By: David J. Morris & Will Cronin
On September 30, 2026, the Securities and Exchange Commission issued a proposal that, if adopted, would amend Rule 205-3 under the Investment Advisers Act of 1940 (the “Advisers Act”) to allow financial advisers to enter performance-based compensation arrangements based on capital gains or capital appreciation (so-called “carried interest”) with a broader group of clients, including accredited investors and regulated funds that satisfy specified conditions. The SEC additionally issued proposals that would change the regulatory framework for interval funds, registered closed-end funds, and business development companies, but these changes are outside of the scope of this article.
Current Framework. Performance-fee arrangements and multiple-class structures have historically been more readily available in the private fund industry and unavailable to investors that do not meet the current, relatively stringent financial requirements needed to qualify as a “qualified client” under the Advisers Act. Rule 205-3 currently provides an exemption from the Advisers Act’s general prohibition on compensation based on capital gains or capital appreciation when the advisory client is a “qualified client,” which currently includes (a) advisers with assets under management in excess of $1,400,000, (b) investors with net worth in excess of $2,700,000 and (c) individuals that are employed by or hold an equity stake in the fund manager.
Change in Definition of “Qualified Client”. The proposal would expand the definition of “qualified client” to include (x) registered management investment companies and BDCs and (y) any individuals or companies that otherwise qualify as an “accredited investor”, each of whom would thus qualify for the exemption and enter into performance-fee arrangements with their investment advisers. This change means that advisers who manage private funds for accredited investors could conclusively rely on that accredited investor status when deciding to charge performance compensation, rather than having to utilize a second, more stringent standard.
If the proposed rule changes are approved, investment advisers would gain access to a larger pool of clients eligible for performance-fee arrangements and, conversely, many investors would have additional opportunities to invest in funds where adviser compensation is more directly tied to fund performance and shareholder returns.
Performance Compensation Caps. An adviser’s performance compensation could not exceed 20% of the regulated fund’s net capital gains or net capital appreciation over a specified period or as of specified dates. The proposal would not prescribe a minimum measurement period, so advisers would have broad discretion in determining the mechanics of any performance compensation arrangement.
Enhanced Fund-Governance and Disclosure Requirements. A regulated fund relying on the new exemption would have to comply with the Investment Company Act’s fund-governance standards. Among other things, those standards require a majority of the board to be independent directors with enough directorial authority to select independent legal counsel, conduct annual board evaluations and executive sessions, and to retain advisers and experts. As part of the annual advisory contract review process, a majority of directors who are not interested persons would have to determine that any performance-fee arrangement is in the best interests of the fund and its shareholders. Additionally, any fund using performance-based compensation would be required to disclose such fee arrangements in the regular disclosures provided to its investors.
New Classes of Accredited Investors. The SEC additionally proposes redefining the standards for accredited investors to additionally recognize many individuals who had obtained professional licensure, including CPAs, CFAs and CFPs, as well as the holders of certain FINRA licenses. The SEC would additionally allow any individual over the age of 18 to become an accredited investor by taking an exam, which would be administered by FINRA and based on the existing Securities Industry Essentials Exam. The exam would consist of 75 multiple choice questions covering a broad variety of topics related to securities investment.
What Happens Next
The proposals are now subject to a 60-day public comment period, which expires on November 29, 2026. Following the public comment period, the SEC’s commissioners may modify, scale back, or expand proposed provisions based on received feedback before ultimately voting on whether to accept the proposed final language for the rule.
Although the rules that are ultimately adopted may differ materially from what is currently proposed, financial advisers, fund sponsors, and related service providers should begin evaluating how the changes could affect existing and planned funds, including whether current private fund could admit additional investors under the new definition of “qualified client” and whether a registered fund strategy could support performance fee compensation for the its financial advisers.
If adopted, the proposals will provide more flexibility across a variety of fund management strategies, but they do not simply deregulate these arrangements. Investment advisers and fund managers hoping to utilize these strategies will need to ensure that they comply with all relevant principles, including those regarding detailed board oversight and enhanced investor disclosures.
If you have questions about the proposed Rule 205-3 amendments and how these developments may affect your business, please contact David J. Morris ([email protected]) or Will Cronin ([email protected]).
David J. Morris
David Morris is a capital partner and Chair of the Corporate & Securities Group. David practices in the areas of corporate and securities, corporate finance and investment management. David concentrates his practice on mergers and acquisitions, private equity, venture capital, fund formation, securities, banking and finance, trading and commodities law, emerging growth companies and general corporate matters. He also serves as outside general counsel to start-up, emerging growth and middle market companies in a wide variety of industries. David has significant experience in investment management and proprietary trading and represents private investment funds (hedge funds, private equity funds, venture capital funds and real estate funds), broker-dealers, registered investment advisers, proprietary trading firms and other investment management and proprietary trading industry participants.
Will Cronin
Will Cronin is an associate in the Firm’s Corporate & Securities Group. Will focuses his practice on mergers and acquisitions, including private equity and venture capital transactions. He has substantial experience representing both buyers and sellers in a variety of middle-market strategic and financial acquisitions, as well as borrowers receiving commercial loans for purposes including acquisition financing. He represents private equity funds, family offices, venture capital investors and businesses in a variety of industries, including manufacturing, retail, health care, insurance and consumer lending.
This article contains material of general interest and should not be construed as legal advice or a legal opinion on any specific facts or circumstances. Under applicable rules of professional conduct, this content may be regarded as attorney advertising.