On October 12, 2010, the Securities and Exchange Commission (the “SEC”) proposed new Rule 202(a)(11)(G)-1 (the “Proposed Rule”)1 under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), that defines the term “family office” for purposes of the family office exclusion from the definition of investment adviser under the Advisers Act as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). The Dodd-Frank Act eliminated the 15-client exemption from investment adviser registration that many investment advisers, including many family offices, traditionally have relied upon to avoid SEC registration. The Dodd-Frank Act mandated that the SEC adopt several rules to define certain terms and to establish the boundaries of certain investment adviser exceptions and exemptions created by the Dodd-Frank Act. The Proposed Rule is the first rule proposed from the SEC that would implement one of the provisions of the Dodd-Frank Act concerning investment adviser registration.2 The Proposed Rule would create an exclusion (not an exemption, as discussed below) from the definition of “investment adviser.” This Alert discusses the policy behind the exclusion and summarizes the key features of the Proposed Rule.

I. Family Offices as Investment Advisers; Historical Exemption from Registration

In general terms, family offices are entities established by wealthy families to manage the assets of, and provide tax, estate planning and other related services to, family members. A family office that, for compensation, provides family members and other related entities (e.g., family trusts or pooled investment vehicles owned by family members) with advice regarding investing, holding and trading in securities would fall within the general definition of “investment adviser” under the Advisers Act. Absent an exemption from registration, such a family office would be required to register with the SEC and be subject to the substantive provisions of the Advisers Act applicable to registered investment advisers.  

Historically, family offices have not been required to register with the SEC under the Advisers Act, either because (1) they could rely upon the so-called “private adviser” exemption provided to investment advisers with fewer than fifteen (15) clients or (2) they had applied for and been granted an exemption from investment adviser status by the SEC. Because the Dodd-Frank Act repeals the private adviser (15-client)3 exemption from adviser registration, as of July 2011 many family offices that had not been granted a specific exemption from investment adviser status would have lost their exemption from adviser registration. Recognizing this, Congress included in the Dodd-Frank Act a provision requiring the SEC to pass a rule that would define “family offices” that are excluded from the definition of “investment adviser” under the Advisers Act. The Proposed Rule defines “family offices” in order to provide the contours of the exclusion created by Congress in the Dodd-Frank Act.  

II. The Proposed Rule

A. General Discussion and Policy Behind the Exclusion

The SEC states that the Proposed Rule was intended, for the most part, to codify the existing exemptive orders the SEC has issued previously to single family offices. In doing so, the SEC states that the core policy that supports those existing exemptive orders also supports the Proposed Rule, which is that the Advisers Act was not designed to regulate the interactions of family members in the management of their own wealth. This, of course, means that determining which persons qualify as family clients for purposes of the exclusion is critical to whether the family office exclusion is available. Both the definition of “family office” and “family member” are discussed in greater detail below.  

The Proposed Rule will create an exclusion from the definition of “investment adviser” under the Advisers Act. This is significant because, unlike some of the other exemptions created by the Dodd-Frank Act, a family office that qualifies for the definitional exclusion from investment adviser status will not be subject to any recordkeeping and reporting requirements that might be required of exempt advisers under the rules the SEC will adopt in the wake of the Dodd-Frank Act, and they will also not be subject to the provisions of the Advisers Act that apply to advisers that are exempt from registration under the Advisers Act. For example, a family office that qualifies for the definitional exclusion of the Proposed Rule will not be subject to the general antifraud provisions of the Advisers Act (Sections 206(1) and 206(2)) or the requirement to obtain client consent for principal transactions (Section 206(3)). The SEC stated that true family offices can have their disputes with family members adjudicated under state law that is designed to deal with family disputes rather than through the SEC or under the Advisers Act.  

B. Family Office Exclusion Only Available to Single Family Offices

Another significant aspect of the Proposed Rule is that, like the existing exemptive orders that have been issued to family offices by the SEC to date, the Proposed Rule would make the exclusion available only to single family offices—that is, family offices that manage the money and assets of a single family (as well as other specified permitted persons associated with that single family). Offices that manage the wealth of more than one family (multi-family offices) would not qualify for the exclusion provided in the Proposed Rule.  

C. Key Definitions—“Family Office”, “Family Client” and “Family Member”

The Proposed Rule defines a “family office” as a company (including its directors, partners, trustees and employees acting within the scope of their employment) that:  

  • has no clients other than “family clients”;  
  • is wholly owned and “controlled” (directly or indirectly) by “family members”; and  
  • does not hold itself out to the public as an investment adviser.  

Under the Proposed Rule, a person who is not a family client, but who becomes a client of the family office as a result of the death of a “family member” or “key employee” or other involuntary transfer from a family member or key employee, will be deemed a “family client” for four (4) months following the transfer of assets resulting from the death or other involuntary transfer event.  

As mentioned above, the most critical element in determining whether the family office exclusion is available to a firm or person is to whom the firm/person provides investment advice and whether those recipients of the investment advice are the types of persons that do not trigger the policies that require the registration and regulation of investment advisers under the Advisers Act. Thus, the definitions of “family client” and “family member” are essential.

Under the Proposed Rule, a “family client” means any: (i) family member (see below); (ii) key employee; (iii) charitable foundation, charitable organization, or charitable trust, in each case established and funded exclusively by one or more family members or former family members; (iv) trust or estate existing for the sole benefit of one or more family clients; (v) entity wholly owned and controlled (directly or indirectly) exclusively by, and operated for the sole benefit of, one or more family clients; provided that if any such entity is a pooled investment vehicle, it is excepted from the definition of “investment company” under the Investment Company Act of 1940, as amended; (vi) former family member, subject to certain requirements included in the Proposed Rule; or (vii) former key employee, subject to certain requirements included in the Proposed Rule. This definition makes clear that family trusts that only have family members as beneficiaries and private funds that are owned and controlled solely for the benefit of family members will qualify as “family clients.” Thus, the SEC is recognizing that the family office exclusion should apply not only to direct management of individual family member’s assets but also to some of the more common ownership structures that families set up to manage the wealth of multiple members of the same family.  

“Family member” means: (i) the founders, their lineal descendants (including by adoption and stepchildren), and such lineal descendants’ spouses or spousal equivalents; (ii) the parents of the founders; and (iii) the siblings of the founders and such siblings’ spouses or spousal equivalents and their lineal descendants (including by adoption and stepchildren) and such lineal descendants’ spouses or spousal equivalents.  

“Key employee” means any natural person (including any person who holds a joint, community property or other similar shared ownership interest with that person’s spouse or spousal equivalent) who is an executive officer, director, trustee, general partner or person serving in a similar capacity of the family office or any employee of the family office (other than an employee performing solely clerical, secretarial or administrative functions with regard to the family office) who, in connection with his or her regular functions or duties, participates in the investment activities of the family office, provided that such employee has been performing such functions and duties for or on behalf of the family office, or substantially similar functions or duties for or on behalf of another company, for at least twelve (12) months.  

D. Grandfather Provision

The Proposed Rule contains a grandfathering provision so that a person who was not registered (or not required to be registered) under the Advisers Act on January 1, 2010 is not excluded from the definition of “family office” solely because such person was engaged before January 1, 2010 in providing investment advice to:  

  • natural persons who, at the time of their applicable investment, are officers, directors or employees of the family office who have invested with the family office before January 1, 2010 and are accredited investors, as defined in Regulation D under the Securities Act of 1933, as amended;  
  • any company owned exclusively and controlled by one or more family members; or  
  • any investment adviser registered under the Advisers Act that provides investment advice to the family office and who 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 represents, in the aggregate, not more than five (5) percent 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 subsection (3) shall be deemed to be an investment adviser for purposes of the antifraud provisions of the Advisers Act.  

III. Next Steps

Comments to the Proposed Rule must be received by the SEC by November 18, 2010. The SEC requests comments generally on the Proposed Rule, and specifically seeks comments on the number of small entities that would be affected by the Proposed Rule and whether the effect of the Proposed Rule on small entities would be economically significant.  

If you are interested in submitting a comment on the Proposed Rule to the SEC, or are contemplating doing so, please feel free to contact us to assist in the preparation of your comment.