SEC Division of Investment Management staff letter: Gerald Zuckerman

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON. D.C. 20549

DIVISION OF

..STMENT MANAGEMENT
February 1, 1994

.-..
Mr. Gerald Zuckerman i 0(0- ~'-"
."..--..-.. --- Service Support Group, Inc. ,'" ' ; !,.L9.! 7655 East Gelding Drive ~~~P:i~~ ....,.. Sui te A-3 i~~--OS~ :J) Scottsdale, AZ 85260 1 l i" ,- . ~,"._'~~ "'~

Dear Mr. Zuckerman:
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Your letter to Chairman Levitt has been referred to this Office for response. You state that you are a registered investment adviser and would like to charge clients a fee based

upon a percentage of the profits earned. You ask (1) why

performance fees are generally prohibited; (2) whether a

performance fee arrangement requires that you postpone billing

the client for at least one year after the date you begin working

on an account; and (3) if there is any way the one year

restrlction can be amended or appealed.

Section 205 (a)(l) of the Investment Advisers Act ("Advisers

Act") generally prohibits an investment advisory contract that

provides compensation to the adviser on the basis of a share of capi tal gains upon or capital appreciation of the funds or any portion of the cl ient i s funds ("performance fee"). Congress incl uded the performance fee prohibition in the Advisers Act because of concern that performance fees create incentives for an

adviser to take inappropriate risks in managing a client's

account in order to increase advisory fees. 1/ Performance fees

in use at the time Congress enacted the Advisers Act typically

rewarded an adviser, above and beyond its customary fee, for gõod

performance, without penalizing it for poor performance.

Congress concluded that performance fees encouraged an adviser to

speculate unduly because it had everything to gain and little to lose. Rule 205-3 under the Advisers Act provides a limited

exemption from the performance fee prohibition for advisory

contracts with wealthy clients having at le~st $500,000 under the

adviser's management or a net worth exceeding $1 million. The

rule requires, among other things, that the compensation paid to

the adviser be based on performance over a period of not less

than one year. The Commission believed that a one year period

would be of sufficient duration to preclude an adviser from

basing an incentive fee on short-term fluctuations in securities

1/ See H.R. Rep. No. 2639, 76th Congo 2d Sess. 29 (1940).

prices. 1/ Thus, in response to your second question, an adviser

may not bill a client until passage of at least one year from the

date the adviser begins providing investment advice to the

cl ient. After the initial one-year period elapses, however, the

adviser may bill the client on a "rolling" basis. 1/

You also ask whether the one year period can be amended or

appealed. The Division of Investment Management believes that

further exemptions from the performance fee prohibition are

warranted but require Congressional action. The Division has

recommended in its Investment Company Act study that the

Commission consider legislation that would authorize the

Commission generally to provide exemptions from the performance

fee prohibition for advisory contracts with any person whom the

Commission determines does not need the protections of the prohibi tion i based on financial sophistication, net worth, knowledge and experience in financial matters, amount of assets

under management, relationship with a registered investment

adviser, or any other factors the Commission may determine are

relevant.!/ The Commission has not yet acted on the Division's proposal. Finally, you allude to section 205 (b) (2) of the Advisers

Act, which permits an investment adviser to charge a "fulcrum

fee" when advising either a registered investment company or

certain persons with whom the adviser has contracted to manage at

least $1 million in assets. with a fulcrum fee, an adviser's

compensation increases or decreases depending on how an account

performs relative to an appropriate index or other measure of

performance over a specified period. ~ If you incorporate a

fulcrum fee compensation arrangement, you would not have to

adhere to the one year performance period requirement of Rule

205-3.
1/ See Investment Advisers Act Rel. No. 996 (Nov. 14, 1985) ("Release No. 996"). 1/ See Release No. 996 (adviser can use any method for

receiving payment of a performance fee .provided it is

consistently applied and fully disclosed to the client).

!/ See Division of Investment Management, U.S. Securities and

Exchange Commission, Protectinq Investors: A Hal f Centurv of

Investment Companv Regulation Chapter 6 (May, 1992) (copy

enclosed) .
~ See Rules 205-1 and 205-2 under the Advisers Act.

• 2

I hope this information is helpful. If you have any further

questions you may write this Office or call Jana Cayne, Attorney,

at (202) 272-2030.

Sincerely,
~~-~

Thomas S. Harman

Associate Director

(Chief Counsel)

• 3

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Service Support Group. Inc. t."7 0%11: 7655 East Gelding Drive . Suite A-3 . r Scottsdale, Arizona 85260 .."C) Phone (602) 998-1616 .~ c: c= ,.. rl1 :-l ,.. CJ : e,: N " .' .., .-, December 23, 1993 -, -. ít; ~ e; ;4::
;:'. :J ~' Chairman Arthur Levitt Jr. .
:: ::

• p-r Securities and Exchange Commission .;. '.. ~. ... t!~ c; 450 5th St. NW
  :l " C
  Washington, DC 20549 0 j; .if
  Dear Chairman Levitt,

THE BACKGROUND

I have recently been registered as an Investment Advisor #801
44041. I am developing a business around my proprietary software

which I will use to pick stocks. I anticipate offering my

services to individuals, pensions and mutual funds. My

compensation will be entirely based up a percentage of the

profi ts' earned for my clients.
THE RULES

Under the provisions of section 205 (1) I would be permitted to

base my fees upon a percentage of the profits. There are several

restrictions however that apply. My clients are permitted to

hire me on a percentage basis only if they have a net worth in

excess of $1,000,000 at the time they hire me or they must have

$500,000 under management with me.

If the client does not meet these two criteria they are, and I am, prohibited from doing business with one another based on this performance formula. ie: if the client does well I do welL. This may seem strange given the fact that many vocations that pay commission do so with the understanding that the success or failure of the venture will determine the pay of the worker. Is this not the premise upon which the capitalistic system is

based?
I have been also advised that even meeting these criteria

($500,000 under management or S 1,000,000 + net worth) I must then

base my income on at least a year i s worth of history. My

instructions are a little hazy. I don It know if this means I

must wait one year from the date I start working an account

before I can bill them or if I must wait one year from the end of

a period of time before I bill them.

, .

~

By way of example: Client "A". If I start advising them on

January 1, 1994 does the law require me not to bill them until

January 1, 1995 for the year? Or: Client "B". If I start with

them January 1, 1994 and I bill them on a monthly basis, does

this mean that I can not bill them until February 1, 1995 which

would be one complete year after the first month in question?

THE PROBLEM

In any event it certainly puts an incredible hardship on someone

trying to make a living if they must wait a full year before they

can get paid for work performed simply because they have chosen

to work on a commission or percentage of the profits basis.

Is there any way that this restriction can be amended or

appealed? After all when we speak of clients having S500,000

under management or having a net worth in excess of Sl, 000,000 we

are not speaking of unsophisticated buyers. If the client is

willing to pay and the worker is willing to work on the basis of

a percentage of the profits as compensation then why not let them

do it?

After a~l if either party is unhappy with the arrangement it can

be canceled by either party at any time. By restricting an

investment adviser in such a way that he can only be paid after

one year then for many this is the same as saying that even

though the law has a provision enabling you to do something, you

as a practical matter, will be severely hampered in your right or

abili ty to do so.

THE SOLUTION

Is there one? Can not the period be something more workable than

a year? How about monthly or even on a quarterly basis?

Something reasonable so that the parties to this arrangement can

do business with the ground rules that work for them. I

understand that an index may be used but this is such a

convoluted formula and is not found in a simple pay for

performance contract.

Thank you for your time. I hope I have stated my case clearly.

Respectfully,