Review of State Investment Advisory Fee Rules
One of the things I have tried to emphasize within this blog is that there is no “one size fits all” legal solution to hedge fund formation. Each client/manager has a unique set of circumstances and will be subject to a potentially different sets of laws or regulations depending on those circumstances. This is especially true with regard to those managers who must register in a state that requires hedge fund manager registration. Because no two sets of state laws and regulations are the same, the manager must make sure that he understands the rules which are specific to his state.
High Asset Management Fees and Disclosure
One issue which comes up every now and again is whether or not disclosure will be required when the manager charges an annual asset management fee in excess of 3% of AUM. Generally regulators will require that certain disclosures be made to investors through the manager’s disclosure documents (generally in both the Form ADV and the hedge fund offering documents). Sometimes the regulator will require such disclosures based on a general provision (see CO IA fee rule discussion below) or on more explicit provisions (see 116.13(a) of the Texas Administrative Code). In either case managers will generally be required to make a prominent disclosure to investors that a 3% (or higher) annual asset management fee is in excess of industry norms and that similar advisory services may be obtained for less (whether or not this is true). While such a disclosure would, in most instances, be a best practice, managers should be aware that it may also be required if they are registered with a particular state.
State Performance Fee Rules
Like management fee disclosures, the rules for performance fees may differ based on the state of registration. For example, here are how four different states deal with performance fee issue:
Texas – Like most states, Texas allows state-registered investment advisers to charge performance fees only to those investors in a fund which are “qualified clients” as defined in Rule 205-3 of the Investment Advisers Act. This means that a hedge fund manager can only charge performance fees to investors in the fund which have a $1.5 million net worth or who have $750,000 of AUM with the manager (can be in the fund and through other accounts). See generally 116.13(b) of the Texas Administrative Code reprinted below.
New Jersey – Many states adopted laws and regulations based on the 1956 version of the Uniform Securities Act and have yet to make the most recent update to their laws and regulations (generally those found in the 2002 version of the Uniform Securities Act). Under the New Jersey laws a manager can charge performance fees to those clients with a $1 million net worth.
Indiana – similar to New Jersey, Indiana has laws which allow a manager to charge performance fees to those investors with a $1 million net worth. Additionally, Indiana allows a manager to charge performance fees or to those investors who have $500,000 of AUM with the manager (can be in the hedge fund and through other separately managed accounts). Indiana also has an interesting provision which specifies the manner in which the performance fee may be calculated – it requires that the fee be charged on a period of no less than one year. This rule is based on an earlier version of SEC Rule 205-3. What this means, essentially, is that managers who are registered in Indiana cannot charge quarterly performance fees, but must charge their performance fees only on an annual basis (or longer).
Michigan – Unlike any other state, Michigan actually forbids all performance fees for Michigan-registered investment advisors. The present statute is probably an unintended consequence of some sloppy drafting. Nonetheless, it is a regulation on the books. Hedge Fund Managers registered with Michigan, however, should see the bright spot – Michigan is in the process of updating its securities laws and regulations. This means that sometime in late 2009 or early 2010 it should be legal for investment advisors in Michigan to charge their clients a performance fee under certain circumstances (likely to mirror the SEC rules).
New York – Sometimes, states will have some wacky rules. In the case of New York, there are no rules regarding performance fees.
Other Issues
With regard to performance fees, the other issue which should be discussed with your hedge fund lawyer is whether or not the state “looks through” to the underlying investor to determine “qualified client” status. Generally most states will follow the SEC rule on this issue and look through the fund to the underlying investors to make this determination.
While these cases are just a couple of examples of the disparate treatment of similarly situated managers, they serve as a reminder that investment advisor (and securities) laws may differ wildly from jurisdiction to jurisdiction. Managers should be aware of the possibility of completely different laws and should be ready to discuss the issue with legal counsel.
The various rules discussed above have been reprinted below.
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Texas Rule
The full text of the Texas IA fee rules can be found here and are copied below.
§116.13.Advisory Fee Requirements.
(a) Any registered investment adviser who wishes to charge 3.0% or greater of the assets under management must disclose that such fee is in excess of the industry norm and that similar advisory services can be obtained for less.
(b) Any registered investment adviser who wishes to charge a fee based on a share of the capital gains or the capital appreciation of the funds or any portion of the funds of a client must comply with SEC Rule 205-3 (17 Code of Federal Regulations §275.205-3), which prohibits the use of such fee unless the client is a “qualified client.” In general, a qualified client may include:
(1) a natural person or company who at the time of entering into such agreement has at least $750,000 under the management of the investment adviser;
(2) a natural person or company who the adviser reasonably believes at the time of entering into the contract: (A) has a net worth of jointly with his or her spouse of more than $1,500,000; or (B) is a qualified purchaser as defined in the Investment Company Act of 1940, §2(a)(51)(A) (15 U.S.C. 80a-2(51)(A)); or
(3) a natural person who at the time of entering into the contract is: (A) An executive officer, director, trustee, general partner, or person serving in similar capacity of the investment adviser; or (B) An employee of the investment adviser (other than an employee performing solely clerical, secretarial, or administrative functions with regard to the investment adviser), who, in connection with his or her regular functions or duties, participates in the investment activities of such investment adviser, provided that such employee has been performing such functions and duties for or on behalf of the investment adviser, or substantially similar function or duties for or on behalf of another company for at least 12 months.
CO Rule
The full text of the Colorado laws and regulations can be found here. The fee discussion is reprinted below.
51-4.8(IA) Dishonest and Unethical Conduct
Introduction
A person who is an investment adviser or an investment adviser representative is a fiduciary and has a duty to act primarily for the benefit of its clients. While the extent and nature of this duty varies according to the nature of the relationship between an investment adviser and its clients and the circumstances of each case, an investment adviser or investment adviser representative shall not engage in dishonest or unethical conduct including the following:
J. Charging a client an advisory fee that is unreasonable in light of the type of services to be provided, the experience of the adviser, the sophistication and bargaining power of the client, and whether the adviser has disclosed that lower fees for comparable services may be available from other sources.
New Jersey
The full text of the New Jersey performance fee rules can be found here and are copied below.
13:47A-2.10 Performance fee compensation
…
(b) The client entering into the contract subject to this regulation must be a natural person or a company as defined in Rule 205-3, who the registered investment advisor (and any person acting on the investment advisor’s behalf) entering into the contract reasonably believes, immediately prior to entering into the contract, is a natural person or a company as defined in Rule 205-3, whose net worth at the time the contract is entered into exceeds $1,000,000. The net worth of a natural person shall be as defined by Rule 205-3 of the Investment Advisors Act of 1940.
http://www.njconsumeraffairs.gov/bos/bosregs.htm
Indiana
The Indiana rule can be found here and is reprinted below.
(f) The client entering into the contract must be either of the following:
(1) A natural person or a company who immediately after entering into the contract has at least five hundred thousand dollars ($500,000) under the management of the investment adviser.
(2) A person who the investment adviser and its investment adviser representatives reasonably believe, immediately before entering into the contract, is a natural person or a company whose net worth, at the time the contract is entered into, exceeds one million dollars ($1,000,000). The net worth of a natural person may include assets held jointly with that person’s spouse.
Michigan
The current law (until October 1, 2009) can be found here and is copied below.
451.502 Investment adviser; unlawful practices.
(b) It is unlawful for any investment adviser to enter into, extend, or renew any investment advisory contract unless it provides in writing all of the following:
(1) That the investment adviser shall not be compensated on the basis of a share of capital gains upon or capital appreciation of the funds or any portion of the funds of the client.
New York
No laws regarding performance fees for state registered investment advisers.
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Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website. Mr. Mallon’s legal practice, Cole-Frieman & Mallon LLP, is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund. If you are a hedge fund manager who is looking to start a hedge fund, please call Mr. Mallon directly at 415-296-8510.