Do you currently use performance-based fees?

This question assesses your firm's compliance with federal securities law regarding performance fees. The SEC prohibits charging performance fees to most retail clients to protect them from the associated conflicts of interest. By confirming that all relevant clients are "Qualified Clients," you demonstrate that your firm is adhering to these critical regulations, which is a key factor in evaluating your firm's compliance risk.

• What is "Rule 205(a)"? Rule 205(a) of the Investment Advisers Act of 1940 is the law that generally prohibits registered investment advisers from charging fees based on a share of capital gains or appreciation of a client’s funds.
• What is a "Qualified Client"? Under Rule 205-3, this is a client who is legally eligible to be charged performance fees, primarily due to their financial sophistication. This includes clients with at least $1.1 million in assets under your management, clients with a net worth over $2.2 million, or certain knowledgeable employees of your firm. These thresholds are periodically adjusted by the SEC.

To answer this, you must confirm that every single client to whom you charge a performance-based fee meets the legal definition of a "Qualified Client."

• This requires having a process to verify each client's status (e.g., reviewing assets under management or net worth) before entering into a performance fee agreement.
• If all clients with performance fees meet this standard, you can answer "yes."
• If even one client with a performance fee does not meet the "Qualified Client" definition, you must answer "no."

• Mistake: Believing that a client's consent is enough.
  • A client cannot simply agree to a performance fee if they do not meet the legal "Qualified Client" standard. Disclosure is not a substitute for meeting the regulatory requirements.
• Pitfall: Using outdated financial thresholds.
  • The SEC adjusts the asset and net worth thresholds for inflation. You must ensure your verification process uses the current, legally effective amounts ($1.1M AUM / $2.2M net worth as of the 2021 adjustment).
• Mistake: Guessing or assuming a client qualifies.
  • Your firm must have a documented process for verifying a client's status. An incorrect assumption can lead to a serious regulatory violation.

This question helps the insurance carrier understand the scale and scope of your firm's use of performance-based fees. While the previous questions established the existence and compliance of the practice, knowing the number of clients involved allows the underwriter to quantify the overall risk exposure. A larger number of clients with these fee structures may indicate a greater firm-wide exposure to the conflicts of interest and potential claims associated with this practice.

• What defines a "Customer" for this question? This refers to the total number of distinct clients (individuals or entities) for whom you charge a performance-based fee. If a single client has multiple accounts under a performance fee agreement, they are typically counted as one customer.

To answer this, you need to provide the total number of clients who are currently subject to a performance-based fee arrangement.

• Review your client records to get an accurate count.
• This number should reflect only those clients who have agreed to a fee structure based on investment gains or outperformance.
• Exclude any clients who are only charged asset-based, fixed, or hourly fees.

An exact number is preferred, but a reasonable, current estimate is acceptable if necessary.

• Mistake: Counting accounts instead of customers.
  • The question asks for the number of customers. One customer might have several accounts, but they should be counted as a single client for the purpose of this question.
• Pitfall: Providing a rough guess without checking records.
  • While an estimate may be acceptable, taking a moment to review your client list will provide a more accurate number, which reflects better on your firm's diligence.