a qualified client solely by virtue of its
own status as an accredited investor. Instead, pursuant to proposed
rule 205-3(c)(1)(iii), a private investment company may qualify as a
qualified client if each of its equity owners (other than those with
respect to which compensation on the basis of a share of capital
gains or capital appreciation is not provided for) separately
qualify as qualified clients, e.g., if each is separately an
accredited investor. See infra section II.C.
\149\ See proposed rule 205-3(c)(1)(i)(A). Under Regulation D, a
person is an ``accredited investor'' if that person either comes
within one or more eligibility categories or is reasonably believed
by the issuer to do so. See rule 501(a). The requirement under the
proposed amendments to rule 205-3 that the adviser ``reasonably
believe'' a person to be an ``accredited investor'' in order for it
to be a ``qualified client'' is not intended to duplicate or
otherwise layer the reasonable belief standard set forth in
Regulation D. Instead, it is intended to ensure that such standard
reaches and applies to the adviser for purposes of rule 205-3.
\150\ See rule 501(a)(5) and (a)(6). See also supra note 72
(discussing prongs of the accredited investor definition that are
not based on net worth or income).
\151\ See rule 501(a)(5); see also rule 501(a)(1), (3), (7), (9)
and (12).
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Because of these distinct qualification thresholds under the
current regulatory framework, an investor may qualify as an accredited
investor and thus be eligible to invest in a section 3(c)(1) private
fund that relies on Regulation D to offer its interests (as well as
other issuers that rely on Regulation D), but may not meet the
definition of a ``qualified client'' necessary to invest in a section
3(c)(1) fund with a performance fee, given its higher eligibility
thresholds. This effectively prevents some accredited investors from
investing in section 3(c)(1) private funds that have performance fee
arrangements despite being otherwise qualified under Regulation D.
Including accredited investors in the definition of a ``qualified
client'' would remove this higher bar on investing in section 3(c)(1)
private funds with performance fees, which should improve access to
investment products with performance fees for accredited investors.
Additionally, the proposed changes would simplify the application
of the qualified client standard with respect to funds that already
limit their investor eligibility to accredited investors by making it
unnecessary to screen potential investors under a separate qualified
client standard in order to charge performance fees. According to Form
ADV reporting, as of the end of 2025, approximately 75% of section
3(c)(1) private funds that rely on Regulation D and are managed by
registered investment advisers limit their sales to investors who meet
the definition of qualified clients under the current rule.
In addition to section 3(c)(1) private funds that rely on
Regulation D, separately managed accounts of accredited investors (as
well as other types of advisory services to accredited investors) would
be eligible for performance fee arrangements under the proposed
amendments. Although the proposed amendments would not specify
conditions in order for an adviser to enter into a performance fee
arrangement with an accredited investor client (other than that the
client be an accredited investor), an adviser's services would remain
in this context subject to its fiduciary obligations, as well as its
other obligations under the federal securities laws. The extent and
nature of advisory compensation, including any performance fees, are
material facts relating to an advisory relationship, about which an
adviser must make full and fair disclosure in order to satisfy its
fiduciary duty.\152\ As the Commission has stated before, in applying
this fiduciary principle, ``the specific obligations that flow from the
adviser's fiduciary duty [will] depend upon what functions the adviser,
as agent, has agreed to assume for the client, its principal.'' \153\
With respect to
[[Page 63698]]
separately managed accounts of clients who are not accredited investors
and are not otherwise qualified clients under the proposed amendments,
performance fee arrangements would continue to be prohibited.
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\152\ See, e.g., Commission Interpretation Regarding Standard of
Conduct for Investment Advisers, Investment Advisers Act Rel. No.
5248 (June 5, 2019) [84 FR 33669 (July 12, 2019)].
\153\ Id. at text accompanying n.28 (``For example, the
obligations of an adviser providing comprehensive, discretionary
advice in an ongoing relationship with a retail client (e.g.,
monitoring and periodically adjusting a portfolio of equity and
fixed income investments with limited restrictions on allocation)
will be significantly different from the obligations of an adviser
to a registered investment company or private fund where the
contract defines the scope of the adviser's services and limitations
on its authority with substantial specificity (e.g., a mandate to
manage a fixed income portfolio subject to specified parameters,
including concentration limits and credit quality and maturity
ranges).'').
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An additional benefit of including accredited investors in the
definition of a qualified client would be to recognize measures of
financial sophistication that go beyond monetary thresholds or
employment with the adviser as means for meeting the qualified client
standard. In particular, the accredited investor definition includes
``[a]ny natural person holding in good standing one or more
professional certifications or designations or credentials from an
accredited educational institution that the Commission has designated
as qualifying an individual for accredited investor status.'' \154\ The
Commission used this authority in 2020 to designate as accredited
investors individuals holding in good standing the General Securities
Representative license (Series 7), the Private Securities Offerings
Representative license (Series 82), and/or the Investment Adviser
Representative license (Series 65), and may designate other
professional certifications or designations or credentials in the
future as appropriate.\155\ As such, including accredited investors as
qualified clients would address the current standard's exclusion of
persons with professional certifications or designations or credentials
who may not meet the rule's current net worth, assets-under-management
or knowledgeable employee tests but nonetheless can reasonably be
expected to have sufficient knowledge and experience in financial and
business matters to evaluate the merits and risks of a prospective
investment with performance fees.
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\154\ See rule 501(a)(10).
\155\ See, e.g., Order Designating Certain Professional Licenses
as Qualifying Natural Persons for Accredited Investor Status,
Securities Act Rel. No. 10823 (Aug. 26, 2020) [85 FR 64234 (Oct. 9,
2020)]; see also Potential Designation of Chartered Financial
Analyst Designation as Qualifying Natural Persons for Accredited
Investor Status, Potential Designation of Certified Financial
Planner Certification as Qualifying Natural Persons for Accredited
Investor Status, Potential Designations of the Investment Banking
Representative License (Series 79) and the Research Analyst License
(Series 86 and Series 87) as Qualifying Natural Persons for
Accredited Investor Status, Potential Designation Designate of
Passage of an Accredited Investor Exam to Be Developed by FINRA as
Qualifying Natural Persons for Accredited Investor Status, and
Potential Designation of U.S. Certified Public Accountants License
as Qualifying Natural Persons for Accredited Investor Status
published elsewhere in this issue of the Federal Register.
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The Commission has stated that the ``accredited investor''
definition under Regulation D is intended to capture persons whose
financial sophistication renders the protections of the Securities
Act's registration process unnecessary.\156\ Likewise, the Commission
has characterized rule 205-3 as intended to appropriately provide
``flexibility in structuring performance fee arrangements with clients
who are financially sophisticated or have the resources to obtain
sophisticated financial advice regarding the terms of these
arrangements.'' \157\ Although the monetary qualification thresholds
for natural persons in the accredited investor definition are lower
than the thresholds in the qualified client definition, accredited
investor status is already recognized as a measure for financial
sophistication that is sufficient to indicate whether an investor needs
the protections of the Securities Act's registration process or not. An
investor who is sufficiently financially sophisticated to render the
protections of the Securities Act's registration process unnecessary is
also, in the Commission's view, sufficiently financially sophisticated
to evaluate and bear the risks of an investment product with
performance fees, so as to not need the protections of the Advisers
Act's performance fee prohibition.
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\156\ See supra note 147 and accompanying text.
\157\ 1985 Adoption, supra note 37, at 48557.
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Although the Commission declined to extend eligibility as a
qualified client to persons that satisfied the accredited investor
definition when originally adopting rule 205-3 in 1985,\158\ the nature
and profile of the risks associated with performance fees arrangements
have significantly evolved with their development in the private fund
industry over the intervening decades. Performance fee arrangements
have matured to commonly include features designed to address the
prospect of excessive risk-taking that animated early concerns
regarding the use of performance fees.\159\ At the same time, the
potential impact of excluding accredited investors from accessing
investment products with performance fees has grown considerably, given
the tremendous asset growth of the private markets and the increasing
proportion of investment strategies and opportunities that are now
primarily offered through the private fund industry.\160\ Considering
these significant developments since rule 205-3's original adoption, it
is in our view no longer necessary for the protection of investors to
impose greater restrictions under rule 205-3 to access investment
products with performance fees than are imposed under Regulation D to
access private investment products.
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\158\ In the adopting release for original rule 205-3, the
Commission stated that it declined to extend client eligibility to
any natural person who met the then-minimum $200,000 individual
income test for the purpose of qualifying as an ``accredited
investor'' under Regulation D of the Securities Act of 1933. The
Commission explained its adoption of the $500,000 assets-under-
management and $1 million net-worth tests as proposed based on its
view that these ``alternative eligibility tests . . . will provide
sufficient flexibility to advisers and clients while adequately
protecting investors within the policies and purposes of the
Advisers Act.'' 1985 Adoption, supra note 37, at 48558.
\159\ See supra notes 68-70 and accompanying text. We have
historically recognized that requiring specific contractual
requirements for performance fee arrangements can inhibit the
flexibility of advisers and their clients in structuring performance
fee arrangements that may benefit both parties. See supra notes 53-
54 and accompanying text. The proposed amendments likewise would not
mandate any specific contractual requirement for performance fee
arrangements with accredited investors. Additionally, we note that
Item 6 of Form ADV Part 2A requires a registered investment adviser
that charges performance-based fees or that has a supervised person
who manages an account that pays such fees to disclose this fact. If
such an adviser also manages accounts that are not charged a
performance fee, the item also requires the adviser to discuss the
conflicts of interest that arise from its (or its supervised
person's) simultaneous management of these accounts, and to describe
generally how the adviser addresses those conflicts.
\160\ See supra note 67 and accompanying text.
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In connection with including accredited investors in the qualified
client definition, the proposal would remove from the definition of
qualified client the existing net worth test, which is currently set at
$2.7 million.\161\ As the accredited investor definition already
contains a net worth standard, with natural persons qualifying as
accredited investors if their net worth (individually or with spouse or
partner) is over $1 million (excluding their primary residence), the
existing net worth standard in the qualified client definition would
conflict with the use of the accredited investor standard. We recognize
that certain entity investors would under the proposal be subject to
the investments or assets tests (in each case requiring in excess of $5
million) set forth in the accredited investor definition,\162\ where
they would have otherwise used the $2.7 million net worth or $1.4
million assets-under-management tests set forth in the current
qualified client definition. However, we expect that the number of
entity investors that meet the definition of a qualified client under
either the net worth or the assets-under-management tests but that are
not accredited investors may be minimal as a practical matter, and we
request comment in this regard below. Furthermore, to the extent that
contractual relationships are
[[Page 63699]]
entered into prior to the effective date of the amendments if adopted,
the changes (i.e., addition of accredited investor definition to the
definition and removal of the net worth and assets under management
tests) 7would not generally apply retroactively to such contractual
relationships, subject to the transition rules set forth in rule 205-
3.\163\
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\161\ Rule 205-3(d)(1)(ii)(A); 2026 Inflation Adjustment Order,
supra note 65.
\162\ Rule 501(a)(1), (3), (7), (9), and (12).
\163\ See rule 205-3(c)(1) (``If a registered investment adviser
entered into a contract and satisfied the conditions of this section
that were in effect when the contract was entered into, the adviser
will be considered to satisfy the conditions of this section;
Provided, however, that if a natural person or company who was not a
party to the contract becomes a party (including an equity owner of
a private investment company advised by the adviser), the conditions
of this section in effect at that time will apply with regard to
that person or company.'').
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Finally, the proposal also would remove the existing inflation
adjustment provision from rule 205-3. Under current rule 205-3(e), the
Commission adjusts the net worth test and assets-under-management test
every five years by order.\164\ Because the proposal would remove these
tests from the qualified client definition, the inflation adjustment
provision in rule 205-3 would become inapplicable.
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\164\ See section 205(e) of the Advisers Act; see also 2026
Inflation Adjustment Order, supra note 65.
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We request comment on whether the Commission should amend the
``qualified client'' definition in rule 205-3 to incorporate accredited
investors under Regulation D.
41. Would amending rule 205-3 as proposed to incorporate accredited
investors into the definition of ``qualified client'' be appropriate?
Are there alternative tests or thresholds (monetary or otherwise) that
the Commission should consider for this purpose?
42. Would the proposed amendments to close the eligibility gap
between accredited investors and qualified clients for purposes of the
performance fee prohibition provide investors with greater access to
private market opportunities in practice? Would advisers that sponsor
investment products seek to expand
[…truncated; see source link]Indexed from Federal Register on October 6, 2026.
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