The Family Office Rule

Countdown to compliance

The March 30, 2012 deadline for family offices to comply with the requirements of the Dodd-Frank Act (Dodd-Frank) is fast approaching. For those who’ve not already done so, it’s important to complete your review and analysis and undertake any necessary restructuring, prior to the deadline. Those who can’t satisfy the family office definition adopted by the Securities and Exchange Commission may need to register with the SEC as an investment adviser.

In July 2010, Dodd-Frank amended the Investment Advisers Act of 1940 (the Advisers Act) in two ways of particular importance to family offices. First, Dodd-Frank repealed the so-called “private adviser exemption,” which was previously relied on by many family offices for advisers with fewer than 15 clients. Second, Dodd-Frank created a new exemption for “family offices,” but directed the SEC to issue rules defining a family office.
Last June, the SEC adopted a new rule (the family office rule) setting forth its definition of a family office. The SEC’s final definition was heralded as a vast improvement over its earlier proposed definition. However, family offices wishing to avoid SEC regulation must navigate a new set of obstacles.

The Family Office Rule
The SEC defines a family office as a company that satisfies three criteria:

  • it only serves “family clients;”
  • it’s owned by family clients and controlled by family members or family entities; and
  • it doesn’t hold itself out to the public as an investment adviser.
The family office rule permits a broad range of individuals and entities to qualify as family clients and can accommodate numerous ownership structures. For these purposes, “family client” includes family members and former family members; key employees, and in some cases, former key employees; certain non-profit organizations, charitable foundations and charitable trusts, exclusively funded in each case by family clients; estates of family members, key employees or in some cases, former key employees; certain kinds of trusts; and companies that are wholly owned exclusively by, and operated for the sole benefit of, family clients.

There are several areas of concern that often pose challenges to family offices seeking to rely on the family office rule:
Investment advice for distant relatives and non-family members. Some family offices advise distant relatives who fall outside of the sphere of “family members,” as defined under the family office rule. The rule permits family offices to advise “all lineal descendants … of a common ancestor, and such lineal descendants’ spouses or spousal equivalents; provided that the common ancestor is no more than 10 generations removed from the youngest generation of family members.” However, siblings of the spouses of lineal descendants (for example, a family member’s in-laws) don’t meet this definition. Providing investment advice to such individuals, or other distant relatives that aren’t lineal descendants of a single common ancestor or their spouses, will disqualify the family office from relying on the family office rule.
Similarly, many family offices have long-standing investment advisory relationships with other families or close family friends. Other family offices provide investment advice to collective investment vehicles with owners, or trusts with beneficiaries, that are a mix of family clients and non-family clients. Still other family offices provide investment advice not only to their key employees (who qualify as “family clients”), but also to their key employees’ family members. All of these relationships will disqualify a family office from relying on the exemption provided by the family office rule.
Ownership and control. The family office rule contains specific requirements relating to ownership and control. The SEC has signaled a willingness to accept a broad range of ownership and control structures. However, the family entities, a defined term that specifically excludes key employees, must in fact control the management and policies of the family office. For example, in recently issued guidance, the SEC stated that the ability of family members to appoint, terminate or replace the governing body of the family office wasn’t, by itself, sufficient to satisfy the control requirement. For many family offices in which professional staff controls day-to-day operations and outside advisers have been placed on the board or other governing body, it’s necessary to review the organizational documents to ensure that the family controls the family office in the manner required under the family office rule.
Charitable organizations. The family office rule allows exempt family offices to provide investment advice to non-profit organizations, charitable foundations or other charitable organizations only if the organization is funded exclusively by family clients. A family office won’t meet the requirements of the family office rule if it accepts outside donations or holds an annual fundraising drive. Family offices should be aware that there’s a special grace period for compliance in this instance. If a family office wishes to continue providing investment advisory services to a charitable organization, the organization has until Dec. 31, 2013 to spend all funding attributable to non-family clients.

Most family offices that fail to satisfy the requirements of the family office rule are choosing to restructure rather than to register with the SEC. If the family office is providing investment advice directly to a non-family client in the form of a managed account or other similar arrangement, this process can be fairly simple. However, restructuring can prove more difficult and expensive when it’s necessary to unwind collective investment vehicles or trusts that benefit non-family members other than charities.

Analysis Required
Family offices that don’t take the time to understand how the family office rule affects them do so at their own peril. They should undertake an analysis to determine whether they qualify under the family office rule and, if necessary, devise a plan to restructure. While it’s often fairly easy to identify the changes that need to be made for a family office to qualify for the exemption from SEC registration and regulation, devising a plan that minimizes or avoids the unintended consequences is a greater challenge and requires additional time. Given the March 30 deadline for compliance, family offices should quickly address these issues.

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