On September 30, 2026, the US Securities and Exchange Commission (SEC) issued a proposed rule (the Proposal) that would amend Rule 205-3 under the Investment Advisers Act of 1940, as amended (the Advisers Act), to enable a registered investment adviser to receive performance-based compensation from a broader range of clients. The Proposal would extend eligibility to investors who satisfy the “accredited investor” definition in Regulation D under the Securities Act of 1933, as amended (the Securities Act) and would permit advisers to certain registered management investment companies and business development companies (collectively, regulated funds) to charge performance fees subject to specified conditions.Performance-Based Compensation Modernization, Release No. 33-11443 (proposed Sept. 30, 2026) [hereinafter the “Proposal”], available at https://www.sec.gov/rules-regulations/2026/09/s7-2026-28. It would also require regulated funds to provide enhanced disclosure regarding those fees in their registration statements and shareholder reports.Id.
Separately, the SEC published five notices (the Notices) requesting comment on adding professional certifications, designations, and credentials that would qualify certain natural persons as accredited investors under Rule 501(a)(10) (the Credential Prong) of Regulation D under the Securities Act.Potential Designation of Passage of an Accredited Investor Exam to Be Developed by FINRA as Qualifying Natural Persons for Accredited Investor Status, Securities Act Release No. 33-11445 (Sept. 30, 2026) [hereinafter “FINRA Exam Notice”], available at https://www.sec.gov/files/rules/other/2026/33-11445.pdf; Potential Designation of U.S. Certified Public Accountant License as Qualifying Natural Persons for Accredited Investor Status, Securities Act Release No. 33-11446 (Sept. 30, 2026) [hereinafter “CPA Notice”], available at https://www.sec.gov/files/rules/other/2026/33-11446.pdf; Potential Designation of Chartered Financial Analyst Designation as Qualifying Natural Persons for Accredited Investor Status, Securities Act Release No. 33-11447 (Sept. 30, 2026) [hereinafter “CFA Notice”], available at https://www.sec.gov/files/rules/other/2026/33-11447.pdf; Potential Designation of Certified Financial Planner Certification as Qualifying Natural Persons for Accredited Investor Status, Securities Act Release No. 33-11448 (Sept. 30, 2026) [hereinafter “CFP Notice”], available at https://www.sec.gov/files/rules/other/2026/33-11448.pdf; 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, Securities Act Release No. 33-11449 (Sept. 30, 2026) [hereinafter “Series 79/86/87 Notice”], available at https://www.sec.gov/files/rules/other/2026/33-11449.pdf.
This Client Alert summarizes the Proposal and briefly discusses the Notices.
Section 205(a)(1) of the Advisers Act prohibits a registered investment adviser from entering into an advisory contract that provides for compensation based on a share of the capital gains upon, or the capital appreciation of, a client’s funds, absent an applicable exception or exemption. Rule 205-3 under the Advisers Act exempts such performance-based arrangements where an advisory client is a “qualified client.”Section 205(a)(1) by its terms reaches only compensation calculated on the basis of a share of the capital gains in, or the capital appreciation of, the funds of a client. Compensation measured by a share of a client’s income therefore falls outside the statutory prohibition, and an adviser need not rely on Rule 205-3 — or satisfy the qualified client standard — in order to charge such a fee. Advisers should nonetheless confirm that a fee characterized as income-based is not calculated, directly or indirectly, by reference to capital gains or capital appreciation. Neither the Proposal nor the Notices would alter the treatment of income-based performance fees, which remain outside the scope of this rulemaking. Separate statutory exceptions for symmetrical fulcrum fees and for externally managed business development companies (BDCs) (up to 20% of net realized capital gains) also remain outside the scope of this rulemaking. The SEC has characterized Rule 205-3 as intended to 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.”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, 48557 (Nov. 28, 1985)].
Similarly, the SEC has described the “accredited investor” definition in Rule 501(a) of Regulation D as capturing persons “whose financial sophistication and ability to sustain the risk of loss of investment or fend for themselves renders the protections of the Securities Act’s registration process unnecessary.”See Accredited Investor Definition, Securities Act Rel. No. 10824 (Aug. 26, 2020) [85 FR 64234 (Oct. 9, 2020)]. Under the Credential Prong of the definition, the SEC is permitted to designate natural persons who hold qualifying professional certifications, designations, or credentials as satisfying “accredited investor” status. Credential Prong designations are made by SEC order following notice and an opportunity for public comment.
Under current Rule 205-3, an adviser may charge performance-based fees to clients that meet the definition of “qualified client,” which currently includes net worth and assets under management tests as well as a qualification for a “qualified purchaser,” as such term is defined in the Investment Company Act of 1940, as amended (the Investment Company Act), and a “knowledgeable employee” test.Qualified clients also include, by definition, any client the adviser reasonably believes is a “qualified purchaser” under Section 2(a)(51)(A) of the Investment Company Act, Rule 205-3(d)(1)(ii)(B), and the rule’s knowledgeable employee prong, Rule 205-3(d)(1)(iii), does not cross-reference Rule 3c-5 under the Investment Company Act but mostly tracks the “knowledgeable employee” definition set out in Rule 3c-5(a)(4). However, the two definitions are still different. The Proposal would replace the net worth and assets under management tests with an accredited investor test: any natural person or company (other than a private investment company) that the adviser “reasonably believes” to be an accredited investor under Regulation D at the time an advisory contract is entered into would be considered a qualified client for purposes of Rule 205-3. The qualified purchaser and knowledgeable employee provisions of the current rule would be retained.
Thus, the Proposal would:
The SEC noted that under the current framework, an investor may qualify as an accredited investor eligible to invest in a Section 3(c)(1) private fund relying on Regulation D yet not be a qualified client, with the result that the adviser may not charge a performance fee with respect to that investor’s interest. The Proposal would close this eligibility gap.
The Proposal is not uniformly expansive. Certain investors could fail to meet the qualified client definition. For example, entity investors that currently rely on the $2.7 million net worth or $1.4 million assets under management tests may instead be subject to the accredited investor definition’s $5 million investments or total assets tests, and investors that are not accredited investors but currently qualify via the $1.4 million assets under management test would be excluded. The latter may include non-accredited investors whose liabilities reduce net worth below the accredited investor definition’s $1 million net worth threshold. In practice, the SEC expects both groups to be minimal because non-accredited investors generally may not participate in exempt offerings, but it has requested comment on this point.
Under current Rule 205-3(b), when a client is (1) a private fund relying on the exemption provided by Section 3(c)(1) of the Investment Company Act, or (2) a regulated fund, an adviser must “look through” the fund and treat each equity owner as the client, with the result that the adviser may charge a performance fee only if each equity owner of the fund that will bear the fee is a qualified client. The Proposal would replace this look-through provision with proposed Rules 205-3(c)(1)(iii) and (iv).
Proposed Rule 205-3(c)(1)(iii) would provide that a Section 3(c)(1) private investment company is a qualified client only if each equity owner of the private investment company is a qualified client, except for equity owners with respect to which the adviser does not charge performance-based compensation. A Section 3(c)(1) private investment company cannot qualify on the basis of its own accredited investor status.
Proposed Rule 205-3(c)(1)(iv) would provide that a regulated fund is a qualified client if either each equity owner is a qualified client or the fund satisfies the fund level conditions described above, without the exception for equity owners not charged a performance fee because regulated funds may not vary advisory fee terms from shareholder to shareholder under Section 18(a) of the Investment Company Act and Rule 18f-3 thereunder.
If adopted, the Proposal would not generally apply retroactively to existing advisory contractual relationships, subject to the prior transition rules set forth in Rule 205-3. Compliance would continue to be measured against the conditions of Rule 205-3 in effect when the contract was entered into, meaning that an adviser could continue to charge performance fees under an existing contract with existing clients and investors — and would not need to renew those arrangements — even if an existing client or investor would not qualify as a qualified client under the amended definition. This grandfathering provision is contract-specific, meaning if a natural person or company that was not a party to the contract later becomes a party, including by becoming an equity owner of a private investment company advised by the adviser, the conditions in effect at that time would apply with regard to that person or company. However, a transfer of an equity ownership interest in a private investment company by gift or bequest, or pursuant to an agreement related to a legal separation or divorce, would not cause the transferee to become a party for this purpose.Proposal, supra note 1.
The Notices request public comment on adding additional Credential Prong designations for individuals who:
Each listed credential or credential pathway would independently qualify a natural person as an “accredited investor.” If adopted as described in the Notices, verification of accredited investor status would vary by credential: the CFA Institute and CFP Board maintain public websites; FINRA would provide a verification process for the accredited investor examination, which would be valid for 10 years before retesting would be required; CPA verification would generally be available through NASBA-sourced CPAVerify, and BrokerCheck would verify the Series 79 and Series 86 and 87 licenses.FINRA Exam Notice, supra note 2; CPA Notice, supra note 3; CFA Notice, supra note 3; CFP Notice, supra note 3; Series 79/86/87 Notice, supra note 3. If the Notices are adopted, they would broaden the category of individuals permitted to participate in offerings under Rule 506 of Regulation D.
|
Issue |
Proposed Change / Practical Implication |
|
Qualified Client Standard |
Replace net worth ($2.7M) and assets under management ($1.4M) tests with accredited investor definition, with the adviser subject to “reasonable belief” standard. The change is not uniformly expansive: certain investors currently qualifying under those tests could fall outside the new standard. The current qualified purchaser and knowledgeable employee prongs of the qualified client definition are retained without any changes. |
|
Inflation Adjustment |
Eliminate five-year inflation adjustment mechanism (no longer needed). |
|
Look-Through |
For Section 3(c)(1) private funds, proposed Rule 205-3(c)(1)(iii) would require each equity owner to be a qualified client, except owners with respect to which the adviser does not charge a performance fee. For regulated funds, proposed Rule 205-3(c)(1)(iv) would require either that each equity owner be a qualified client — without that exception, because advisory fee terms may not vary among shareholders — or that the fund qualify under the fund level conditions described above. The specific adviser exception is removed as advisers would generally qualify as accredited investors. |
|
Transition |
The changes would not generally apply retroactively to existing contractual relationships, subject to the existing transition rules set forth in Rule 205-3. |
|
Comment Period |
60 days after Federal Register publication. |
|
Regulated Funds |
Permits advisers to registered open‑end funds, closed‑end funds, and BDCs (excluding UITs and Form N‑3 separate accounts) to charge performance fees capped at 20% of net capital gains or net capital appreciation over a specified period or as of definite dates, subject to specified conditions, including board best‑interest findings. Unlike the Section 205(b)(3) BDC exception, the Rule would reach net unrealized appreciation as well as realized gains. Separately, proposed amendments to Forms N‑1A, N‑2, and N‑CSR would require enhanced disclosure of performance fees in prospectuses and Form N‑CSR filings. |
The authors would like to thank Grace LaBue for her contribution to this Client Alert.