SEC Adopts Final Rules Regarding 'Family Offices' to be Excluded from Investment Adviser Regulation
July 28, 2011
Most small and medium-sized family offices that previously came within the definition of an "investment adviser" (by virtue of providing advice about securities for compensation) have, up to July 21, 2011, relied upon the "private adviser exemption" from registration under Section 203(b)(3) of the Advisers Act. That Section exempted a person that meets the definition of investment adviser if, among other things, the person advised fewer than 15 clients during the immediately preceding 12-month period and did not "hold itself out" generally to the public as an investment adviser (the "Private Adviser Exemption"). The Private Adviser Exemption was the same exemption also relied upon by many advisers to hedge, venture capital and private equity funds. The Dodd-Frank Act rescinded the private adviser exemption effective July 21, 2011. Since 1941, the SEC has also issued exemptive orders to at least 15 family offices holding that particular family offices were "not within the intent" of the meaning of "investment advisers" within the meaning of Section 202(a)(11) of the Advisers Act. Thus without the specific relief for "family offices" under Section 409 of the Dodd-Frank Act, many family offices that previously relied upon the Private Adviser Exemption would (without a special exemptive order) now be required to restructure themselves or to register under the Advisers Act (see the part of this memorandum entitled "What To Do Now?").
The Final Rule's Three Part Test
The SEC issued the proposed "family office" exemption (the "Proposed Rule") on October 12, 2010 and requested comments by November 18, 2010. In the final rule 202(a)(11)(G)-1 of the Advisers Act (the "Final Rule"), the SEC made significant alterations to its Proposed Rule, effectively broadening the coverage of and clarifying the Final Rule. However, many family offices will still find the expansion not broad enough for their particular circumstances.
The Final Rule sets three basic elements for a family office:
- Limited Clients: The family office can only provide advice to "family clients" ("family clients" include family members, former family members, key employees, former key employees and alter ego entities formed for their benefit including certain trusts, estates and charities);
- Family Owned/Controlled: The family office must be controlled by family members and "family entities" (not current or former key employees, nor former family members) and the family office must be wholly owned by "family clients"; and
- No Holding Out: The family office cannot hold itself out to the public as an investment adviser.
In addition to these requirements, the "grandfathering" provision required by Section 409 of the Dodd-Frank Act has been included as originally proposed without any changes.
Who is a Family Member?
The governing principle of the Final Rule is that a family can come together to form an office that provides investment advice just to members of the family without federal securities regulation. At the heart of this is the central issue of what constitutes a "family". The SEC completely discarded the original concept in the Proposed Rule that the family would be defined by reference to the actual family office founder who was the wealth creator. In its place, the SEC adopted in the Final Rule a new "family tree" approach, centered on the designation of a single common ancestor who is no more than 10 generations removed from the youngest living family member. A "family member" means all lineal descendants of a designated living or deceased common ancestor and such lineal descendants' spouses or spousal equivalents. Once the ancestor is chosen as the trunk of the family tree, the branches grow. Former family members remain family clients when they cease being family members. However, their branches of the family tree cannot grow after they cease being family members. The Final Rule contains ambiguities and inconsistencies as the growth of that family tree is defined by the degree of lineal kinship to the designated relative rather than through the Proposed Rule's definition of 'parents' and 'children.' Furthermore, it is unknown whether the single ancestor concept will fit most family offices or whether the 10 generation limit will cause most family offices to face difficult choices, either now or in the future as the family grows.
Single Common Ancestor and the 10 Generation Limit: Under the Final Rule, every family office must have a designated common ancestor. That designation is neither formal nor permanent. There is no reporting or required documentation to designate the common ancestor. The common ancestor can change over time. The single ancestor may be living or deceased. Lineal descendants are defined with reference to that single ancestor, subject to the 10 generation limit. The SEC notes in the Release that the 10 generation limit will prevent families from choosing an extremely remote ancestor (which could open up the family office to abuse as a disguised commercial advisory business) while accommodating the typical number of generations served by most family offices.
Because family offices under the Final Rule must designate a single person as an ancestor, rather than a couple, a family office founded by a married couple would need to chose one of their parents in order to have all their descendants covered. If the couple chooses the husband's mother, the wife's parents cannot be covered as family members. In that example, his father would be excluded as well. As a second example, if the same married couple forms the family office with the couple's respective brothers and the brothers' wives, the founders will likely find they do not have a single common ancestor. In that case, each brother would need to form their own family office and would designate a parent as the common ancestor so that his spouse was covered. The original couple might be considered 'family' to both or neither, depending on which parent was selected as the designated single ancestor. These situations were covered by the Proposed Rule where the founder, his/her spouse (or spousal equivalent), parents and siblings were included.
Children, Spouses and Former Family Members: The Final Rule provides that a family member is a lineal descendant "including by adoption, stepchildren, foster children and individuals that were a minor when another family member became a legal guardian of that individual" of the single designated ancestor. Current spouses and spousal equivalents of lineal descendants are also family members. The definition of "former family member" includes a spouse, spousal equivalent, or stepchild that was a family member but is no longer a family member due to a divorce or other similar event. While the Proposed Rule would have prevented former family members from making new investments through the family office after they left the family, under the Final Rule former family members may remain family clients. While these rules seem clear and simple to follow, when applied to the complexities of family structures, these rules do not provide much guidance in particular situations.
The concepts of foster children and children in guardianships are both entirely new in the Final Rule, although the Proposed Rule embraced non-traditional families in other ways. While the SEC included children in guardianships, it chose in the Final Rule to specifically exclude adults who become subject to a guardianship by a family member. The SEC stated adult guardianships would need to be addressed in exemptive orders because of their "unique conflicts and issues" as compared to guardianships for minors.
Who is a Family Client?
Besides family members and former family members, key employees and, with some limits, former key employees are included as eligible family clients. Family clients can form any number of entities that are also considered family clients. They include estates, certain charities, certain trusts and any entity wholly owned, directly or indirectly by and operated for the benefit of family clients. In response to comments, the SEC added key employees and expanded the types of trusts to be treated as family clients to accommodate common estate planning and charitable giving plans.
Key Employees: The SEC includes key employees in the Final Rule, creating a very similar definition to "knowledgeable employees" under Rule 3c-5 under the Investment Company Act of 1940, as amended (the "Company Act"). As with the "knowledgeable employee" definition, the definition of "key employee" here is meant to capture the employee's own investment and not broadly cover that employee's family members and family entities. However, the SEC has advised that the term "key employee" includes trusts where the key employee is the sole contributor and decision-maker. Trusts may include assets from the spouse of a key employee only if those assets were already joint or community property.
The Final Rule allows the family office to provide investment advice to any natural person (including any key employee's spouse or spousal equivalent who holds a joint, community property or other similar shared ownership interest with that key employee) who is (i) an executive officer, director, trustee, general partner, or person serving in a similar capacity at the family office or its affiliated family office or (ii) any other employee of the family office or its affiliated family office (other than an employee performing solely clerical, secretarial, or administrative functions) who, in connection with his or her regular functions or duties, participates in the investment activities of the family office or affiliated family office, provided that such employee has been performing such functions or duties for or on behalf of the family office or affiliated family office, or substantially similar functions or duties for or on behalf of another company, for at least 12 months. The SEC in the Release noted that this excludes key employees of family companies other than the family office.
The Final Rule allows the family office to serve as trustee to an employee benefit plan which serves all current and former family office employees (rather than just key employees and former key employees) so long as the family office's role is limited to establishing the plan and the family office does not provide investment advisory services to the plan. Presumably this means that the family office could not offer a family office advised investment option.
Irrevocable Trusts: While the Proposed Rule required that family trusts needed to be for the sole benefit of family members in order to be family clients, the Final Rule requires that one or more family clients be the current beneficiaries of an irrevocable trust. The SEC expanded the rule to cover charitable remainder and other charitable trusts so family clients include irrevocable trusts funded only by one or more family clients where the only current beneficiaries are family clients as well as non-profit organizations, charitable foundations, charitable trusts or other charitable organizations. The charities need not be limited to family charities.
While some commenters recommended that the SEC modify the Proposed Rule to allow a trust to include current beneficiaries that are not family clients as long as such trust is for the primary benefit of one or more family clients, the SEC explicitly rejected this recommendation. The SEC did provide a 12-month transition for non-family clients in the Final Rule. If a family trust names a family friend as a contingent beneficiary and the family friend later becomes a current beneficiary under the terms of the trust, the family office would be able to serve the trust as a family client for 12 months after the non-qualifying event to allow for an orderly transition to another investment adviser.
Revocable Trusts: A family client also includes a revocable trust consisting of one or more family clients as sole grantors. As a result, beneficiaries of the revocable trusts do not have to be family members. The SEC agreed with commenters who argued that given effective control by the grantor, the beneficiaries had no expectation of benefit until the death of the grantor.
Estates: Under the Final Rule, a family client also includes an estate of a family member, a former family member, a key employee or, with certain limitations, a former key employee. In response to commenters, the Final Rule allows a family office to advise the executor of a family member's estate even if that estate will be distributed in whole or in part to non-family members.
With respect to former key employees, the family office may only advise on assets that were under management as of the termination of employment. If the position at the family office is that last job the key employee holds but not quite all assets were under management at that time, a gap is created. The family office would either need to take care not to advise as to the "new assets" or avoid getting involved with the estate at all.
Non-Profit and Charitable Organizations: In the Final Rule, family clients include any non-profit organization, charitable foundation, charitable trust (including charitable lead trusts and charitable remainder trusts whose only current beneficiaries are other family clients and charitable or non-profit organizations) or other charitable organization, in each case funded exclusively by one or more family clients. This is a deviation from the Proposed Rule, which was limited to charities funded exclusively by one or more family members. A charitable organization existing on July 21, 2011 that was created, but not entirely funded, by family clients may remain a client of a family office until December 31, 2013, provided that the organization does not accept additional funding from non-family donors after August 31, 2011, unless the contributions are a fulfillment of a pledge. Family charities and non-profits must cease accepting new contributions as of August 31, 2011, other than in fulfillment of pledges made prior to that date, in order to remain family clients after the end of the transition period. Those prior pledges must be funded by December 31, 2013. Family offices may continue to serve non-qualifying charities and non-profits until the end of the transition period.
In order to effect an orderly transition to these new requirements, family offices need look only to the current funding for charities and non-profits. Specifically, the SEC stated in the Release that the actual contributions should be examined, rather than income, gains or losses on the contributions. Family non-profits and charities may consider non-family contributions as the first dollars spent in determining whether the current funding comes only from family clients.
Other Family Entities: Under the Final Rule, non-family clients may control any company, including a pooled investment vehicle, and such entity would still be deemed a family client. As proposed, the entity would have to be wholly owned, directly or indirectly, by one or more family clients and operated for the sole benefit of family clients. In response to commenters, the SEC eliminated the requirement for control by family clients by explicitly reasoning that "non-family client control does not change that family clients are the ultimate beneficiaries of the investment advice."
Involuntary Transfers: The Final Rule adopts the Proposed Rule's prohibition of an involuntary transfer of assets to a non-family client, but the Final Rule extends the transition period from the proposed 4 months to a full year where a family office could continue to provide advice regarding the transferred assets after an involuntary transfer. However, the Final Rule describes an involuntary transfer as following the death of a family member or a key employee. Former family members and former key employees are left out.
No Family Mutual Funds or BDCs: Because of the "no holding out" requirement, the family office may not serve as investment adviser to an investment company registered under the Company Act or to a company which has elected to be a business development company pursuant to Section 54 of the Company Act.
What is a Family Office?
The Final Rule recognizes that the family office may take many different forms.
Not a Single Person: The SEC used the same definition as Section 202(a)(5) of the Advisers Act, which provides that "company" is "a corporation, a partnership, an association, a joint-stock company, a trust, or any organized group of persons, whether incorporated or not; or any receiver, trustee in a case under title 11 of the United States Code, or similar official, or any liquidating agent for any of the foregoing, in his capacity as such." Thus, a single person is not within the definition. However, if there is a "company," then the Final Rule exempts its directors, partners, members, managers, trustees and employees from registration as investment advisers so long as they are acting within the scope of their position or employment.
Family Ownership and Control: Under the Final Rule, the family office must be wholly owned by family clients and exclusively controlled, directly or indirectly, by one or more family members and/or family entities. The Final Rule expands who may own the family office from "family members," as proposed, to "family clients," thereby allowing key employees to own a non-controlling stake in the family office as part of an incentive compensation package. However, the Final Rule continues to require that control of the family office remain, directly or indirectly, with family members and their related entities, which is in line with the "core policy rationale" that a family office essentially be a family managing its own wealth. The Final Rule includes a definition of "control" as "the power to exercise a controlling influence over the management or policies of a company, unless such power is solely the result of being an officer of such company."
No Limit on Fees: The old exemptive orders rely on family offices not having a profit motive and being run on a break-even basis. The SEC followed the Proposed Rule and did not impose any such requirements under the Final Rule.
Multi-Family Offices Are Outside the Final Rule: The SEC did not expand the definition of "family office" to allow family offices to provide advisory services to multiple families. The SEC noted that it was not persuaded by the comments that the Final Rule could "distinguish in any meaningful way" between such offices and family-owned commercial advisory firms that offer their services to multiple families, or that the protections of the Advisers Act, including the application of the Advisers Act's anti-fraud provisions, would not be relevant to a family obtaining services from an office established by another family with which it could have conflicts of interest.
Under Section 208(d) of the Advisers Act, which prohibits a person from indirectly doing anything that would be unlawful under the Advisers Act if done directly, family offices with the same or substantially the same employees advising multiple unrelated families cannot claim the family office exclusion.
No Holding Out
The Final Rule prevents a family office from holding itself out to the public as an investment adviser. This restriction prohibits various uses of public media to describe the advisory business of the family office, including the internet. However, the SEC clarified in the Release that a family office that is currently registered as an investment adviser and expects to de-register in reliance on the Final Rule will not be prohibited from relying on the Final Rule solely because it had held itself out to the public as an investment adviser while it was registered under the Advisers Act.
Limited Grandfathering of Certain Pre-2010 Family Office Clients
As mandated by the grandfathering provision in Section 409(b)(3) of the Dodd-Frank Act, a family office is not required to register under the Advisers Act even if it does not otherwise fall within the definition of "family office" under the Final Rule solely because the family office provides investment advice to, and was engaged before January 1, 2010 in providing investment advice to:
- Natural persons who, at the time of their applicable investment, are officers, directors, or employees of the family office who have invested with the family office before January 1, 2010 and are "accredited investors", as defined in Regulation D under the Securities Act of 1933, as amended;
- Any company owned exclusively and controlled by one or more family members; and
- Any registered investment adviser who served the family office and co-invested, provided that its share is under 5% of the family office's total assets under management.
The SEC also chose to leave the existing exemptive orders in place for the families that received them under Section 202(a)(11)(G) of the Advisers Act, acknowledging in the Release that some were narrower and some were broader than the relief provided in the Final Rule.
A person or entity that is a family office solely as a result of the grandfathering provision would still be an investment adviser for purposes of the antifraud provisions of the Advisers Act (except for the Section 206(3) on principal and agency cross examination).
Effective Date; Transition Period
The effective date of the Final Rule is August 29, 2011. A family office that implemented a restructuring following the principles set out in the Proposed Rule to serve more than 14 family related clients as of the original Dodd-Frank Act effective date of July 21, 2011 will have jumped the gun if the office went over 14 clients and does not fit within the very limited grandfathering. In a case where the office falls within the Final Rule, it would be difficult from a policy perspective for the SEC to seek to enforce the delay in the effective date of new exemption.
In recognition that the time period between the adoption of the Final Rule and the July 21, 2011 repeal of the private adviser exemption from registration was not be sufficient for every family office to evaluate itself, restructure or register, the SEC provided in the Final Rule that family offices then exempt from SEC registration in reliance on the private adviser exemption and that did not meet the new family office exclusion are not required to register with the SEC until March 30, 2012, provided that the company:
- During the course of the preceding 12 months, has had fewer than 15 clients; and
- Neither holds itself out generally to the public as an investment adviser nor acts as an investment adviser to any investment company registered under the Company Act, or a company which has elected to be a business development company and has not withdrawn its election.
Also, any company existing on July 21, 2011 that would qualify as a family office under the Final Rule except for it having as a client one or more non-profit organizations, charitable foundations, charitable trusts, or other charitable organizations that have received funding from one or more individuals or companies that are not family clients shall be deemed to be a family office until December 31, 2013, provided that such non-profit or charitable organization(s) do not accept any additional funding from any non-family client after August 31, 2011 (other than funding received before December 31, 2013 provided in fulfillment of any pledge made prior to August 31, 2011).
State Law Preemption
Family offices that qualify under the Final Rule are not subject to registration as investment advisers under state securities laws and its "supervised persons" are not to be required to register with a state as investment adviser representatives. The exclusion provided under the Dodd-Frank Act is an exclusion from the definition of investment adviser under Section 202(a)(11) of the Advisers Act, and as such is covered by the preemption of state registration requirements in Section 203A(b)(1)(B) of that Act. This was reconfirmed by our firm last week in conversations with staff of the Colorado Securities Commissioner's office.
What To Do Now?
While the deadline may seem far away, family offices should act soon to carefully consider how the Final Rule applies in their particular circumstances. While family offices have options, many take significant time to implement. The following is a non-exhaustive list of options:
- Rely on the family office exemption. A family office should analyze whether it indeed currently operates under the Final Rule and whether it expects to continue to do so for the foreseeable future. For example, the family office should consider if all recipients of its investment advice are family clients under the Final Rule and if those in control of the family office are family entities.
- Restructure to rely on family office exemption. This requires an assessment of what business, operational and legal changes may need to be made to operate under the Final Rule. While one might otherwise worry about the anti-evasion provisions in the Advisers Act and in the Dodd-Frank Act, given that the SEC specifically contemplated that family offices might restructure to fit the new exemption in the adopting release, there seems to be less risk of inadvertently tripping the anti-evasion provisions. However, if such restructuring involves breaking what would be considered a multi-family office under the new rules into one or more single family offices, one should be mindful of the SEC's admonition against the use of shared personnel. If restructuring involves de-registration as an investment adviser, the SEC explicitly said that was permissible.
- Find another exemption or exclusion. The Dodd-Frank Act did not repeal other exemptions from the definition of investment adviser in the Advisers Act. Advisers who do not advise on securities or who do not act for compensation are not within the definition of investment adviser. Some family offices may fit within the new venture capital exemption.
- Perform only administrative duties and outsource investment activity. A family office can provide many different types of services for family members without providing investment advice. Part of this solution may involve having the family hire a third-party SEC-registered adviser. Each adult family member would likely need to engage the third-party investment adviser directly. Family entities will need to be scrutinized to see if a family member or entity has investment discretion, including the ability to hire or fire the investment adviser, on behalf of others.
- Create a private trust company ("PTC"). This is a vehicle that has been used by certain families for decades. The family office registers as a regulated, non-depository private trust company in a state selected for its regulatory and legal suitability. A PTC is exempt from SEC oversight as it is regulated by the state banking commissioner; in Colorado under recent legislation the banking commissioner determines whether an exemption from state banking regulations exists for a PTC. This approach is somewhat expensive to organize but offers a number of benefits, such as insulating family members and advisors from fiduciary liability, maximizing the family's control over its assets, and eliminating the family's concerns about trustee succession.
- Seek an exemptive order from the SEC. The process to obtain an exemptive order is both expensive and time-consuming. There is no assurance the process can be completed within the transition time or that it will be successful.
- Register as an investment adviser with the SEC by March 30, 2012. The downside of this approach is the loss of privacy that comes with registration. A "registered investment adviser" ("RIA") is required to file and maintain a Form ADV with the SEC which becomes publicly accessible on the SEC website. Forms that are not posted online are accessible to outsiders through Freedom of Information Act requests. RIAs are subject to periodic SEC audits, historically about every 5 years unless there have been complaints (although the SEC staff would like this to be more frequent in the future). Office procedures need to be codified in an operating manual which becomes the basis for the SEC audits. There are other requirements for RIAs; see pages 5-6 of our October 25, 2010 memorandum referenced at note 1 above.
Given the number of questions raised by the Final Rule, it is probable that the SEC will issue additional guidance in this area so family offices should stay tuned. In fact, in the Release the SEC indicated that it will be addressing requests for clarification through its "frequently asked questions" format.
This article is published for general information, not to provide specific legal advice. The application of any matter discussed in this article to anyone's particular situation requires knowledge and analysis by a lawyer of the specific facts involved.
Copyright 2013 Fairfield and Woods, P.C., ALL RIGHTS RESERVED.
 See Fairfield and Woods, P.C. "SEC Proposes Definition of 'Family Offices' to be Excluded from Investment Adviser Definition and Regulation" (October 25, 2010), available at https://www.fwlaw.com/Proposed_Family_Office_Rule.pdf.
 The Final Rule defines "executive officer" as "the president, any vice president in charge of a principal business unit, division or function (such as administration or finance), any other officer who performs a policy-making function, or any other person who performs similar policy-making functions, for the family office."