SHARING THE PAIN & GAIN: CONTROVERSIAL SEC RULES WOULD EASE TYING OF FEES TO ADVISER PERFORMANCE

Spooked by the death-defying heights of the stock market, more and more high net-worth and institutional investors are demanding performance-based management fees from advisers, and the Securities and Exchange Commission may make such fees easier to arrange.

Performance-based schemes sweeten the payoff for managers who beat a benchmark, but make them share the pain of underperformance.

The SEC is expected to issue rules this year that would let big clients negotiate performance-based fees more easily and raise the definition of what constitutes “high net worth” by 50%.

But the commission is running into rough water. The organization that licenses chartered financial analysts opposes a provision that would drop disclosure requirements in performance-fee agreements. And Vanguard Group, which uses such fees, is concerned over an agency suggestion raising the possibility that mutual fund advisers would be allowed to set fees that rise when returns are strong but don’t fall when returns lag benchmarks.

The SEC is also looking more closely at whether some advisers favor clients whopay such fees, according to the head of the division drafting the rules changes.

“Performance fee arrangements appear to be increasingly client-driven,” says a comment letter from the Investment Counsel Association of America Inc., which represents institutional advisers. “Institutional and high-net-worth clients often approach advisers with creative proposals for performance fee incentives that they feel more properly apportion risks of poor performance and benefits of good performance than traditional fee arrangements.”

Current rules specify how contracts must be drawn up and fees calculated — as well as what disclosures must be made. A commission proposal to drop those requirements for high-net-worth clients and institutions — widely supported by the investment industry — is likely to be included.

The proposal also would increase the amount investors need before they are allowed to make performance fee arrangements with advisers. The threshold would rise to $750,000 in assets under management and a net worth of at least $1.5 million from $500,000 and $1 million, the levels in effect since 1985.

Securities law allows advisers to charge only high net-worth clients performance fees to guard against advisers taking undue risks.

few funds involved

Mutual funds, which are considered institutional investors under the law, can use performance-based fees, but few of them do.

But increasingly, clients demand “fulcrum fee” arrangements, giving advisers a higher fee, often including a percentage of capital gains, if they outperform a benchmark and a much lower fee if they don’t.

“More and more clients soliciting requests for proposals for investment management services are asking about performance fees,” says Nancy Morris, vice president and associate counsel of T. Rowe Price Associates Inc. of Baltimore, which has $139 billion in its mutual funds.

This is particularly the case when U.S. firms advise foreign clients, she says. “A lot of arrangements that foreign clients requested did not fit within the specific parameters of the rules the SEC had.”

Vanguard has its guard up about another possible change. Jeffrey Molitor, principal and director of portfolio review with the Valley Forge, Pa., index fund powerhouse, is concerned that the SEC asked for comment on whether money managers should be allowed to charge funds they advise a base fee that would not fall if performance does. Requesting comments sometimes leads to rule changes.

23 performance fee deals

Mr. Molitor says Vanguard has 23 performance fee contracts with fund advisers — covering 25% of its $370 billion in assets under management, including one for its popular Windsor Fund. “It’s clearly a situation where the adviser can only gain by taking additional risk,” says Mr. Molitor. “The risk-reward is not set up in a parallel fashion for the investors vs. the portfolio managers.”

The proposal to reduce disclosures about the fee arrangements has upset the Association for Investment Management and Research of Charlottesville, Va., which represents more than 70,000 investment decision-makers, and which administers the certified financial analyst designation program.

“Given the potential for self-interest and the lack of a level playing field in this area, we think disclosure should be enhanced, certainly not constricted. The SEC is proposing to eliminate it,” says Linda Rittenhouse, the association’s vice president for legislative and regulatory affairs.

A related issue has been raised by Barry Barbash, director of the SEC’s Division of Investment Management. He recently warned advisers at a conference in Washington that allocating better-performing investments to clients who pay the fees without proper disclosure violates fraud regulations.

Yet he sees no conflict between his warning and the SEC’s proposal to loosen disclosure requirements concerning performance fees.

“The duty to act as a fiduciary is separate and apart from any duty the adviser has in establishing a fee arrangement,” he says.