Securities Lawyer's Deskbook                          published by The University of Cincinnati College of Law

Rule 205-3 -- Exemption from the Compensation Prohibition of Section 205(a)(1) for Investment Advisers

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1. General. The provisions of section 205(a)(1) of the Act will not be deemed to prohibit an 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.
   
   
2. 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, 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.
   
   
3. Transition rule.
   
   
   1. An investment adviser that entered into a contract before August 20, 1998 and satisfied the conditions of this section as in effect on the date that the contract was entered into will be considered 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 August 20, 1998.
      
      
   2. Advisers to private funds with non-qualified investors. If you are an investment adviser to a private investment company that is a private fund as that term is defined in rule 203(b)(3)-1, and you were exempt from registration under section 203(b)(3) of the Act prior to February 10, 2005, paragraph (b) of this section will not apply to the existing account of any equity owner of a private investment company who was an equity owner of that company prior to February 10, 2005.
      
      
   3. Advisers to private funds with non-qualified clients. If you are an investment adviser to a private investment company that is a private fund as that term is defined in rule 203(b)(3)-1, and you were exempt from registration under section 203(b)(3) of the Act prior to February 10, 2005, section 205(a)(1) of the Act will not apply to any investment advisory contract you entered into prior to February 10, 2005, provided, however, that this paragraph will not apply with respect to any contract to which a private investment company is a party, and provided further that section 205(a)(1) of the Act 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 on or after February 10, 2005.
      
      
4. Definitions. For the purposes of this section:
   
   
   1. The term qualified client means:
      
      
      1. A natural person who or a company that immediately after entering into the contract has at least $ 750,000 under the management of the investment adviser;
         
         
      2. A natural person who or a company that the investment adviser entering into the contract (and any person acting on his behalf) reasonably believes, immediately prior to entering into the contract, either:
         
         
         1. 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
            
            
         2. Is a qualified purchaser as defined in section 2(a)(51)(A) of the Investment Company Act of 1940 at the time the contract is entered into; or
            
            
      3. A natural person who immediately prior to entering into the contract is:
         
         
         1. An executive officer, director, trustee, general partner, or person serving in a similar capacity, of the investment adviser; or
            
            
         2. 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 functions or duties for or on behalf of another company for at least 12 months.
            
            
   2. The term company has the same meaning as in section 202(a)(5) of the Act, 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 but for the exception provided from that definition by section 3(c)(1) of such Act.
      
      
   4. The term executive officer means the president, any vice president in charge of a principal business unit, division or function (such as sales, administration or finance), any other officer who performs a policy-making function, or any other person who performs similar policy-making functions, for the investment adviser.
      
      

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