In connection with implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC has proposed a rule that would define and exempt “family offices” from being subject to regulation under the Investment Advisers Act of 1940. The new definition of “family office” largely codifies the SEC’s prior exemptive orders that have been issued to certain family offices.
Family offices are entities established by families to manage their money, plan for their families’ financial future and provide other services to family members, including managing securities portfolios and providing financial, tax, accounting and estate planning advice. Previously, many family offices relied upon an exemption from the Advisers Act for entities with fewer than 15 clients in the preceding 12 months and that neither held itself out publicly as an investment adviser nor advised any registered investment company or business development company. Other family offices have sought and received exemptive orders from the SEC based on their particular facts and circumstances.
However, the Dodd-Frank Act repealed the 15-client exemption in order to cause advisers to private funds, such as hedge funds, to be subject to the Advisers Act. This repeal also had the effect of removing the exemption that many family offices relied upon, and to remedy this foreseen consequence, the Dodd-Frank Act requires the SEC to formulate rules that exempt family offices from the purview of the Advisers Act.
The Proposed Three-Part Test
Under the proposed rule, a family office will be exempt from the Advisers Act if it meets three requirements.
Only Family Clients
First, the family office may have no clients other than “family clients.” To this end, “family clients” are defined to include any family member, certain key employees of the family office, any charitable entity established and funded exclusively by family members or former family members, trusts or estates existing for the sole benefit of family clients and entities wholly-owned and controlled by, and operated for the sole benefit of, family clients (with certain exceptions), and under certain circumstances, former family members and former employees.
“Family member” is defined to include the founders of the family office, their lineal descendants (including by adoption and stepchildren) and such lineal descendants’ spouses or spousal equivalents, the founders’ parents, siblings and such siblings’ spouses or spousal equivalents, lineal descendants (including by adoption and stepchildren) and such lineal descendants’ spouses or spousal equivalents.
“Spousal equivalent” is defined as a cohabitant occupying a relationship generally equivalent to that of a spouse.
The proposed rule would allow the family office to provide investment advice to employees that are not solely performing clerical, secretarial or administrative functions and whose regular duties include participation in the investment activities of the family office.
The proposed rule also provides for the treatment of certain persons that no longer qualify as being a family client, such as former family members by divorce and former key employees of the family office, by allowing the family office to continue advising such persons, but only with respect to their investments that existed at the time that they were considered family clients. A transition period also is contemplated for involuntary transfers of assets to a non-family client, such as upon death, in order to allow for the orderly transition of that family client’s assets to another investment adviser.
Ownership and Control
The second requirement for the family office is that it be wholly-owned and controlled, either directly or indirectly, by family members. This requirement would distinguish family offices from “familyrun offices” that may provide advice to other people, including other families, and otherwise operate as a more typical commercial investment adviser.
Holding Out to Public
Lastly, a family office relying on the exemption would be prohibited from holding itself out to the public as an investment adviser. Doing otherwise would be inconsistent with the basis for the SEC’s prior exemptive orders relating to family offices and rationale for the current proposed exemption for family offices.
Consistent with past practice, a family office that does not meet all of the requirements of the new rule can seek an exemptive order from the SEC based on its specific facts and circumstances. In this regard, the SEC proposes that existing exemptive orders not be rescinded in connection with adopting the new rule.
The period for public comment on this proposed family office exemption ends on November 18, 2010. Areas where the SEC is specifically soliciting comments include the scope of the employees that would be construed as “family clients,” the requirement that a family office be wholly owned and controlled by family members and the prohibition on family offices serving multiple families.