Key Question
Could the SEC’s proposal fundamentally change who may pay an investment adviser a performance fee and open performance-based compensation to a much broader range of separately managed account clients?
Our View
Yes. If adopted substantially as proposed, the SEC’s amendments would materially expand performance-fee eligibility for RIAs by incorporating accredited investors into Rule 205-3’s “qualified client” definition, eliminating the separate $1.4 million AUM and $2.7 million net-worth tests, and expressly allowing performance-fee arrangements for separately managed accounts of accredited investors, while leaving fiduciary, disclosure, conflict-management, and supervisory obligations fully in place.
Executive Summary
On September 30, 2026, the Securities and Exchange Commission proposed Investment Adviser Performance-Based Compensation Modernization, a significant restructuring of the framework governing when investment advisers may receive performance-based compensation. Under current Rule 205-3, registered investment advisers generally may charge performance fees only when the client is a “qualified client” or another statutory or regulatory exception applies. Earlier this year, the SEC increased the principal qualified-client financial thresholds to $1.4 million in assets under management with the adviser or $2.7 million in net worth.
The new proposal moves in a different direction: it would incorporate the Regulation D accredited-investor standard into the qualified-client definition and remove those separate AUM and net-worth tests. The proposal expressly states that separately managed accounts of accredited investors, as well as other advisory services provided to accredited investors, would become eligible for performance-fee arrangements. For RIAs, that could materially expand the population of clients eligible for performance-based compensation, but it would not make performance fees automatically appropriate for every eligible client.
The amendments remain proposed, and existing Rule 205-3 standards continue to govern unless and until final amendments become effective.
Regulatory Background: From Higher Thresholds to a Different Eligibility Standard
Section 205(a)(1) of the Investment Advisers Act generally prohibits an investment adviser from entering into an advisory contract that provides compensation based on a share of capital gains or capital appreciation in a client account. Rule 205-3 provides an important exemption for contracts with “qualified clients.” Historically, the rule has relied in part on financial thresholds intended to identify clients with sufficient resources or sophistication to enter into performance-fee arrangements.
The SEC tightened that framework earlier in 2026 by issuing an inflation adjustment under Rule 205-3. Effective June 29, 2026, the principal thresholds increased to $1.4 million in assets under management and $2.7 million in net worth. The LeGaye Law Group addressed the development in its May 2026 alert, “Inflation Adjustment Raises the Bar: SEC Proposes Higher ‘Qualified Client’ Thresholds for Performance Fees.”
The September 30 proposal, Release Nos. 33-11443, 34-106533, IA-7022 and IC-36350, File No. S7-2026-28, would change the framework more fundamentally. Rather than maintaining a separate, higher financial standard for performance-fee eligibility, the SEC proposes to include accredited investors under Regulation D in the qualified-client definition and to remove Rule 205-3’s separate net-worth and AUM tests. The Commission describes the change as a way to harmonize performance-fee eligibility with the accredited-investor framework already used for many private offerings.
Key Developments and Practical Impact
For advisers, the proposal is important not only because more investors could qualify. It changes how eligibility is determined and could affect product design, client segmentation, onboarding, documentation, billing, and conflict management. The most significant developments are outlined below.
- Separately Managed Accounts Could Be the Most Immediate RIA Impact. The SEC expressly states that separately managed accounts for accredited investors, as well as other advisory services to accredited investors, would be eligible for performance-fee arrangements under the proposed amendments. This represents a meaningful expansion beyond the private-fund context. An RIA that currently uses traditional AUM-based pricing for high-net-worth clients could consider performance-based compensation for a broader group of SMA clients. However, an SMA client who is neither an accredited investor nor otherwise a qualified client under the amended rule would remain ineligible.
- The Existing $1.4 Million AUM and $2.7 Million Net-Worth Tests Would Be Removed. The proposal would not merely lower the current qualified-client thresholds. It would eliminate the separate tests. For natural persons, accredited-investor status can be established under the Regulation D net-worth or income standards, among other pathways. As a result, an individual could qualify for a performance-fee arrangement even if the individual does not satisfy either of today’s Rule 205-3 financial thresholds.
- Professional Credentials Could Create a New Route to Performance-Fee Eligibility. The accredited-investor definition is not limited to wealth and income. It also includes natural persons who hold SEC-designated professional licenses or credentials in good standing. The SEC has already designated the Series 7, Series 82, and Series 65 licenses. Incorporating accredited-investor status into Rule 205-3 could therefore permit certain financially sophisticated professionals to qualify for performance-fee arrangements even if they do not meet the current AUM or net-worth tests.
- Private Funds Could Use a More Unified Eligibility Standard. For certain Section 3(c)(1) private funds relying on Regulation D, the proposal could reduce the need to apply two investor-qualification standards: accredited-investor status for the offering and qualified-client status for performance compensation. The SEC specifically cites this mismatch as a reason for the proposal. However, some entity investors could face a different outcome if they currently rely on the Rule 205-3 AUM or net-worth test but do not satisfy an applicable accredited-investor category.
- Eligibility Would Not Eliminate Performance-Fee Conflicts. The proposal does not equate accredited-investor status with a determination that a particular compensation arrangement is appropriate. Performance fees create incentives that may encourage greater risk-taking and can create allocation and management conflicts when an adviser manages both performance-fee and non-performance-fee accounts simultaneously. The SEC emphasizes that the nature and extent of advisory compensation are material facts that require full and fair disclosure. Form ADV Part 2A, Item 6 also requires RIAs charging performance-based fees to disclose that fact and, when they manage accounts that are not charged performance fees, to discuss the resulting conflicts and how they are addressed.
- Existing Contracts Would Generally Receive Transition Protection. The proposal indicates that contractual relationships entered into before the effective date of any adopted amendments would generally not be retroactively affected, subject to Rule 205-3’s transition provisions. Firms should nevertheless preserve records showing the eligibility standard relied upon when an existing performance-fee arrangement was established and carefully evaluate new parties, transfers, and new contractual relationships under the rule in effect at the time.
Recommended Actions
Because the amendments are not yet final, RIAs should not change current Rule 205-3 eligibility determinations based on the proposal. The better approach is to evaluate the operational consequences now so the firm can respond efficiently if the SEC adopts the framework substantially as proposed.
- Inventory Existing Performance-Fee Arrangements. Identify SMA and private-fund relationships that currently depend on qualified-client status, document the basis for each client’s eligibility, and retain the applicable contract and qualification records.
- Evaluate the Potential SMA Business Model. Determine whether the firm would want to offer performance-based compensation to a broader population of accredited-investor clients. The analysis should include strategy fit, client profile, fee methodology, billing capabilities, and the economic incentives the arrangement creates.
- Review Accredited-Investor Verification Processes. If accredited-investor status becomes a Rule 205-3 pathway, firms will need a defensible process to establish the adviser’s reasonable belief that the client qualifies at the time the advisory contract is entered into. Existing private-fund questionnaires may provide a starting point but should not be assumed sufficient for SMA onboarding.
- Reassess Conflicts, Form ADV, and Advisory Agreements. Performance-fee expansion should be accompanied by a review of Form ADV Part 2A Item 6, advisory contract language, trade and investment-opportunity allocation controls, and disclosures addressing incentives to favor performance-fee accounts or to assume additional investment risk.
- Do Not Implement the Proposal Early. Current Rule 205-3 remains controlling. Firms should monitor the rulemaking and prepare implementation options, but should not rely solely on accredited-investor status as sufficient for a new performance-fee arrangement unless and until an applicable final rule becomes effective.
Public Comment and Rulemaking Status
The proposal remains subject to the SEC’s notice-and-comment rulemaking process. The proposing release states that comments are due 60 days after publication in the Federal Register; the version reviewed for this alert still contains placeholders for the Federal Register publication date and the resulting calendar deadline. The SEC is requesting input on, among other issues, whether accredited-investor status is an appropriate measure of sophistication for performance-fee arrangements, whether the existing net-worth or AUM tests should be retained, and whether additional contractual requirements should apply. Those comments will be part of the rulemaking record the Commission considers when deciding whether and in what form to adopt final amendments. The request for comment does not change the immediate compliance obligation: advisers must continue to apply existing Rule 205-3 until any final amendments become effective.
Key Takeaways
The proposal could substantially reshape performance-fee eligibility for investment advisers. For compliance officers and senior management, the following points should frame the firm’s initial review:
- Accredited Investors Could Become Qualified Clients. The proposal would incorporate the Regulation D accredited-investor standard into Rule 205-3, potentially expanding the pool eligible for performance-based compensation.
- The Current Financial Tests Would Be Removed. If the proposal is adopted as drafted, the $1.4 million AUM and $2.7 million net-worth tests would no longer serve as separate qualified-client pathways.
- SMAs Are Directly Affected. The SEC expressly contemplates performance-fee arrangements for separately managed accounts held by accredited investors, making the proposal particularly important for RIAs serving high-net-worth and sophisticated individual clients.
- Eligibility Is Not the Same as Appropriateness. Fiduciary duties, compensation disclosures, conflict management, allocation controls, and supervisory expectations remain central even when a client is legally eligible to pay a performance fee.
- Nothing Changes Yet. The amendments are proposed. The existing Rule 205-3 requirements remain in effect while the SEC receives comments and considers adopting a final rule.
Conclusion
Earlier this year, advisers were focused on higher qualified-client financial thresholds. The September proposal asks a more fundamental question: whether performance-fee eligibility should continue to depend on a separate, higher qualified-client financial standard at all. If adopted substantially as proposed, the framework could materially expand performance-based compensation for RIAs, particularly in separately managed accounts, while simplifying qualification for many private funds. The compliance challenge will be to separate expanded legal eligibility from the adviser’s continuing obligation to structure, disclose, supervise, and manage performance-fee arrangements consistently with its fiduciary duties.