Prior to the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd- Frank”), family offices typically avoided registering under the Investment Advisers Act of 1940 (“Advisers Act”) by relying on the exemption provided for private advisers. This exemption was available to advisers who during the preceding 12 months had less than 15 clients and did not hold themselves out to the public as an investment adviser. Dodd-Frank repealed this exemption but in doing so, added a new exclusion for family offices to be defined by the Securities and Exchange Commission (“SEC”). On June 22, 2011, the SEC issued its final rules defining a family office that is excluded from registration under the Advisers Act.1
To qualify for exclusion from registration as a family office, the office must satisfy three requirements: i) it must only advise “family clients;” ii) it must be wholly owned by family clients and controlled by family members and family entities; and iii) it must not hold itself out to the public as an investment adviser. The final requirement is not an issue for most true family offices. The critical parts of the rules are determining who is a family client and the ownership/ management requirement.
An excluded family office can provide investment advice only to “family clients.” Under the new rules family clients include: i) family members; ii) former family members; iii) key employees; iv) former key employees; iv) non-profit organizations solely funded by family clients; v) estates of family members, former family members, key employees and former key employees; vi) certain trusts; and, vii) companies wholly owned by family clients and operated for the sole benefit of family clients. These categories will be examined in more detail below.
Family members and former family members
Family members include all lineal descendants of a designated common ancestor who is no more than 10 generations removed from the youngest generation being advised by the family office. Descendants include adopted children, stepchildren, foster children and individuals that were a minor when another family member became their legal guardian. Also included are spouses and spousal equivalents, which are defined by the rule as a “cohabitant occupying a relationship generally equivalent to that of a spouse.” The definition of “spousal equivalents” seems broad enough to include same-sex Registered Domestic Partners under California law and other states having similar provisions. In the preamble to rules, the SEC states that the Defense of Marriage Act does not prohibit it from according family member status to spousal equivalents. Its reasoning is that the rule does not define “spouse” and “spousal equivalent” is a separate category of family member under the rules. Under the definition provided by the SEC, the couple must cohabit the same dwelling. If the SEC issues any further clarification on this point, we will keep you apprised. Former family members are treated as family members and include ex-spouses or equivalents and their children. Under the final rule, former family members may continue to invest new funds through the family office after they become a former family member.
The common ancestor may be a deceased person. As the family expands and younger generations come under the management of the family office, the office is permitted to designate a younger generation member as the new common ancestor. Note, however, that such a re-designation of the common ancestor to a younger generation family member may require the office to drop certain branches of the family as clients. Normally, a family office should choose as the common ancestor, the youngest ancestor whose lineage will permit servicing all of the family members for which office wishes to provide service. Picking the youngest such ancestor will maximize the time before a new ancestor has to be chosen.
There is also a useful inadvertent transfer rule. Suppose a family member dies and leaves assets that are under management of the family office to a non-family member? The rule permits those assets to continue to be managed for the non-family member for up to one year after the transfer of legal title to the assets to the non-family member. This grace period will permit the non-family member time to make his own arrangement for the management of those assets and the family office time to assist the orderly transition of that non-family member’s assets.
Key employees and former key employees
The family office may permit key employees to invest through it. A key employee is an executive officer, director, trustee, general partner or person serving in an equivalent capacity of the family office or affiliated family office. Affiliated family offices are multiple family offices controlled by one family. The SEC was made aware that some families have more than one family office operation. It also includes any nonclerical employee who as part of his regular duties participates in investment activities for the family office or affiliated family office and has done so for at least 12 months. An investment by a key employee includes one in which his spouse or spouse equivalent holds a joint, community property or other shared ownership interest. A former key employee may keep his investment with family office but may not make any new investment through the family office unless such investment was contractually committed at the time his employment terminated.
This is an important and somewhat complex category of family clients. It includes charitable foundations, trusts and other organizations for which all of the funding currently held by such entity comes from family clients. This category includes charitable lead and remainder trusts whose only current beneficiaries are family clients and charitable or non-profit organizations funded exclusively by family clients. The non-profit organization does not have to have been formed by a family member if all currently held funding came from family clients.
A non-profit organization that has received funding from non-family clients may continue to be advised by the family office until December 31, 2013, provided the office does not accept further non-family contributions after August 31, 2011 unless made in fulfillment of a pledge made prior to August 31, 2011. The preamble to the rules sets forth a means by which such an organization can purge itself of nonfamily client contributions. If a non-profit organization has accepted non-family contributions, any spending by the organization in the year of such contribution or subsequent years may first be allocated to the nonfamily contributions. Only the non-family contributions need be purged through spending; earnings on the non-family contributions can be ignored. If the organization can purge itself of any non-family contributions by December 31, 2013, it may continue to be advised by the family office.2
Estates of family members, former family members, key employees and former key employees
The family office may continue to represent the estate of a deceased family member or former family member, even if the estate will ultimately be distributed to non-family members. The office may also represent the estate of a key employee, or former key employee, provided that in the case of the estate of a former key employee, no new investment can be made through the family office.
The rule regarding trusts distinguishes between irrevocable trusts and revocable trusts. In the case of irrevocable trusts, the office may manage investments for the trust if the only current beneficiaries are other family clients. Contingent beneficiaries do not have to be family clients. If a non-family contingent beneficiary becomes a current beneficiary, the involuntary transfer rule would apply and the office could manage the investments for the trust for one year thereafter. The office can also manage investments for an irrevocable trust that is funded solely by family clients and all current beneficiaries are other family clients and charities or non-profit organizations.
A revocable trust’s investments can be managed by the family office if family clients are the sole grantors. Finally, a trust may have its investments managed by the family office where each trustee or person authorized to make decisions is a key employee and each settlor or other person who has contributed assets to the trust is a key employee or spouse or former spouse who at the time of contribution holds a joint, community property or other shared ownership interest with the key employee.
The family office may manage investments for any company wholly (directly or indirectly) owned by and operated for the sole benefit of, one or more family clients. The company does not have to be managed or controlled by family clients; however, no degree of non-family client ownership is permitted.
Ownership and control of the family office
The other important requirement is the ownership requirement. The office must be wholly owned by family clients and must be exclusively controlled (directly or indirectly) by one or more family members and/or family entities. This rule permits key employees (which are included in the definition of family client) to hold an ownership interest in the family office entity, however it does not permit key employees to have management control of the family office. The definition of family entity, for purposes of this provision excludes key employees. Control means the power to exercise a controlling influence over the management or policies of the company, unless such power is solely the result of being an officer of the family office.
In certain limited situations, some family office operations in existence on January 1, 2010 may be grandfathered from the registration provisions of Dodd-Frank even if they do not meet the new family office requirements. A family office will continue to be exempt from registration if on January 1, 2010, in addition to family clients, it provided investment advice to natural persons who at the time of their investment were officers, directors or employees of the family office who invested before January 1, 2010 and are accredited investors under Regulation D. It also includes management of investments for any company owned exclusively and controlled by one or more family members. Please note that to the extent a family office is exempt from the definition of “investment adviser” by virtue of the grandfathering provision, the family office will nevertheless be deemed an investment adviser for purposes of certain antifraud provisions of the Advisers Act, namely Sections 206(1)(2) and (4) thereunder.
There is another grandfather provision that will be beneficial to some family offices. If the office has previously received an exemptive order from the SEC, determining it to not be subject to the registration requirements of the Advisers Act (pre- Dodd-Frank), it may continue to operate under that exemptive order.
Window for Compliance
The SEC recognized that family offices would need some time to determine if they will continue to be excluded from registration and possibly to reconfigure their operations to make them excluded or to register under the Advisers Act if they do not. Therefore, the rules also provide that any company existing on July 21, 2011 that provides investment advice to members of a single family is exempt from registration until March 30, 2012 as long as during the preceding twelve months it had fewer than 15 clients and did not hold itself out to the public as an investment adviser.
What you need to do
You should immediately review the operations of your family office to determine whether it will qualify or can be re-configured to qualify, for exclusion from registration under the SEC rules or whether it will need to register or seek an exemptive order from the SEC. We are happy to assist you in the process. Please contact your usual attorney in our group and he or she will put you in touch with our experts in this area.