Exemption To Allow Investment Advisers To Charge Fees Based Upon a Share of Capital Gains Upon or Capital Appreciation of a Client's Account

SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 275

[Release No. IA-1682, File No. S7-29-97]

RIN 3235-AH25

Exemption To Allow Investment Advisers To Charge Fees Based Upon

a Share of Capital Gains Upon or Capital Appreciation of a Client's

Account

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Commission is proposing amendments to the rule under the

Investment Advisers Act of 1940 that permits investment advisers to

charge certain clients performance or incentive fees. The amendments

would modify the rule's criteria for clients eligible to enter into a

contract under which a performance fee is charged and eliminate

provisions specifying required contract terms and disclosures. The

amendments would provide investment advisers greater 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.

DATES: Comments must be received on or before January 20, 1998.

ADDRESSES: Comments should be submitted in triplicate to Jonathan G.

Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street,

N.W., Stop 6-9, Washington, D.C. 20549. Comments also may be submitted

electronically at the following E-mail address: [email protected].

All comment letters should refer to File No. S7-29-97; this file number

should be included on the subject line if E-mail is used. Comment

letters will be available for public inspection and copying in the

Commission's Public Reference Room, 450 Fifth Street, N.W., Washington,

D.C. 20549. Electronically submitted comment letters also will be

posted on the Commission's Internet web site (http://www.sec.gov).

tters should refer to File No. S7-29-97; this file number

should be included on the subject line if E-mail is used. Comment

letters will be available for public inspection and copying in the

Commission's Public Reference Room, 450 Fifth Street, N.W., Washington,

D.C. 20549. Electronically submitted comment letters also will be

posted on the Commission's Internet web site (http://www.sec.gov).

FOR FURTHER INFORMATION CONTACT: Kathy D. Ireland, Attorney, or

Jennifer S. Choi, Special Counsel, at (202) 942-0716, Task Force on

Investment Adviser Regulation, Division of Investment Management, Stop

10-6, Securities and Exchange Commission, 450 Fifth Street, N.W.,

Washington, D.C. 20549.

SUPPLEMENTARY INFORMATION: The Commission is requesting public comment

on proposed amendments to rule 205-3 [17 CFR 275.205-3] under the

Investment Advisers Act of 1940 [15 U.S.C. 80b-1 et seq.] (``Advisers

Act'').

Table of Contents

Executive Summary

I. Background

II. Discussion

A. Elimination of Specific Contractual and Disclosure

Requirements

B. Qualified Clients

C. Identification of the Client

D. Transition Rule

E. General Request for Comment

III. Cost-benefit Analysis

IV. Summary of Regulatory Flexibility Analysis

V. Statutory Authority

Text of Proposed Rule Amendments

Executive Summary

Rule 205-3 under the Advisers Act permits investment advisers to

charge performance fees to clients with at least $500,000 under the

adviser's management or with a net worth of more than $1,000,000. The

rule requires certain terms to be included in contracts providing for

performance fees and specific disclosures to be made to clients

entering into these contracts. The Commission is proposing to eliminate

the provisions of the rule that prescribe contractual terms and require

specific disclosures

least $500,000 under the

adviser's management or with a net worth of more than $1,000,000. The

rule requires certain terms to be included in contracts providing for

performance fees and specific disclosures to be made to clients

entering into these contracts. The Commission is proposing to eliminate

the provisions of the rule that prescribe contractual terms and require

specific disclosures. In addition, the Commission is proposing to

revise the threshold levels for determining client eligibility to

reflect the effects of inflation on the levels set in 1985 when the

rule was adopted and to add a third criterion for eligibility. Under

the proposed amendments, eligible clients must have assets under

management with the adviser of at least $750,000, net worth of more

than $1,500,000, or be ``qualified purchasers'' under section

2(a)(51)(A) of the Investment Company Act of 1940 (``Investment Company

Act'').1

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\1\ 15 U.S.C. 80a-2(a)(51)(A).

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I. Background

Section 205(a)(1) of the Advisers Act generally prohibits an

investment adviser from entering into, extending, renewing, or

performing any investment advisory contract that provides for

compensation to the adviser based on a share of capital gains on, or

capital appreciation of, the funds or any portion of the funds of the

client.2 Congress enacted the prohibition against

performance fees in 1940 to protect advisory clients from compensation

arrangements that it believed might encourage advisers to take undue

risks with client funds to increase advisory fees.3

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on, or

capital appreciation of, the funds or any portion of the funds of the

client.2 Congress enacted the prohibition against

performance fees in 1940 to protect advisory clients from compensation

arrangements that it believed might encourage advisers to take undue

risks with client funds to increase advisory fees.3

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\2\ 15 U.S.C. 80b-5(a)(1).

\3\ H.R. Rep. No. 2639, 76th Cong., 3d Sess. 29 (1940).

Performance fees were characterized as ``heads I win, tails you

lose'' arrangements in which the adviser had everything to gain if

successful and little, if anything, to lose if not. S. Rep. No.

1775, 76th Cong., 3d Sess. 22 (1940). See also SEC, Investment

Trusts and Investment Companies, H.R. Doc. No. 477, 76th Cong., 3d

Sess. 30 (1939). Congress, however, recognized that performance fees

may not be harmful in every context and initially excluded from the

prohibition contracts between investment advisers and investment

companies. Investment Advisers Act of 1940, ch. 686, Sec. 205(1), 54

Stat. 847, 852 (1940) (amended 1970).

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In 1970, Congress provided an exception from the prohibition in

section 205(a)(1) for advisory contracts relating to the investment of

assets in excess of $1,000,000,4 so long as an appropriate

``fulcrum fee'' is used.5 This

statutory exception was the only provision under which advisers could

enter into performance fee contracts with so-called ``high net worth''

clients until 1985 when the Commission adopted rule 205-3.6

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elating to the investment of

assets in excess of $1,000,000,4 so long as an appropriate

``fulcrum fee'' is used.5 This

statutory exception was the only provision under which advisers could

enter into performance fee contracts with so-called ``high net worth''

clients until 1985 when the Commission adopted rule 205-3.6

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\4\ Trusts, governmental plans, collective trust funds, and

separate accounts referred to in section 3(c)(11) of the Investment

Company Act [15 U.S.C. 80a-3(c)(11)] are not eligible for this

exception from the performance fee prohibition under section

205(b)(2)(B) of the Advisers Act [15 U.S.C. 80b-5(b)(2)(B)].

\5\ 15 U.S.C. 80b-5(b). A fulcrum fee generally involves

averaging the adviser's fee over a specified period and increasing

and decreasing the fee proportionately with the investment

performance of the company or fund in relation to the investment

record of an appropriate index of securities prices. See Adoption of

Rule 205-2 Under the Investment Advisers Act of 1940, as Amended,

Defining ``Specified Period'' Over Which the Asset Value of the

Company or Fund Under Management is Averaged, Investment Advisers

Act Release No. 347 (Nov. 10, 1972) (37 FR 24895 (Nov. 23, 1972));

Adoption of Rule 205-1 Under the Investment Advisers Act of 1940

Defining ``Investment Performance'' of an Investment Company and

``Investment Record'' of an Appropriate Index of Securities Prices,

Investment Advisers Release No. 327 (Aug. 8, 1972) (37 FR 17467

(Aug. 29, 1972)).

In 1980, Congress added an exception for contracts involving

business development companies under conditions set forth in section

205(b)(3) of the Advisers Act (15 U.S.C. 80b-5(b)(3)).

\6\ Rule 205-3 was adopted under section 206A of the Advisers

Act (15 U.S.C. 80b-6a), which grants the Commission general

exemptive authority. In providing this authority, Congress noted

that the Commission would be able to ``exempt persons . .

for contracts involving

business development companies under conditions set forth in section

205(b)(3) of the Advisers Act (15 U.S.C. 80b-5(b)(3)).

\6\ Rule 205-3 was adopted under section 206A of the Advisers

Act (15 U.S.C. 80b-6a), which grants the Commission general

exemptive authority. In providing this authority, Congress noted

that the Commission would be able to ``exempt persons . . . from the

bar on performance-based advisory compensation'' in appropriate

cases. H.R. Rep. No. 1382, 91st Cong., 2d Sess. 42 (1970); S. Rep.

No. 184, 91st Cong., 1st Sess. 46 (1969).

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Under rule 205-3, an adviser may charge performance fees to a

client that has $500,000 under management with the adviser or has a net

worth of $1,000,000. Because of their wealth, financial knowledge, and

experience, the Commission presumed that these clients are less

dependent on the protections provided by the Advisers Act's

restrictions on performance fee arrangements.7 The rule,

however, imposes a number of required provisions on performance fee

contracts and obligates the adviser to provide certain disclosures to

clients. These provisions were included as ``alternative safeguards to

the statutory prohibition.'' 8

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\7\ Exemption to Allow Registered Investment Advisers to Charge

Fees Based Upon a Share of Capital Gains Upon or Capital

Appreciation of a Client's Account, Investment Advisers Act Release

No. 996 (Nov. 14, 1985) (50 FR 48556 (Nov. 26, 1985)).

\8\ Id. at Section I.C.

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\7\ Exemption to Allow Registered Investment Advisers to Charge

Fees Based Upon a Share of Capital Gains Upon or Capital

Appreciation of a Client's Account, Investment Advisers Act Release

No. 996 (Nov. 14, 1985) (50 FR 48556 (Nov. 26, 1985)).

\8\ Id. at Section I.C.

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In 1992, the Commission's Division of Investment Management issued

a report concluding that the existing exemptions from the performance

fee prohibition should be expanded to permit certain sophisticated

clients of investment advisers to enter into arrangements without the

restrictions in the statutory or administrative exemptions.9

The Division expressed the 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.'' 10 The Division

recommended that Congress enact legislation specifically authorizing

the Commission to provide exemptions from the performance fee

prohibition for advisory contracts with any person whom the Commission

determined did not need the protections of the

prohibition.11 Four years later, Congress included in the

National Securities Markets Improvement Act of 1996 (``1996 Act'')

12 two additional statutory exceptions from the performance

fee prohibition 13 and new section 205(e) of the Advisers

Act, which authorizes the Commission to exempt conditionally or

unconditionally from the performance fee prohibition advisory contracts

with persons that the Commission determines do not need its

protections.14

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ditional statutory exceptions from the performance

fee prohibition 13 and new section 205(e) of the Advisers

Act, which authorizes the Commission to exempt conditionally or

unconditionally from the performance fee prohibition advisory contracts

with persons that the Commission determines do not need its

protections.14

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\9\ See Division of Investment Management, U.S. Securities and

Exchange Commission, Protecting Investors: A Half Century of

Investment Company Regulation 237-49 (1992) (``Protecting

Investors'').

\10\ Id. at 245.

\11\ Id. at 245, 247-48.

\12\ Pub. L. No. 104-290, 110 Stat. 3416 (1996) (codified in

scattered sections of the U.S. Code).

\13\ Section 210 of the 1996 Act added to section 205 of the

Advisers Act exceptions for contracts with companies excepted from

the definition of investment company by section 3(c)(7) of the

Investment Company Act [15 U.S.C. 80a-3(c)(7)] and contracts with

persons who are not residents of the United States. The definition

of ``person'' under section 202 of the Advisers Act includes

companies, which in turn includes corporations, partnerships,

associations, joint-stock companies, trusts and organized groups of

persons [15 U.S.C. 80b-2(a)(5), (16)]; therefore, the exception for

foreign residents includes foreign investment companies.

\14\ 15 U.S.C. 80b-5(e). Section 205(e) provides that the

Commission may determine that persons may not need the protections

of section 205(a)(1) 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].''

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II. Discussion

A. Elimination of Specific Contractual and Disclosure Requirements

, 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].''

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II. Discussion

A. Elimination of Specific Contractual and Disclosure Requirements

As noted above, rule 205-3 contains several conditions on advisers

entering into performance fee contracts in addition to those related to

the eligibility of clients.\15\ First, the compensation provided to the

adviser under the contract must be based on the performance of

securities that is calculated pursuant to two different methodologies

specified in the rule, depending upon the nature of the securities

under management.16 In addition, the performance fee must be

based on the gains less the losses in the client's account for a period

of not less than one year.17 Second, the investment adviser

must disclose to the client, or to the client's independent agent,

prior to entering into the contract, all material information

concerning the proposed advisory arrangement, including: (1) the

possibility that the arrangement may create an incentive for the

adviser to make riskier or more speculative investments; (2) the fact

(if applicable) that the adviser may receive increased compensation

based on unrealized appreciation as well as realized gains; (3) the

periods that will be used to measure investment performance and their

significance in the computation of the fee; (4) the nature and

significance of any index that will be used as a comparative measure of

investment performance, and why the index is appropriate; and (5) if

the fee is based on unrealized appreciation of securities for which

market quotations are not readily available, how the securities will be

valued and the extent to which the value will be determined

independently.18 Finally, the adviser must reasonably

believe that the contrac

that will be used as a comparative measure of

investment performance, and why the index is appropriate; and (5) if

the fee is based on unrealized appreciation of securities for which

market quotations are not readily available, how the securities will be

valued and the extent to which the value will be determined

independently.18 Finally, the adviser must reasonably

believe that the contract represents an arm's-length arrangement and

that the client, alone or together with an independent agent,

understands the proposed compensation arrangement and its

risks.19

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\15\ Before the enactment of the 1996 Act, rule 205-3 was

available only to Commission-registered investment advisers. Title

III of the 1996 Act, the Coordination Act, which became effective on

July 8, 1997, generally limited Commission registration to larger

investment advisers but continued the application of the prohibition

of section 205(a)(1) of the Advisers Act to all advisers (other than

those exempt from registration pursuant to section 203(b) of the Act

[15 U.S.C. 80b-3(b)]), regardless of whether they are prohibited

from registering with the Commission pursuant to the Coordination

Act. 1996 Act, supra note 12. In light of this provision, the

Commission amended rule 205-3 earlier this year to permit all

advisers to take advantage of the limited exemption in the rule.

Rules Implementing Amendments to the Investment Advisers Act of

1940, Investment Advisers Act Release No. 1633 (May 15, 1997) [62 FR

28112 (May 22, 1997)] (``Implementing Release''). The proposed

amendments herein also include conforming changes to the May 1997

rule amendments.

\16\ If market quotations for the securities involved are

readily available, then the formula must include realized capital

losses and unrealized capital depreciation of the securities

Investment Advisers Act Release No. 1633 (May 15, 1997) [62 FR

28112 (May 22, 1997)] (``Implementing Release''). The proposed

amendments herein also include conforming changes to the May 1997

rule amendments.

\16\ If market quotations for the securities involved are

readily available, then the formula must include realized capital

losses and unrealized capital depreciation of the securities. If

market quotations are not readily available, then the formula still

must include realized capital losses, but need not include

unrealized capital depreciation unless it also includes unrealized

capital appreciation. Rule 205-3(c)(1), (2) [17 CFR 275.205-3(c)(1),

(2)].

\17\ Rule 205-3(c)(3) [17 CFR 275.205-3(c)(3)].

\18\ Rule 205-3(d) [17 CFR 275.205-3(d)].

\19\ Rule 205-3(e) [17 CFR 275.205-3(e)]. The rule also contains

a number of definitions of terms necessitated by these conditions,

including ``affiliated person,'' ``client's independent agent,''

``interested person,'' ``securities for which market quotations are

readily available,'' and ``securities for which market quotations

are not readily available.'' Rule 205-3(g)(3)-(6) [17 CFR 275.205-

3(g)(3)-(6)].

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Whether these provisions are necessary to protect sophisticated

clients of the type contemplated by rule 205-3 was examined by the

Division of Investment Management in 1992. The Commission agrees with

the Division's conclusion that if a client appreciates the risk of

performance fees and is in a position to protect itself from

overreaching by the adviser, then the terms of the arrangement are best

left to

provisions are necessary to protect sophisticated

clients of the type contemplated by rule 205-3 was examined by the

Division of Investment Management in 1992. The Commission agrees with

the Division's conclusion that if a client appreciates the risk of

performance fees and is in a position to protect itself from

overreaching by the adviser, then the terms of the arrangement are best

left to

the client.20 While the conditions of rule 205-3 are

intended to protect clients, the Commission's experience with the rule

suggests they also may inhibit flexibility of advisers and their

clients in establishing performance fee arrangements beneficial to both

parties. Moreover, in light of the other protections provided by the

Advisers Act, the Commission believes that these clients may not need

the protections of the rule.21 Therefore, the Commission

believes that the conditions may not be necessary to protect these

types of clients and proposes, pursuant to its exemptive authority

under new section 205(e) of the Advisers Act, to eliminate all of the

contractual and disclosure provisions in rule 205-3 other than the

client eligibility tests.

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\20\ See Protecting Investors, supra note 9, at 245.

\21\ Advisers are regarded as fiduciaries who are required to

deal fairly with their clients and to make full and fair disclosure

of, among other things, their compensation agreements. See SEC v.

Capital Gains Research Bureau, 375 U.S. 180, 194 (1963). In

addition, advisers registered with the Commission are required to

provide their clients with a brochure describing their fee

arrangements. See Part II of Form ADV.

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make full and fair disclosure

of, among other things, their compensation agreements. See SEC v.

Capital Gains Research Bureau, 375 U.S. 180, 194 (1963). In

addition, advisers registered with the Commission are required to

provide their clients with a brochure describing their fee

arrangements. See Part II of Form ADV.

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Under the proposed rule amendments, performance fee contracts would

no longer be subject to the prescribed contract terms and disclosures.

Thus, an adviser would be free to negotiate all of the terms of a

performance fee contract with a client. The Commission emphasizes,

however, that an adviser charging a performance fee would continue to

be subject to the Advisers Act's prohibitions against

fraud.22 As a result, an adviser could not enter into a

performance fee arrangement that was inconsistent with the adviser's

fiduciary duties and could not fail to disclose material information

about the performance fee to the client.23

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\22\ Section 206 of the Advisers Act [15 U.S.C. 80b-6].

\23\ The proposed amendments also would eliminate paragraph (h)

of the current rule, which states that ``[a]n investment adviser

entering into or performing an investment advisory contract under

this rule is not relieved of any obligations under section 206 of

the Advisers Act or of any other applicable provisions of the

federal securities laws.'' The Commission believes that the proposed

rule amendments by their terms provide an exemption only from

section 205(a)(1), and that separate reference to section 206 and

other provisions of the federal securities laws is unnecessary

under

this rule is not relieved of any obligations under section 206 of

the Advisers Act or of any other applicable provisions of the

federal securities laws.'' The Commission believes that the proposed

rule amendments by their terms provide an exemption only from

section 205(a)(1), and that separate reference to section 206 and

other provisions of the federal securities laws is unnecessary. By

proposing to eliminate this reference, the Commission does not

intend in any way to suggest that compliance with the amended rule

would relieve advisers of any obligations under section 206 of the

Advisers Act or of any other applicable provisions of the federal

securities laws.

The Commission further notes that advisers entering into

performance fee arrangements with employee benefit plans covered by

the Employee Retirement Income Security Act of 1974 (``ERISA'') are

subject to the fiduciary responsibility and prohibited transaction

provisions of ERISA. 29 U.S.C. 1001-1461. The proposed amendments to

rule 205-3 would not affect an adviser's obligation to comply with

ERISA. Issues involving performance fee arrangements under ERISA are

within the jurisdiction of the Department of Labor, which is

responsible for administering ERISA's fiduciary provisions and has

addressed performance fee arrangements in a number of advisory

opinions under ERISA. U.S. Department of Labor Advisory Opinion No.

89-28A (Sept. 25, 1989); U.S. Department of Labor Advisory Opinion

86-21A (Aug. 29, 1986); U.S. Department of Labor Advisory Opinion

86-20A (Aug. 29, 1986).

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's fiduciary provisions and has

addressed performance fee arrangements in a number of advisory

opinions under ERISA. U.S. Department of Labor Advisory Opinion No.

89-28A (Sept. 25, 1989); U.S. Department of Labor Advisory Opinion

86-21A (Aug. 29, 1986); U.S. Department of Labor Advisory Opinion

86-20A (Aug. 29, 1986).

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Comment is requested on whether rule 205-3 should be amended to

eliminate all of the contractual and disclosure requirements for

sophisticated clients. Should the ``arm's-length contract'' or any of

the other provisions be retained? Are certain conditions on performance

fee contracts necessary to protect even clients the Commission presumes

are able to protect themselves? Are there alternative conditions that

should be considered?

B. Qualified Clients

As noted above, in adopting rule 205-3 in 1985, the Commission

concluded that clients having a net worth in excess of $1,000,000, or

assets under management of at least $500,000, do not need the full

protections provided by the Advisers Act's restrictions on performance

fee arrangements.24 The Commission believes that a similar

finding by the Commission would support the proposed expansion of the

exemption under the new authority granted the Commission last year in

section 205(e) of the Advisers Act.25

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\24\ See supra note 7 and accompanying text.

\25\ See supra note 14 and accompanying text.

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would support the proposed expansion of the

exemption under the new authority granted the Commission last year in

section 205(e) of the Advisers Act.25

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\24\ See supra note 7 and accompanying text.

\25\ See supra note 14 and accompanying text.

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The Commission recognizes that, since 1985, the net worth and

assets under management thresholds have been affected by inflation:

$1,000,000 in 1985 dollars is now worth approximately $1,521,000; and

$500,000 in 1985 dollars is now worth approximately $760,000. The

Commission therefore proposes to increase the amounts of the net worth

and assets under management tests from $1,000,000 and $500,000 to

$1,500,000 and $750,000, respectively. This increase is not intended to

reduce the number or to alter the types of clients with which an

adviser may enter into a performance fee arrangement, but to reflect

the effects of inflation on the rule.

The Commission also is proposing to permit advisers to enter into

performance fee contracts with clients who are ``qualified

purchaser[s]'' under section 2(a)(51)(A) of the Investment Company

Act.26 The 1996 Act amended the Investment Company Act,

among other things, to add new section 3(c)(7), which exempts from

regulation under the Investment Company Act certain investment pools

whose interests are not offered to the public and whose shareholders

consist primarily of ``qualified purchasers,'' including individuals

with at least $5,000,000 of investments.27 Although, in most

cases, persons who would be qualified purchasers under section

2(a)(51)(A) would be eligible to enter into a performance fee contract

with advisers under rule 205-3, even as proposed to be amended, in some

cases, such persons would not.28 Therefore, the Commission

proposes to add ``qualified purchasers'' as eligible clients under the

rule so that an investor who meets the eligibility requ

st

cases, persons who would be qualified purchasers under section

2(a)(51)(A) would be eligible to enter into a performance fee contract

with advisers under rule 205-3, even as proposed to be amended, in some

cases, such persons would not.28 Therefore, the Commission

proposes to add ``qualified purchasers'' as eligible clients under the

rule so that an investor who meets the eligibility requirements of

section 3(c)(7) also could enter into a performance fee arrangement

outside the context of a section 3(c)(7) company.29

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\26\ See supra note 1.

\27\ 15 U.S.C. 80a-3(c)(7).

\28\ For example, in determining the amount of investments for

purposes of the definition of qualified purchaser, only outstanding

indebtedness incurred to acquire or for the purpose of acquiring the

investments must be deducted. Rule 2a51-1(e) of the Investment

Company Act (17 CFR 270.2a51-1(e)). See also Privately Offered

Investment Companies, Investment Company Act Release No. 22597 (Apr.

3, 1997) (62 FR 17512 (Apr. 9, 1997)). Thus, a person with less than

$750,000 in assets under management could have over $5,000,000 of

investments, but a net worth of less than $1,500,000 because of

other debt. Under the proposed rule amendments, such a person would

be eligible to enter into a performance fee contract under rule 205-

3.

\29\ Under section 205(b)(4)] of the Advisers Act [15 U.S.C.

80b-5(b)(4)], section 3(c)(7) companies may enter into performance

fee contracts without relying on rule 205-3. Each investor in a

section 3(c)(7) company need not satisfy the eligibility criteria

for an adviser to charge performance fees to the section 3(c)(7)

company. See infra note 36.

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f the Advisers Act [15 U.S.C.

80b-5(b)(4)], section 3(c)(7) companies may enter into performance

fee contracts without relying on rule 205-3. Each investor in a

section 3(c)(7) company need not satisfy the eligibility criteria

for an adviser to charge performance fees to the section 3(c)(7)

company. See infra note 36.

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Under the proposed amendments, clients who satisfy the new

eligibility criteria contained in rule 205-3 would be referred to as

``qualified client[s].'' 30 Comment is requested on the

revised criteria for entering into a performance fee contract and

whether the Commission should consider alternative criteria for

qualified clients. Are the criteria sufficient for the Commission to

make the required finding under section 205(e) that qualified clients

do not need the protections of the statutory prohibition on performance

fee arrangements? Rather than including the qualified purchaser as the

third alternative criterion, should the Commission use the qualified

purchaser threshold in lieu of the other two tests?

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\30\ Proposed rule 205-3(d)(1).

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In addition to criteria such as financial sophistication and

knowledge and experience in financial matters, section 205(e) permits

the Commission

to consider whether a client may not need the protections of the

Advisers Act by virtue of its relationship with the

adviser.31 Should the Commission exempt advisers that have a

pre-existing relationship with clients that suggests that the abuses

Congress sought to prevent by prohibiting performance fee arrangements

are unlikely to occur? If so, what should be the nature of those

relationships? 32

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virtue of its relationship with the

adviser.31 Should the Commission exempt advisers that have a

pre-existing relationship with clients that suggests that the abuses

Congress sought to prevent by prohibiting performance fee arrangements

are unlikely to occur? If so, what should be the nature of those

relationships? 32

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\31\ See supra note 14.

\32\ In the context of the definition of investment adviser

representative, the Commission has proposed that natural persons

with certain business or familial relationships with the supervised

person would not need the protection of state qualification

requirements. Exemption for Investment Advisers Operating in

Multiple States; Revisions to Rules Implementing Amendments to the

Investment Advisers Act of 1940, Investment Advisers Act Release No.

1681 (Nov. 13, 1997).

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Should the Commission revise the criteria to prevent the net worth

and assets under management criteria from becoming less meaningful as a

result of inflation? Should the criteria be indexed to prevent future

effective lowering of the amounts? Should the Commission adopt more

detailed criteria to assure the financial sophistication of qualified

clients if the objective thresholds are effectively decreased as result

of inflation?

C. Identification of the Client 33

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\33\ The following discussion of the identity of the ``client''

is relevant only for purposes of this rule and not for purposes of

section 206 of the Advisers Act (15 U.S.C. 80b-6).

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d as result

of inflation?

C. Identification of the Client 33

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\33\ The following discussion of the identity of the ``client''

is relevant only for purposes of this rule and not for purposes of

section 206 of the Advisers Act (15 U.S.C. 80b-6).

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Rule 205-3 provides that with respect to certain clients entering

into performance fee contracts with an adviser--private investment

companies,34 registered investment companies, and business

development companies--the adviser must ``look through'' the legal

entity to determine whether each equity owner of the company would be a

qualified client.35 The proposed amendments would retain the

``look through'' provision 36 and clarify that any equity

owners that are not charged a performance fee would not be required to

meet the qualified client test.37

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\34\ The definition of ``private investment company'' included

in paragraph (g)(1) of the current rule [17 CFR 275.205-3(g)(1)]

would continue in the amended rule to refer solely to those

companies excepted from the definition of investment company under

section 3(c)(1) of the Investment Company Act [15 U.S.C. 80a-

3(c)(1)]. Reference to section 3(c)(7) is unnecessary because, as

noted above, companies excepted from the definition of investment

company under this provision also are excepted from the performance

fee prohibition pursuant to section 205(b)(4) of the Advisers Act

(15 U.S.C. 80b-5(b)(4)).

\35\ Rule 205-3(b)(2) [17 CFR 275.205-3(b)(2)].

\36\ Proposed rule 205-3(b). The Commission is not proposing to

extend the ``look through'' provision of rule 205-3 to section

3(c)(7) companies

xcepted from the definition of investment

company under this provision also are excepted from the performance

fee prohibition pursuant to section 205(b)(4) of the Advisers Act

(15 U.S.C. 80b-5(b)(4)).

\35\ Rule 205-3(b)(2) [17 CFR 275.205-3(b)(2)].

\36\ Proposed rule 205-3(b). The Commission is not proposing to

extend the ``look through'' provision of rule 205-3 to section

3(c)(7) companies. In the 1996 Act, Congress explicitly excepted

section 3(c)(7) companies from the prohibition on performance fees

having concluded that ``investors in a qualified purchaser pool are

sophisticated enough to be allowed to enter into a fee arrangement

that is not a fulcrum fee.'' See S. REP. NO. 293, 104th Cong., 2d

Sess. 11 (1996).

\37\ Proposed rule 205-3(b). See, e.g., Hellmold Associates,

Inc. (pub. avail. Dec. 18, 1992) (adviser may receive performance

fee from certain limited partners when the fee would be based solely

on a limited partner's capital account and not based on the overall

performance of the partnership). See also Compass Investors (pub.

avail. Dec. 18, 1996).

The proposed amendments would retain the provision in rule 205-3

that an equity owner who is the investment adviser entering into the

performance fee contract need not be a qualified client.

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Comment is requested whether this ``look through'' provision should

continue to be included in rule 205-3. The Commission also requests

comment concerning whether the rule should specifically address the

application of the ``look through'' provision to other entities.

D. Transition Rule

eed not be a qualified client.

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Comment is requested whether this ``look through'' provision should

continue to be included in rule 205-3. The Commission also requests

comment concerning whether the rule should specifically address the

application of the ``look through'' provision to other entities.

D. Transition Rule

The proposed amendments would add a transition rule permitting

investment advisers and their clients to maintain their existing

performance fee arrangements notwithstanding the clients' failure to

meet the eligibility criteria after the thresholds increase to $750,000

and $1,500,000.38 Such arrangements could continue under the

transition rule if they were entered into before the effective date of

the amendments to the rule and they satisfied the requirements of the

rule as in effect on the date that they were entered into. A new party

to an existing arrangement, however, would be required to satisfy the

new qualified client test.

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\38\ Proposed rule 205-3(c).

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E. General Request for Comment

Any interested persons wishing to submit written comments on the

proposed rule amendments that are the subject of this Release, to

suggest additional changes (including changes to the provisions of the

rule that the Commission is not proposing to amend), or to submit

comments on other matters that might have an effect on the proposals

described above, are requested to do so. Commenters suggesting

alternative approaches are encouraged to submit their proposed rule

text.

III. Cost-benefit Analysis

rmance fee arrangements.40 The

Commission, however, does not have information from which to analyze

the precise effect of the proposed amendments on the number of

performance fee arrangements. Comment is requested on whether the

proposed amendments would increase or decrease the number of

performance fee arrangements.

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\39\ According to data from the 1995 Survey of Consumer Finances

conducted by the Federal Reserve Board, approximately 1,100,000

households have net worth between $1,000,000 and $1,500,000. This

figure, however, represents the net worth of households and not the

individual persons who might be clients. Furthermore, the survey

results do not address clients that are not natural persons.

\40\ The Commission knows of no information concerning the

incidence of performance fee arrangements in the United States, and

requests the submission of data concerning such incidence.

Performance fee arrangements, however, appear to be accepted

practices in many other countries. See International Survey of

Investment Adviser Regulation 15 (Marcia L. MacHarg & Roberta R. W.

Kameda eds., 1994) (noting that performance fees generally are

permitted in Australia, Brazil, Canada (Ontario, with client's

written consent), France, Germany, Italy, Japan, Spain, Switzerland

(up to 20% of net capital gain), the United Kingdom and Venezuela).

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To the extent that the proposed rule amendments increase the number

of performance fee arrangements, advisers and clients may benefit

overall.41 For example, proponents of performance fees have

argued that these arrangements may benefit both parties to the advisory

contract because linking advisory compensation to performance may

result in a closer alignment of the goals of the adviser and the

client.42 If the goals of both parties coincide, then

the number

of performance fee arrangements, advisers and clients may benefit

overall.41 For example, proponents of performance fees have

argued that these arrangements may benefit both parties to the advisory

contract because linking advisory compensation to performance may

result in a closer alignment of the goals of the adviser and the

client.42 If the goals of both parties coincide, then

the benefits of performance fee arrangements would include fewer

conflicts of interest in advisory relationships. Better alignment of

the goals of the adviser and the client might also result in more

efficient investing and allocation of capital.

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\41\ The Commission's Division of Investment Management

discussed the advantages and disadvantages of performance fees in

more detail in its 1992 study. Protecting Investors, supra note , at

239-40.

\42\ Richard Grinold & Andrew Rudd, Incentive Fees: Who Wins?

Who Loses?, 43 Fin. Analysts J. 27, 37 (Jan.-Feb. 1987); Harvey E.

Bines, The Law of Investment Management para. 5.03[2][b], at 5-43

(1978 & Supp. 1986) (observing that the principal justification for

performance fees is that they permit the uncertainty in the quality

of the product--the management of the portfolio--to be shared

between the adviser and the client).

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Proponents also claim that performance fees may encourage better

performance by rewarding good performance rather than linking

compensation and assets under management as in more traditional

arrangements.43 Thus, such arrangements may produce more

cost-effective results than arrangements with more traditional fee

structures.

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nts also claim that performance fees may encourage better

performance by rewarding good performance rather than linking

compensation and assets under management as in more traditional

arrangements.43 Thus, such arrangements may produce more

cost-effective results than arrangements with more traditional fee

structures.

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\43\ See, e.g., Stephen Lofthouse, A Fair Day's Wages for a Fair

Day's Work, 4 Journal of Investing 74, 76 (Winter 1995); Grinold &

Rudd, supra note 42, at 37; Bines, supra note 42, at 5-36 to 5-37.

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In addition, advocates of the increased use of performance fees

assert that they may encourage the establishment of new advisory

firms.44 Performance fees could result in greater

competition and produce a wider array of investment advisers and

services and lower overall advisory costs. Proponents also state that

performance fees provide an incentive for investment advisers to

service smaller accounts that otherwise might be less attractive to the

advisers.45 Furthermore, supporters argue that performance

fees permit advisers to focus on a smaller number of clients than they

otherwise would under traditional compensation arrangements by allowing

them to generate sufficient income without the necessity for a large

asset base.46 Such results also could increase the variety

of services provided to a wider array of clients, and decrease advisory

costs overall.

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\44\ Julie Roher, The Great Debate Over Performance Fees, 17

Institutional Investor 123, 124 (Nov. 1983) (stating that new firms

can begin generating profits before attracting a large asset base).

\45\ See, e.g., id.

\46\ See, e.g., id.

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rall.

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\44\ Julie Roher, The Great Debate Over Performance Fees, 17

Institutional Investor 123, 124 (Nov. 1983) (stating that new firms

can begin generating profits before attracting a large asset base).

\45\ See, e.g., id.

\46\ See, e.g., id.

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The increased use of performance fees, however, also may produce

some costs to advisory clients and the economy in general. Opponents of

advisory fees have cited the potential for the adviser under a

performance fee arrangement to engage in excessive risk taking with

respect to the client's account.47 Excessive risk taking may

result in unexpected losses to the clients, which may prompt investors

to withdraw from the market and discourage capital formation. Critics

also challenge whether there is any basis, theoretical or analytical,

for believing that performance fees will improve

performance.48 In addition, some detractors have expressed

concern that performance fees might result in discrimination against

clients that do not pay performance fees. One form of such

discrimination may be advisers devoting more of their time and

resources to clients that pay such fees.49 Such an argument

relies on an assumption, which may not be necessarily correct, that an

adviser cannot increase the amount of its advisory resources.

Nonetheless, this argument notes the potential for an increase in

conflicts of interest on the part of advisers.50

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ir time and

resources to clients that pay such fees.49 Such an argument

relies on an assumption, which may not be necessarily correct, that an

adviser cannot increase the amount of its advisory resources.

Nonetheless, this argument notes the potential for an increase in

conflicts of interest on the part of advisers.50

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\47\ Lofthouse, supra note 43, at 77; Roher, supra note 44, at

127.

\48\ Lofthouse, supra note 43, at 79 (citing the lack of

empirical data); Roher, supra note 44, at 128 (noting that

incentives for good performance already exist because advisers are

compensated on the basis of account size and must perform well to

retain their clients); Bines, supra note 42, at 5-36 (indicating

that there is no demonstrable connection between performance fees

and superior performance).

\49\ See, e.g., Lofthouse, supra note 43, at 77.

\50\ See In re McKenzie Walker Investment Management, Inc.,

Investment Advisers Act Release No. 1571 (July 16, 1996) (investment

adviser favoring its performance-fee clients in the allocation of

hot initial public offerings).

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The arguments for and against performance fee arrangements provide

no definitive answers concerning their effect on advisers, clients and

the markets in general. The costs and benefits of performance fee

arrangements in general are difficult to quantify because of their

theoretical nature. Comment is requested on whether the benefits and

costs could be quantified.

The Commission has determined to permit clients who are financially

sophisticated or have the resources to obtain sophisticated financial

advice to weigh the costs and benefits of entering into such

arrangements and to determine for themselves whether to enter into such

contracts

because of their

theoretical nature. Comment is requested on whether the benefits and

costs could be quantified.

The Commission has determined to permit clients who are financially

sophisticated or have the resources to obtain sophisticated financial

advice to weigh the costs and benefits of entering into such

arrangements and to determine for themselves whether to enter into such

contracts. Although an increase in the use of performance fees may

impose some overall costs, such costs could result from the existing

rule 205-3 even if the Commission did not adopt the proposed

amendments.

With respect to the rule amendments at issue, the Commission

believes that the proposed amendments would not impose any additional

costs on investment advisers or their clients. Once the adviser

determines that a client is qualified, the rule does not prescribe

detailed contractual requirements or require specific disclosures to

clients. The Commission has observed over the years that the detailed

conditions of the current rule raise numerous interpretive

issues.51 The proposed rule should reduce the costs of

establishing and monitoring compliance with the current rule.

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\51\ See, e.g., Valuemark Capital Management, Inc. (pub. avail.

June 4, 1997) (limited partners purchasing or redeeming mid-year

immaterial if performance fee based on performance of partnership

over a period of at least one year); Securities Industry Association

(pub. avail. Nov. 18, 1986) (use of rolling one-year periods after

initial one-year period); P.E. Becker, Inc. (pub. avail. July 21,

1986) (individual limited partners may be considered the ``client''

for purposes of the ``arm's-length'' negotiation requirement).

---------------------------------------------------------------------------

d of at least one year); Securities Industry Association

(pub. avail. Nov. 18, 1986) (use of rolling one-year periods after

initial one-year period); P.E. Becker, Inc. (pub. avail. July 21,

1986) (individual limited partners may be considered the ``client''

for purposes of the ``arm's-length'' negotiation requirement).

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Comment is requested on this cost-benefit analysis. Commentators

are requested to provide views and empirical data relating to any costs

and benefits associated with the proposed rules and performance fees in

general.

For purposes of the Small Business Regulatory Enforcement Fairness

Act of 1996, the Commission also is requesting information regarding

the potential effect of the proposed rule amendments on the economy on

an annual basis. Commentators should provide empirical data to support

their views.

IV. Summary of Regulatory Flexibility Analysis

The Commission has prepared an Initial Regulatory Flexibility

Analysis (``IRFA'') in accordance with 5 U.S.C. 603 regarding proposed

amendments to rule 205-3 under the Advisers Act. The following

summarizes the IRFA.

As set forth in greater detail in the IRFA, the 1996 Act added

section 205(e) to the Advisers Act, which authorizes the Commission to

exempt conditionally or unconditionally from the performance fee

prohibition contained in section 205(a)(1) of the Advisers Act advisory

contracts with persons that the Commission determines do not need the

protections of the prohibition

summarizes the IRFA.

As set forth in greater detail in the IRFA, the 1996 Act added

section 205(e) to the Advisers Act, which authorizes the Commission to

exempt conditionally or unconditionally from the performance fee

prohibition contained in section 205(a)(1) of the Advisers Act advisory

contracts with persons that the Commission determines do not need the

protections of the prohibition. The IRFA states that the proposed rule

amendments would liberalize rule 205-3, which permits performance fees

to be charged to sophisticated clients by eliminating required contract

terms and disclosures, update the current criteria for determining

eligible clients to reflect the effects of inflation on the current

assets under management and net worth tests, and add a new category of

eligible clients based upon the definition of ``qualified purchaser''

in section 2(a)(51)(A) of the Investment Company Act.

The IRFA sets forth the statutory authority for the proposed rule

amendments. The IRFA also discusses the effect of the proposed rule

amendments on small entities. For the purposes of the Advisers Act and

the Regulatory Flexibility Act, an investment adviser generally is a

small entity (i) if it manages assets of $50 million or less, in

discretionary or non-

discretionary accounts, as of the end of its most recent fiscal year or

(ii) if it renders other advisory services, has $50,000 or less in

assets related to its advisory business.52 The Commission

estimates that approximately 17,650 investment advisers are small

entities.53 The Commission does not have information,

however, from which to estimate either the number of clients of small

entities who would satisfy the tests of sophistication or the number of

such clients who would enter into performance fee arrangements under

the rule

ets related to its advisory business.52 The Commission

estimates that approximately 17,650 investment advisers are small

entities.53 The Commission does not have information,

however, from which to estimate either the number of clients of small

entities who would satisfy the tests of sophistication or the number of

such clients who would enter into performance fee arrangements under

the rule. The Commission, however, believes that it would be reasonable

to estimate that the overall effect of the proposed amendments to the

rule would be to increase the use of the exemption by small entities,

and that the economic effect on small entities may be significant.

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\52\ Rule 275.0-7 [17 CFR 275.0-7]. In January 1997, the

Commission proposed to revise this definition of ``small entity.''

See Definitions of ``Small Business'' or ``Small Organization''

Under the Investment Company Act of 1940, the Investment Advisers

Act of 1940, the Securities Exchange Act of 1934, and the Securities

Act of 1933, Release Nos. 33-7383, 34-38190, IC-22478, and IA-1609

(Jan. 22, 1997) (62 FR 4106 (Jan. 28, 1997)). The Commission expects

to adopt a revised definition of small investment adviser for

Regulatory Flexibility Act purposes to reflect the Coordination Act.

\53\ This estimate of the number of small entities was made for

purposes of the Final Regulatory Flexibility Analysis for the rules

implementing the Coordination Act. See Implementing Release, supra

note 15, at nn.189-190 and accompanying text. Under rule 203A-5 of

the Advisers Act, all investment advisers registered with the

Commission were required to file a completed Form ADV-T with the

Commission by July 8, 1997, indicating whether they remain eligible

for Commission registration

ry Flexibility Analysis for the rules

implementing the Coordination Act. See Implementing Release, supra

note 15, at nn.189-190 and accompanying text. Under rule 203A-5 of

the Advisers Act, all investment advisers registered with the

Commission were required to file a completed Form ADV-T with the

Commission by July 8, 1997, indicating whether they remain eligible

for Commission registration. Of the 23,350 Commission-registered

investment advisers, approximately 7,200 advisers indicated that

they remain eligible for Commission registration, 10,600 advisers

withdrew their registrations, and 5,800 advisers did not file their

Form ADV-T. The Commission believes that most of the investment

advisers that did not file the Form ADV-T are either no longer in

the advisory business or no longer eligible to register with the

Commission. The Commission expects to cancel the registrations of

most of these investment advisers. The Commission also expects to

adopt a revised definition of small entity for purposes of the

Regulatory Flexibility Act. See supra note 52. Therefore, the

Commission plans to revise its estimate of the number of advisers

that are small entities after the transition is complete so that the

Commission would have more accurate information to determine the

number of small entities under the new definition of that term.

---------------------------------------------------------------------------

atory Flexibility Act. See supra note 52. Therefore, the

Commission plans to revise its estimate of the number of advisers

that are small entities after the transition is complete so that the

Commission would have more accurate information to determine the

number of small entities under the new definition of that term.

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The IRFA states that the proposed rule amendments would not impose

any new reporting, recordkeeping or compliance requirements, and that

the Commission believes that no rules duplicate, overlap or conflict

with the proposed rule amendments.

The IRFA discusses the various alternatives considered by the

Commission in connection with the proposed rule amendments that might

minimize the effect on small entities, including (a) the establishment

of differing compliance or reporting requirements or timetables that

take into account the resources of small entities; (b) the

clarification, consolidation or simplification of compliance and

reporting requirements under the rule amendments for small entities;

(c) the use of performance rather than design standards; and (d) an

exemption from coverage of the rule or any portion of the rule, for

small entities. As discussed in more detail in the IRFA, the Commission

believes that it would be inconsistent with the purposes of the

Advisers Act to exempt small entities from the proposed rule amendments

or to use performance standards to specify different requirements for

small entities. Different compliance or reporting requirements for

small entities are not necessary because the proposed rule amendments

do not establish any new reporting, recordkeeping or compliance

requirements. The Commission has determined that it is not feasible to

further clarify, consolidate or simplify the proposed rule amendments

for small entities

pecify different requirements for

small entities. Different compliance or reporting requirements for

small entities are not necessary because the proposed rule amendments

do not establish any new reporting, recordkeeping or compliance

requirements. The Commission has determined that it is not feasible to

further clarify, consolidate or simplify the proposed rule amendments

for small entities.

The IRFA includes information concerning the solicitation of

comments with respect to the IRFA generally, and in particular, the

number of small entities that would be affected by the proposed rule

amendments. A copy of the IRFA may be obtained by contacting Kathy D.

Ireland, Securities and Exchange Commission, 450 5th Street, N.W., Mail

Stop 10-6, Washington, DC 20549.

V. Statutory Authority

The Commission is proposing amendments to rule 205-3 pursuant to

the authority set forth in section 205(e) of the Investment Advisers

Act of 1940 [15 U.S.C. 80b-5(e)].

List of Subjects in 17 CFR Part 275

Reporting and recordkeeping requirements, Securities.

Text of Proposed Rule Amendments

For the reasons set out in the preamble, Title 17, Chapter II of

the Code of Federal Regulations is proposed to be amended as follows:

PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940

1. The authority citation for Part 275 is revised to read as

follows:

Authority: 15 U.S.C. 80b-2(a)(17), 80b-3, 80b-4, 80b-6(4), 80b-

6a, 80b-11, unless otherwise noted.

Section 275.203A-1 is also issued under 15 U.S.C. 80b-3a.

Section 275.203A-2 is also issued under 15 U.S.C. 80b-3a.

Section 275.204-2 is also issued under 15 U.S.C. 80b-6.

Section 275.205-3 is also issued under 15 U.S.C. 80b-5(e).

2. Section 275.205-3 is revised to read as follows:

Sec. 275.205-3 Exemption from the compensation prohibition of section

205(a)(1) for investment advisers.

ted.

Section 275.203A-1 is also issued under 15 U.S.C. 80b-3a.

Section 275.203A-2 is also issued under 15 U.S.C. 80b-3a.

Section 275.204-2 is also issued under 15 U.S.C. 80b-6.

Section 275.205-3 is also issued under 15 U.S.C. 80b-5(e).

2. Section 275.205-3 is revised to read as follows:

Sec. 275.205-3 Exemption from the compensation prohibition of section

205(a)(1) for investment advisers.

(a) General. The provisions of section 205(a)(1) of the Act (15

U.S.C. 80b-5(a)(1)) will not be deemed to prohibit any investment

adviser from entering into, performing, renewing or extending an

investment advisory contract that provides for compensation to the

investment adviser on the basis of a share of the capital gains upon,

or the capital appreciation of, the funds, or any portion of the funds,

of a client, Provided, That the client entering into the contract

subject to this section is a qualified client, as defined in paragraph

(d)(1) of this section.

(b) Identification of the client. In the case of a private

investment company, as defined in paragraph (d)(3) of this section, an

investment company registered under the Investment Company Act of 1940,

or a business development company, as defined in section 202(a)(22) of

the Act (15 U.S.C. 80b-2(a)(22)), each equity owner of any such company

(except for the investment adviser entering into the contract and any

other equity owners not charged a fee on the basis of a share of

capital gains or capital appreciation) will be considered a client for

purposes of paragraph (a) of this section.

0,

or a business development company, as defined in section 202(a)(22) of

the Act (15 U.S.C. 80b-2(a)(22)), each equity owner of any such company

(except for the investment adviser entering into the contract and any

other equity owners not charged a fee on the basis of a share of

capital gains or capital appreciation) will be considered a client for

purposes of paragraph (a) of this section.

(c) Transition rule. An investment adviser that entered into a

contract before [insert the effective date of the final rule] and

satisfied the conditions of this section as in effect on the date that

the contract was entered into will be deemed to satisfy the conditions

of this section; Provided, however, that this section will apply with

respect to any natural person or company who is not a party to the

contract prior to and becomes a party to the contract after [insert the

effective date of the final rule].

(d) Definitions. For the purposes of this section:

(1) The term qualified client means a natural person who or a

company that:

(i) Immediately after entering into the contract has at least

$750,000 under the management of the investment adviser; or

(ii) The investment adviser entering into the contract (and any

person acting on his behalf) reasonably believes, immediately prior to

entering into the contract, either:

(A) Has a net worth (together, in the case of a natural person,

with assets held jointly with a spouse) of more than $1,500,000 at the

time the contract is entered into; or

(B) Is a qualified purchaser as defined in section 2(a)(51)(A) of

the Investment Company Act of 1940 (15 U.S.C. 80a-2(a)(51)(A)) at the

time the contract is entered into.

(2) The term company has the same meaning as in section 202(a)(5)

of the Act (15 U.S.C. 80b-2(a)(5)), but does not include a company that

is required to be registered under the Investment Company Act of 1940

but is not registered.

a qualified purchaser as defined in section 2(a)(51)(A) of

the Investment Company Act of 1940 (15 U.S.C. 80a-2(a)(51)(A)) at the

time the contract is entered into.

(2) The term company has the same meaning as in section 202(a)(5)

of the Act (15 U.S.C. 80b-2(a)(5)), but does not include a company that

is required to be registered under the Investment Company Act of 1940

but is not registered.

(3) The term private investment company means a company that would

be defined as an investment company under section 3(a) of the

Investment Company Act of 1940 (15 U.S.C. 80a-3(a)) but for the

exception provided from that definition by section 3(c)(1) of such Act

(15 U.S.C. 80a-3(c)(1)).

Dated: November 13, 1997.

By the Commission.

Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 97-30295 Filed 11-18-97; 8:45 am]

BILLING CODE 8010-01-P