On October 12, 2010, the Securities and Exchange Commission (the "SEC") proposed a new definition of "family offices" that would be excluded from the definition of an "investment adviser" under the Investment Advisers Act of 1940 (the "Advisers Act") and therefore not subject to registration or other regulation under the Advisers Act.1 The SEC will issue a final rule following a period of public comment, which closes on November 18, 2010. This client alert provides a brief overview of the existing regulatory framework, the newly-proposed "family office" definition and the implications thereof.
Current Status of Family Offices Under the Advisers Act
Family offices may meet the Advisers Act definition of "investment adviser." Currently, many family offices avail themselves of the exemption from registration under Advisers Act Section 203(b)(3), which applies to any adviser that during the course of the preceding twelve months had fewer than fifteen clients and neither held itself out to the public as an investment adviser nor advised any registered investment company or business development company. Other family offices have sought exemptive orders from the SEC declaring such offices to be outside the scope of “investment advisers” that Congress intended to regulate.
On July 21, 2010, the President signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act") which, among other things, will repeal the less than fifteen-client exemption contained in Section 203(b)(3), effective July 21, 2011. The purpose of the repeal of Section 203(b)(3) is to require advisers of certain private funds (such as hedge funds) to register under the Advisers Act. To soften the impact on family offices, the Dodd-Frank Act authorizes a new exemption from the Advisers Act for family offices that satisfy the definition ultimately adopted by the SEC.
The Proposed Definition
The proposed definition of "family office" would be set forth in new Rule 202(a)(11)(G)-1 under the Advisers Act. The proposed definition "largely would codify" prior exemptive orders granted by the SEC to family offices. A family office that satisfies the new definition would not be subject to any of the provisions of the Advisers Act.
The proposed definition has three basic elements (all of which must be satisfied):
1. Provision of services to family clients only. Excluded family offices would not be permitted to have any investment advisory clients other than family clients. Under the proposed definition, family clients include:
- Any family member, defined as the individual and his or her spouse or spousal equivalent for whose benefit the family office was established and any of their subsequent spouses or spousal equivalents, their parents, their lineal descendants (including by adoption and stepchildren), and such lineal descendants’ spouses or spousal equivalents, and also including siblings of the founders of the family office, their spouses or spousal equivalents, their lineal descendants (including by adoption and stepchildren), and such lineal descendants’ spouses or spousal equivalents.2
- Any key employee, defined as any natural person (including persons who hold joint or community property with their spouse or spousal equivalent) who is (i) an executive officer, director, trustee, general partner or person serving in a similar capacity of the family office, or (ii) any other employee of the family office (other than an employee performing solely clerical, secretarial or administrative functions) who, in connection with his or her regular duties, has participated in the investment activities of the family office, or similar functions or duties for or on behalf of another company, for at least twelve months.3
- Any charitable foundation, charitable organization or charitable trust, in each case established and funded exclusively by one or more family members or former family members; any trust or estate existing for the sole benefit of one or more family clients; and any company (including a pooled investment vehicle excepted from the definition of “investment company” under the Investment Company Act of 1940) that is wholly owned and controlled, directly or indirectly, exclusively by one or more family clients and operated for the sole benefit of family clients.
2. Ownership and Control. To be eligible for the exclusion from the Advisers Act, a family office would need to be wholly owned and controlled, either directly or indirectly, by family members. The SEC believes that the family ownership and control requirement "assures that the family is in a position to protect its own interests and thus is less likely to need the protection of the federal securities laws," and also helps to distinguish exempt family offices from family-run offices whose operations more resemble those of a "typical commercial investment adviser."4
3. No Holding Out. A family office relying on the proposed rule may not hold itself out to the public as an investment adviser.
As mandated by the Dodd-Frank Act, the proposed SEC rule specifies that the definition of family office will not exclude from its coverage any person who was not registered or required to be registered under the Advisers Act on January 1, 2010 that would meet all of the required conditions under the proposed rule but for the fact that the entity provides investment advice to, and was engaged before January 1, 2010 in providing investment advice to, certain enumerated types of clients. The certain enumerated grandfathered clients include (i) natural persons who, at the time of their investment, are officers, directors or employees of the family office, had invested with the family office before January 1, 2010 and are accredited investors under Regulation D; (ii) any investment adviser registered under the Advisers Act that in turn provides investment advice and identifies investment opportunities to the family office and invests in such transactions on substantially the same terms as the family office invests, but does not invest in other funds advised by the family office and whose assets as to which the family office directly or indirectly provides investment advice represent, in the aggregate, not more than 5% of the value of the total assets as to which the family office provides investment advice; provided that a family office that would not be a family office but for this clause, will be deemed to be an investment adviser for purposes of the antifraud provisions of the Advisers Act; and (iii) any company owned exclusively and controlled by one or more family members.
The period of public comment on the proposed rule closes on November 18, 2010, after which time the SEC will promulgate a final rule defining family offices exempt from the Advisers Act. Family offices should now carefully read the proposed rule and release to determine whether they fit within the proposed definition. Family offices that do not satisfy the proposed rule’s criteria will need to act quickly if they wish to submit their comments and suggestions for the SEC’s consideration. These family offices may also wish to consider restructuring in light of the proposed definition. Family offices that come within the purview of the proposed definition may also desire to submit comments suggesting that the definition be adopted as proposed (or with modifications in light of anticipated activities).
Additionally, since the Section 203(b)(3) exemption will be repealed effective July 21, 2011, family offices that do not fit within the proposed rule should begin to make preparations to register under the Advisers Act. Such family offices may also desire to discuss with counsel the possibility of obtaining an exemptive order from the SEC, in the event the family office does not conduct the type of commercial advisory activities that the Advisors Act was intended to regulate (despite falling outside of the proposed definition). In the event that registration is required, the registering family office would need to (among other things) file a Form ADV, adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act and the rules thereunder, and designate a chief compliance officer. Family offices for which registration ultimately is required can also consider requesting confidential treatment of certain sensitive information.