On October 12, 2010, the SEC proposed Rule 202(a)(11)(G)-1 to define "family offices," which will be excluded from the definition of "investment adviser" under the Investment Advisers Act of 1940, as amended, and invited comment. This is one of the first proposed rules to interpret the new obligations of private fund managers under the Dodd-Frank Wall Street Reform and Consumer Protection Act.1 The proposed rule provides the definitional details requested by Congress in the Dodd-Frank Act. In its proposed rule, the SEC focused on single family offices that typically manage assets in excess of $100 million. A family office that satisfies the SEC criteria will be exempt from the provisions of the Advisers Act. In addition to these conditions, the SEC has included certain "grandfathered" investment advisers in the definition of "family office" as required by the Dodd-Frank Act.
A family office is an entity established by a single high net worth family to provide wealth management, accounting, tax and other services to its members. In its proposing release, the SEC estimates that there are approximately 3,000 single family offices that together manage more than $1.2 trillion in assets. Prior to the Dodd-Frank Act, many single family offices relied on the "private adviser" exemption, which exempted from registration any adviser that had fewer than 15 clients during the course of the preceding 12 months and neither held itself out to the public as an investment adviser nor advised any registered investment company or business development company. Other single family offices that did not qualify for the "private adviser" exemption sought and obtained exemptive orders from the SEC on the basis that such family offices were "not within the intent" of the meaning of investment adviser under the Advisers Act.
The Dodd-Frank Act eliminated the "private adviser" exemption, but added a new exemption for "family offices" under the Advisers Act. Congress directed the SEC to define "family office" for the purposes of the exemption in a manner "consistent with the previous exemptive policy" of the SEC and to take into consideration "the range of organizational, management, and employment structures and arrangements employed by family offices."2
In contrast to the single family offices described above, the SEC has historically regulated multi-family offices (i.e., family offices that advise more than one family) or family-run offices (i.e., offices operated and managed by a family, but offering investment advisory services to unrelated clients). Multi-family and family-run offices more closely resemble commercial investment advisory firms because they advise a broader group of clients. Accordingly, the proposed rule does not exempt multi-family and family-run offices from registration under the Advisers Act.
What is a Family Office?
Proposed Rule 202(a)(11)(G)-1 sets forth a three-part test for what constitutes a "family office" under the Advisers Act:
- The family office must provide advice to "family clients" only.
- The family office must be wholly-owned and controlled by "family members."
- The family office must not hold itself out to the public as an investment adviser.
"Family clients" only
The proposed rule defines "family client" to mean (i) "family members;" (ii) former family members; (iii) certain key employees; (iv) former "key employees;" and (v) certain charitable entities, family trusts and other family entities. In addition, the term "family client" extends, albeit briefly, to those natural persons or entities to whom involuntary transfers are made from a family client. If such an involuntary transfer is made (e.g., if a family member dies and bequeaths her assets to someone outside the family), the investment adviser will have four months to transfer the management of those assets to another adviser to maintain its "family office" exemption.
The term "family members" is broadly defined to mean (i) the founder of a family office; (ii) the founder's spouse or spousal equivalent and any subsequent spouses or spousal equivalents; (iii) the founder's parents; (iv) the founder's lineal descendents (including by adoption and stepchildren) and such lineal descendants' spouses and spousal equivalents; and (iv) the founder's siblings and such siblings' spouses or spousal equivalents and their lineal descendents (including by adoption and stepchildren) and such lineal descendents' spouses or spousal equivalents. A spousal equivalent is defined as a cohabitant occupying a relationship generally equivalent to that of a spouse. By defining "family member" to include spousal equivalents, parents and stepchildren, the SEC expanded the scope of its prior exemptive orders. One of the few family relationships excluded from the definition are cousins.
Other categories of natural persons and entities qualify as "family clients" under the rule. For example, certain "key employees" are defined as "family clients." Key employees include any natural person 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 employees performing solely clerical, secretarial or administrative functions) who has regularly participated in the investment activities of the family office for at least 12 months. This concept mirrors the "knowledgeable employee" exception under the Advisers Act with respect to clients who may be charged performance fees, as well as similar provisions in rules adopted under the Investment Company Act of 1940. "Family client" also includes (i) charitable foundations, charitable organizations or charitable trusts, provided that each such charitable entity is established and funded exclusively by family members; (ii) trusts or estates existing for the sole benefit of family clients; and (iii) entities wholly-owned and controlled by, and operated for the sole benefit of, family clients including a pooled investment vehicle.
For the purposes of the proposed rule, former family members and former key employees are treated similarly, whereby they qualify as "family clients" with respect to any investments made prior to any legal separation from or termination of employment with the family. After a legal separation or termination of employment, former family members and key employees are not permitted to make additional investments with the family office, other than additional investments that are contractually required.
Family member ownership and control
To qualify for the "family office" exemption, an investment adviser must be wholly-owned and controlled, either directly or indirectly, by family members. This ownership condition removes the need for a family office to operate on a not-for-profit basis, which was commonly required in the SEC's previous exemptive orders. In its proposing release, the SEC explains that a not-for-profit requirement is no longer necessary because profits generated by the family office only accrue to family members.3
Not held out to public as investment adviser
A family office relying on this exemption may not hold itself out to the public as an investment adviser. This prohibition is based on the concept that the exemption is not applicable for relationships with non-family clients.
The Dodd-Frank Act requires the SEC to include within the definition of "family office" certain family offices that were not registered or required to be registered on January 1, 2010, and that meet the requirements of the proposed rule, except that such offices provide investment advice to natural persons who, at the time of their applicable investment, are officers, directors or employees of the family office who invested with the family office before January 1, 2010, and are "accredited investors," as defined under the SEC's Regulation D private offering exemption. Additionally, any company owned exclusively and controlled by more than one family member is included within the definition of "family office" pursuant to the grandfathering provisions. The final category of grandfathered family offices is registered investment advisers advised by the family office. These investment advisers in turn provide investment advice and invest in substantially the same opportunities on substantially the same terms as the family office. However, these investment advisers may not invest in other funds advised by the family office and the assets of the investment adviser that the family office advises may not constitute more than 5% of the total assets for which the family office provides investment advice.
An investment adviser that is a family office solely by virtue of the grandfathering provisions will be deemed an investment adviser for the purposes of the antifraud provisions of the Advisers Act.
State Law Preemption
A family office that qualifies for the "family office" exemption will also be exempt from state registration under the proposed rule.
Comments to the SEC regarding this proposed rule must be received on or before November 18, 2010.