IA Compensation Restrictions - USA Section 102(c)
While the previous sections focused on broker-dealer compensation, investment advisers (IAs) face their own set of compensation rules under the Uniform Securities Act (USA). The most important restriction is the general prohibition on performance-based fees.
General Prohibition on Performance-Based Fees
Under USA Section 102(c)(1), it is unlawful for an investment adviser to enter into, extend, or renew an advisory contract unless the contract provides in writing that the adviser shall not be compensated on the basis of a share of capital gains upon, or capital appreciation of, the client's funds.
Why the prohibition exists: Performance-based fees could incentivize advisers to take excessive risks with client money to boost returns (and their own compensation). The prohibition protects retail investors from this conflict.
Exam Tip: Gotchas
- The performance-fee prohibition is in the USA (state law), not just federal law. The Series 63 tests state-level rules.
Permitted Fee Structures for IAs
Although performance-based fees are generally prohibited, IAs may charge:
| Fee Type | Description |
|---|---|
| AUM fees | A percentage of total assets under management, typically billed quarterly |
| Hourly fees | Charged for time spent on advisory services |
| Flat/fixed fees | A set dollar amount for defined services |
| Fees based on total fund value | Based on total value averaged over a definite period or as of definite dates (USA Section 102(d)) |
Exam Tip: Gotchas
An AUM fee is not a performance-based fee, even though the fee amount increases when the account grows. An adviser charging 1% of AUM earns more as the portfolio increases in value - but this is based on total value, not on capital gains or appreciation. The key distinction: performance fee = share of gains; AUM fee = percentage of total value.
Exception: Fulcrum Fees (USA Section 102(d))
- Section 102(c)(1) does not prohibit compensation based on the total value of a fund averaged over a definite period or as of definite dates
- This allows fulcrum fee arrangements where the adviser's fee increases or decreases symmetrically based on the fund's total value relative to a benchmark
- A fulcrum fee goes up and down equally - it is not a one-way performance fee
Example: An adviser's fee increases by 0.10% for every 1% the fund outperforms the benchmark, and decreases by 0.10% for every 1% the fund underperforms. This symmetry is what distinguishes a fulcrum fee from a prohibited performance fee.
Exam Tip: Gotchas
- Fulcrum fees are permitted because they are symmetrical - the adviser's fee goes up and down. A one-way "bonus for gains" arrangement would be a prohibited performance fee.
Exception: Qualified Clients
- The Administrator may, by rule or order, adopt exemptions from Section 102(c)(1) (USA Section 102(f))
- Under federal law (Investment Advisers Act (IAA) Section 205(e) and SEC rules), performance-based fees are permitted for qualified clients:
| Qualified Client Test | Threshold |
|---|---|
| Assets under management with the adviser | At least $1,100,000 |
| Net worth (excluding primary residence) | At least $2,200,000 |
| Qualified purchasers under the Investment Company Act | Meets ICA definition |
| Knowledgeable employees of the adviser | Meets SEC definition |
- These thresholds are adjusted for inflation periodically by SEC order
Rationale: Qualified clients are presumed to be sophisticated enough to understand and bear the risks of performance-based fee arrangements.
Exam Tip: Gotchas
- The qualified client net worth test excludes the value of the primary residence. This mirrors the accredited investor net worth test under Reg D.
- The policy structure: Performance fee prohibition (USA 102(c)) protects retail investors from excessive risk-taking, with exceptions for fulcrum fees (symmetrical) and qualified clients (sophisticated).