Advisers Act Rule Proposal on a Fast Track

As required under the Dodd-Frank Act1, the Securities and Exchange Commission has proposed new Rule 202(a)(11)(G)-1 to define a "family office" under the Investment Advisers Act of 1940 (the "Advisers Act").2 Section 409 of the Dodd-Frank Act amended the Advisers Act to exclude a family office from the definition of "investment adviser" in the Advisers Act.

Family offices include many types of firms and arrangements, typically dedicated to serving multiple needs of one or more families or individuals with significant assets. Services may include asset management, banking, fiduciary, charitable giving, tax exempt foundation, trust and accounting services, administrative matters such as bill-paying, and management of household staff and properties. Many offices serve only a single family, including lineal descendents, current and former spouses and significant others. Other "multi-family" offices serve several or more families, and there are also established stand-alone businesses organized as trust companies, banks and investment advisers oriented to providing a range of services to families and individuals. Family offices often permit affiliated entities and key employees to participate in services and investments offered to family members.

Historically, to the extent a family office offered advice about securities for compensation, it fell under the definition of "investment adviser" in Section 202(a)(11) of the Advisers Act. Many family offices were able to rely on the "private adviser" exemption under Section 203(b) of the Advisers Act, which generally exempted an investment adviser from registration so long as the adviser did not hold itself out to the public as an investment adviser, and the adviser provided advice to 14 or fewer clients during the preceding twelve-month period. Section 403 of the Dodd-Frank Act amended the Advisers Act to eliminate, as of July 21, 2011, the "private adviser" exemption under Section 203(b). Thus, family offices will no longer be able to rely on the private adviser exemption.

Since the 1940's, certain "single family" family offices that were unable to rely on the private adviser exemption (usually because of the number of their family clients) have obtained exemptive orders from the SEC holding that the offices are not investment advisers under the Advisers Act. Recognizing this line of precedent, Congress elected, through the Dodd -Frank Act, to provide the new family office exclusion from the definition of investment adviser for those "family offices", as defined by the SEC. Congress directed the SEC to define the term "family office" in a manner consistent with such prior SEC exemptive orders. The definition that the SEC has proposed generally follows the conditions contained in these prior orders, establishing three conditions for a family office to be eligible for the new exclusion:

  1. "Family clients" only. Eligible family clients would include family members, certain employees of the family office, charities 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 exclusively by, and operated for the sole benefit of, family clients (with certain exceptions), and, under certain circumstances, former family members and former employees. A "family member" is proposed to include the individual and his or her spouse or spousal equivalent for whose benefit the family office was established and any of their subsequent spouses or spousal equivalents, their parents, lineal descendants and such descendants' spouses and spousal equivalents. Adopted children and step-children are treated as family members. The proposed rule would not extend to an office serving multiple families; the release notes that the SEC has never granted exemptive relief from the Advisers Act to a multifamily office and that many multifamily offices "more resemble a typical commercial investment adviser appropriately subject to the Advisers Act".
  1. Involuntary Transfers. In the event of an involuntary transfer to a non-family client, such as by a bequest to a charity of an interest in a family-advised family fund, the family office could continue to manage the assets involved for a period of four months, in order to provide for a transition period for the family office to move the assets to another investment adviser, seek exemptive relief or otherwise restructure its activities to comply with the Advisers Act.
  2. Former Family Members. Former spouses, spousal equivalents and stepchildren would be permitted to retain any investments held through the family office at the time they became a family member, but would not be able to make new investments.
  3. Charitable Organizations, Estates and Other Family Entities. Charitable organizations established and funded exclusively by one or more family members, and any trust or estate existing for the sole benefit of one or more family clients, along with any company or pooled investment vehicle that is wholly-owned and controlled, directly or indirectly, by one or more family clients and operated for the sole benefit of family clients, will all be treated as a "family client" under the rule.
  4. Key Employees. Certain key employees, such as executive officers, trustees, and those participating in investment activities, would be treated as family members under the rule, to allow them to receive investment advice from and participate in investment opportunities provided by the family office.
  1. Family members must own and control the office. To operate under the proposed rule, the family office must be wholly-owned and controlled, directly or indirectly, by family members. The SEC believes that this condition helps distinguish family offices from family-run offices that operate more like a typical commercial investment adviser, noting that most family offices that have obtained exemptive orders have represented that they do not operate to generate a profit, and charge fees only to cover their costs. The SEC suggests that restricting the ownership and control of a family office to only family members alleviates any concern about the profit structure of the office, because any profits for managing family assets will accrue only to family members.
  1. No holding out to the public as an investment adviser. A family office relying on the rule could not hold itself out to the public as an investment adviser. The SEC believes that holding oneself out as an investment adviser is a prime indicator of investment adviser status and thus inconsistent with the exclusion for family offices from the Advisers Act.

Grandfathering Provision. Section 409(b) of the Dodd-Frank Act includes a "grandfathering clause" that precludes the SEC from excluding family offices from the new definition solely because they provide advice to certain clients and had provided advice to those clients before January 1, 2010. The grandfathered clients are (i) natural persons who had invested in the family office prior to January 1, 2010 and who, at the time of their investment in or via the family office, were officers, directors or employees of the family office (each such person must be an "accredited investor" under Regulation D of the Securities Act of 1933), and (ii) registered investment advisers that provide investment advice and identify investment opportunities to the family office and invest in such transactions on substantially the same terms as the family office invests, but such an adviser may not invest in other funds advised by the family office, and the assets as to which the family office directly or indirectly provides investment advice, must represent, in the aggregate, not more than 5% of the value of the total assets as to which the family office provides investment advice.

State Law Preemption. Family offices falling under the new definition are excluded from the definition of investment adviser under the Advisers Act and therefore will be exempt from state registration under Section 203A(b)(1)(B) of the Advisers Act, which prohibits states from requiring the registration of any person that is excepted from the definition of an investment adviser under Section 202(a)(11) of the Advisers Act.

Comment Period and Next Steps. The proposed definition, as expected, is narrow in scope and some of the conditions seem unduly restrictive. The SEC has requested comment on a range of issues and questions, and it is possible that the comments will result in more family offices being able to fit under the final exclusion. A family office that does not meet the conditions imposed by the rule may seek its own exemptive order from the SEC, however the SEC will likely continue to require the types of conditions imposed by prior orders. Also, it can take many months, and longer, for the SEC staff to evaluate and process exemptive applications. Thus, ineligible family offices will either have to register as investment advisers on or before July 21, 2011, or revise their operating models to come within the newly defined exclusion. Some family offices may seek to consolidate their operations with another family office that is already registered as an investment adviser. In any case, all family offices will need to evaluate their circumstances carefully in light of the rule proposal.

Comments to the proposal should be provided by November 18, 2010. The SEC can be expected to act quickly in digesting the comments on the proposal. If you have questions about the proposal or would like assistance in preparing and submitting comments, please contact Mike McNamara, Ira Roxland, Walter Van Dorn, Mike Zolandz or your regular SNR Denton contact.