On Oct. 12, 2010, the Securities and Exchange Commission issued a proposed rule (Proposed Rule 202 (a) (11) (G)-1) that clarifies the family office exclusion under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act). The SEC clearly intends to address what it considers the vast majority of traditional family office activities and structures. Accordingly, the proposed rule defines which entities will be considered “family offices” for purposes of being exempt from the Dodd-Frank Act’s requirement to register as investment advisers. In this process, the proposed rule looks to concepts such as “family members,” “family clients,” who “controls” the family office, who “owns” the family office, and certain other definitions (for example, “key employee”) and concepts (such as “grandfathering”).
Yet, the SEC’s initial attempt illustrates how very difficult it is to create a comprehensive rule of general applicability that responds to the myriad circumstances that one encounters in practice. While we praise the SEC for its even-handed attempt to craft a family office exemption, we believe the SEC’s proposed rule leaves various issues unresolved and that the SEC needs to address other issues differently.
Historically, single family offices were required to register as an investment adviser under the Investment Adviser Act of 1940 just as any commercial investment advisory firm, unless the family office qualified for an exemption from registration. Prior to the Dodd-Frank Act, enacted on July 21, 2010, most single family offices relied on the private adviser exemption (that is, being an adviser with less than 15 clients) to avoid registration. However, the Dodd-Frank Act repealed that exemption and created new methods to avoid registration, including the family office exclusion. Under the Dodd-Frank Act, families have a one-year transition period in which to restructure to avoid registration, or in which to register as an investment adviser (under federal or state regulatory rules, as applicable). Fortunately for family offices, the Dodd-Frank Act excludes “any family office” that meets certain criteria to be established by SEC rules.
The SEC requested comments from practitioners and is considering those comments. As a proactive matter, my colleagues and I have prepared and are submitting extensive comments and recommendations. Other practitioners and groups, such as the Private Investor Coalition, also are submitting comments. All of these comments are, of course, intended to assist the SEC in its efforts to fulfill the Congressional mandate that the new rule takes into account the wide range of variations in the structure and management of family offices.
Here’s a summary of our recommendations to the SEC.
1. The proposed rule limits the definition of “family members” to those who are related to the founders of the family office. In defining the limits of what constitutes a “family member” for purposes of determining whether a family office is a single family office, and in applying the grandfathering exception, the test should turn on the family relationship among current clients of the office and include all clients who are descended from a common ancestor, instead of asking who are the “founders” of the office. We believe that:
A. The “founders” concept raises a number of issues and unduly restricts the scope of who is in the “family.”
B. “Family” is better defined as those persons who can prove a link to a common ancestor.
2. Resource-sharing and the use of overlapping directors and other personnel with another family office, which many family offices do to reduce expenses, shouldn’t preclude a family office from qualifying for the new exclusion, due to a claim by regulators that each office is also serving the clients of the other office and thus has clients who are not “family clients.”
3. Using the concept of a “family-funded entity” would address multiple definitional issues raised in the proposed rule, such as determining the exact scope of what is “charitable,” and yet would still be true to the rationale of the family office exemption – the family office is providing investment advice regarding the family’s own money, not someone else’s.
A. For example, in requiring family members to “own” the family office, a “family-funded entity” would be treated as owned by the family for this purpose.
B. A “family-funded entity” would qualify as a permissible “family client” due to it being funded and controlled by the family, making it unnecessary to engage in delicate determinations such as whether an entity is “charitable.”
4. The proposed rule disqualifies family offices from the exception unless they’re wholly owned and controlled by family members. A family office shouldn’t fail to qualify due to an immaterial amount of non-family ownership or due to providing investment advisory services to non-family members for no charge. Furthermore, if the ownership threshold is met, then a separate test of family “control” shouldn’t be necessary; the family owns it and thus will exercise an appropriate amount of control. Moreover, a trust for the primary current benefit of family members should be considered a permissible owner of a family office.
5. To be a permissible client, the proposed rule requires entities to be owned and operated “exclusively” for family members. This should be changed so that the proposed rule doesn’t disrupt commonly used forms of trusts and estate plans. Otherwise, a small gift to one’s alma mater in one’s estate plan would preclude a trust from being a permissible client.
A. In determining whether a charitable split-interest trust is a “family client,” a charitable lead trust should be considered a family funded entity, provided that the family controls the selection of the charitable recipient; a charitable remainder trust should be a trust for the benefit of the family and thus a permissible family client, because the family members are the initial beneficiaries and charity is only a beneficiary after a certain date (usually measured by the life of a family member).
B. The four-month grace period for involuntary transfers should be changed to 24 months, subject to further extension in certain limited cases.
6. Under the proposed rule, if a person becomes a former family member (for example, through divorce) then the family office may no longer provide investment advice to him, except for certain pre-existing investments. A former family member (including, for instance, a divorced spouse or a step-child) who is still treated as a member of the family by the family office should continue to be considered a “family member” rather than “former family.”
We hope that our comments, and those being submitted by others, will be helpful in fashioning a rule that adheres to the principles underlying the family office exclusion and, at the same time, avoids leaving too many family offices outside the exception, with no option but to seek recourse to separate requests for exemptive relief or worse, undergoing expensive and in our opinion, unnecessary, registration.