Since the adoption of the Dodd-Frank act in 2010, family offices have been faced with new rules for determining whether or not a particular firm is subject to regulation by the Securities and Exchange Commission.
If any family offices are still unsure about their exempt status, they need to act soon: Nonexempt family offices have until March 30 to either register with the SEC or restructure to conform with exemption requirements.
The Dodd-Frank act contained two amendments to the Investment Advisers Act of 1940 that are of particular importance to family offices. First, it repealed the so-called "Private Adviser Exemption" that exempted investment advisors with fewer than 15 clients-including many family offices-from registering with the SEC. Second, the act led to the creation of the Family Office Rule, which sets new conditions under which family offices may avoid SEC regulation.
The Family Office Rule
Under the Family Office Rule, family offices are defined as a company that only serves family clients, is owned by family clients and controlled by family members or family entities, and does not hold itself out to the public as an investment advisor. If a family office meets these requirements, it is exempt from SEC regulation.
The Family Office Rule permits a broad range of individuals and entities to qualify as family clients. However, several common pitfalls could prevent family offices from meeting the rule's requirements. What follows is an overview of these pitfalls and some of the possible unintended consequences for family offices that try to restructure to qualify for the exclusion.
Ownership and control: While the SEC has signaled that it will accept a broad range of ownership and control structures, one fact remains: The family must control the family office to qualify for exemption. In cases where professional staff controls day-to-day operations and outside advisors are members of the office's governing body, a review of organizational documents may be needed to ensure that the family has ultimate control of the entity.
Investment advice for non-family clients: Many family offices have long-standing investment advisory clients who do not fit the definition of "family client." Some family offices, for example, provide investment advice to other families or to close family friends, or to collective investment vehicles that are owned by a mix of family clients and non-family clients. These clients were acceptable under the Private Adviser Exemption, if they numbered fewer than 15. However, family offices that wish to remain exempt from regulation can no longer safely assume that these types of client relationships will pass muster under the Family Office Rule. Serving non-family clients is the most common reason that entities fail to meet the requirements of the rule.
Investment advice for distant relatives: Some family offices face SEC regulation because they advise distant relatives who fall outside the rule's definition of family members. The rule permits family offices to advise "all lineal descendants ... of a common ancestor, and such lineal descendants' spouses or spousal equivalents, provided that the common ancestor is no more than ten generations removed from the youngest generation of family members." A family member's in-laws, for example, do not meet this definition. Providing investment advice to such individuals will disqualify the family office from exemption.
Non-family client funding of charitable organizations: It is common for family offices to provide investment advice to non-profit organizations, charitable foundations or other charitable organizations. However, the Family Office Rule allows exempt family offices to provide investment advice only to charitable organizations that are funded exclusively by family clients. Even charities that receive only a small portion of their funding from non-family sources are off limits to exempt family offices. There is a grace period for compliance in this instance. If a family office wishes to continue providing investment advisory services to a charitable organization, the charitable organization has until December 31, 2013, to spend all funding attributable to non-family clients.
Non-U.S. clients of non-U.S. family offices: The new rule does not clearly limit its applicability to U.S. family offices or to U.S. clients. This raises a concern for family offices that are not located in the U.S. and who count among their advisory clients individuals or entities that are not located in the U.S. (in addition to their clients located in the U.S.). The SEC has not issued definitive guidance as yet on whether a family office will be disqualified for exemption because it has foreign non-family clients. Pending further information from the SEC, family offices with non-U.S. clients should be cautious about providing investment advice to foreign clients.
Most family offices that fail to satisfy the requirements of the Family Office Rule are choosing to restructure rather than register with the SEC. If the family office is providing investment advice directly to a non-family client in the form of a managed account or other similar arrangement, this process can be fairly simple. However, restructuring can have unintended consequences and can prove more difficult and expensive than anticipated.
For example, a family office that provides investment advice to a collective investment vehicle may decide to purchase the interests of non-family clients. This may prove expensive, however, particularly if the family office has no legal right to expel investors and purchasing the non-family interests can only be accomplished at a premium.
As an alternative, the family office may seek to terminate the investment vehicle and distribute its holdings in kind. But this alternative may be complicated by limitations on the ability to transfer the collective investment vehicle's holdings, as would be the case with a fund investment or a direct investment in private placement securities.
A third option would be to liquidate the collective's holdings, but this could raise ethical issues. Family offices may have fiduciary obligations to their clients. If non-family clients suffer financial losses due to this type of restructuring they could argue the family office breached its fiduciary duties to act in the best interests of investors.
A family office that provides investment advice to a charitable organization that receives non-family funding is also in an uncomfortable position. It could stop providing investment advice to the charitable organization, but that may be counter to the family's mission. The entity could also stop accepting non-family donations, but this would exclude community involvement in the charitable enterprise.
While it is often easy to identify the changes that need to be made for a family office to qualify for regulatory exemption, devising a plan that avoids these types of unintended consequences is a greater challenge.
In conclusion, family offices that do not take the time to understand how the Family Office Rule affects them do so at their own peril. It is not safe to assume that your family office remains exempt from SEC regulation simply because it was exempt under the Private Adviser Exemption. Instead, you should undertake an analysis to determine whether you qualify under the new rule and, if necessary, devise a plan to restructure.
David S. Guin and Mark J. Tice are a partner and associate, respectively, at the law firm of Withers Bergman.