On Tuesday, Oct. 12, 2010, the Securities and Exchange Commission (the “SEC” or the “Commission”) proposed a new rule, based on requirements under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), that would enable “family offices” to be exempt from investment adviser registration under the Investment Advisers Act of 1940, as amended (the “Advisers Act”).
Family offices are entities established by wealthy families generally considered to be families with at least $100 million or more of investable assets, to manage their own money and provide tax and estate planning and similar services. Historically, family offices have not been required to register with the SEC under the Advisers Act because of an exemption provided to investment advisers with fewer than 15 clients. The Dodd-Frank Act removes that exemption (primarily so that the SEC can regulate hedge fund and other private fund advisers), but includes a new provision requiring the SEC to define family offices in order to exempt them from regulation under the Advisers Act.
The Commission is proposing to define a family office as any firm that: (i) provides investment advice only to family members, as defined by the rule, certain key employees, charities and trusts established by family members, and entities wholly owned and controlled by family members; (ii) is wholly owned and controlled by family members; and (iii) does not hold itself out to the public as an investment adviser. Public comments on the proposed rule must be received by the Commission by Nov. 18, 2010. (Press Rel. 2010-189).
As a result of the Commission’s action, “family offices” that meet the definition will not be subject to any provisions of the Advisers Act applicable to “investment advisers, “including registration as an adviser with the SEC or any state, and certain other provisions of the Advisers Act that are applicable to persons who meet the definition of an investment adviser, whether or not they are required to register with the SEC, such as the antifraud provisions of Advisers Act Section 206.
The Commission estimates that thereare 2,500 to 3,000 single-family offices managing over $1.2 trillion in assets. Because the services provided by family offices often include providing advice about securities, family offices generally would fall within the definition of “investment adviser” and, absent an available exemption, would need to register under the Advisers Act, or state securities authorities.
Historically, many family offices were structured to take advantage of the exemption from registration provided by Section 203(b)(3) of the Advisers Act, the so-called “private adviser” or “fewer than 15 client” exemption. That exemption, however, has been eliminated by the Dodd-Frank Act. Section 409 of the Dodd-Frank Act creates a new exclusion from the Advisers Act for “family offices,” a term to be defined by the Commission in a manner consistent with the Commission’s prior exemptive relief in this area. Family offices satisfying the conditions of the new exclusion would not be subject to any of the provisions of the Advisers Act.
The proposed rule contains three general conditions:
1. the exemption only is available to family offices that provide advice about securities exclusively to certain family members and key employees;
2. the family office must be wholly owned and controlled by family members; and
3. the family office may not hold itself out to the public as an investment adviser.
The definition incorporates the grandfathering provision in Section 409(b)(3) of the Dodd-Frank Act and provides that the definition of a family office shall not exclude any person, who was not registered or required to be registered under the Advisers Act on Jan. 1, 2010, solely because such a person provides investment advice to, and was engaged before Jan. 1, 2010 in providing investment advice to the following categories of persons:
“(1) 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;
(2) Any company owned exclusively and controlled by one or more family members; or
(3) 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 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 (c) shall be deemed to be an investment adviser for purposes of paragraphs (1), (2) and (4) of section 206 of the [Advisers] Act.”
Perhaps the most interesting aspect of the proposal is that the Commission, the nation’s federal securities regulatory authority, is defining the terms “family member” and “spousal equivalent.” This is an arena which historically has been left to the states and the courts. Whether these definitions will have consequences outside the proposed exemption from the Advisers Act is, at this point, impossible to predict. The Commission may be sailing into unchartered waters when it includes in the definition of “family client” stepchildren but generally excludes (subject to a shortterm, i.e, four-month exception) persons who are involuntary transferees of family members. Similarly, there are many questions or possible scenarios seemingly not addressed by the proposal. For example, the term “spousal equivalent” means “cohabitant occupying a relationship generally equivalent to that of a spouse.” Would that include same-gender relationships? Could a person have multiple “spousal equivalents?” Why does it seem as though family members of key employees are not treated as “family members?” Does it really make sense to prohibit former family members from making any new investments through the family office? Why are uncles, aunts, and cousins of family office founders excluded from the definition of “family member?”
As indicated above, comments on the proposed rule must be received by the Commission by Nov. 18, 2010.