On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). The Dodd-Frank Act, among other things, will repeal the 15-client exemption contained in Section 203(b)(3) of the Advisers Act, effective July 21, 2011. The primary purpose of repealing this exemption was to require advisers to private funds to register under the Advisers Act. However, another consequence, which Congress recognized, was that many family offices that have relied on that exemption would be required to register under the Advisers Act or seek an exemptive order from the Securities Exchange Commission (the “Commission”) before the law becomes effective.
In order to prevent that consequence, Section 409 of the Dodd-Frank Act creates a new exclusion from the Advisers Act in Section 202(a)(11)(G), under which family offices, as defined by the Commission, are not investment advisers subject to the Advisers Act. While Section 409 instructs that any definition the Commission adopts should be consistent with the previous exemptive policy, and recognize “the range of organizational, management, and employment structures and arrangements employed by family offices,” this bulletin is meant to inform clients of the manner in which the proposed definition, which is now subject to public comment, may differ from existing practice.
The proposed rule contains three general conditions:
- It would limit the availability of the rule to family offices that provide advice about securities only to certain family members and key employees.
- It would require that the family members wholly own and control the family office.
- It would preclude a family office from holding itself out to the public as an investment adviser.
Who are Family Clients? Similar to existing practice, this term would include family members, certain employees of the family office, 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 and under certain circumstances, former family members and former employees.
Changes from Existing Practice
The following are all-new concepts in which the Commission has requested comment from the family office community as to their appropriateness. In addition, in general, the Commission wishes to know whether it is drawing the line too broadly or too narrowly regarding who is a family member and who is not.
Step-Children - The Proposed Rule 202(a)(11)G-1 would include step-children as family members. Step-Children would be permitted to be included as members of a family office but would not be required to be included.
Spousal Equivalents – The Proposed Rule 202(a)(11)(G)-1(d)(3) would include “spousal equivalents” which is defined as a cohabitant occupying a relationship generally equivalent to that of a spouse.
Parents of the family office’s founders – The Proposed Rule 202(a)(11)(G)-1(d)(3) would include the parents of the family office’s founders in recognition that these founders may wish to include one or more of their parents as a client of the family office.
Siblings of the founders of the family office, their spouses or spousal equivalents, their lineal descendants (including by adoption and step-children), and such lineal descendants’ spouses or spousal equivalents – See Proposed Rule 202(a)(11)(G)-(1)(d)(3).
Multiple families - The practice of adding other families to a family office to achieve economies of scale will not be permitted under the Proposed Rule. The Commission is concerned that these multifamily offices more resemble a typical commercial investment adviser requiring registration under the Advisers Act.
Involuntary Transfers - The Proposed Rule 202(a)(11)(G)-1(b)(1) would permit the family office to continue to advise the beneficiary of an involuntary transfer who does not qualify as a family client for four months following the transfer of assets resulting from the involuntary event. The four month period is deemed adequate to allow the family office to orderly transition that client’s assets to another investment adviser, seek exemptive relief, or register under the Advisers Act.
Former Family Members - The Proposed Rule 202(a)(11)(G)-1(d)(2) (vi) and (d)(4) would for the first time permit former family members, i.e., former spouses, spousal equivalents and step-children, to retain any investment held through the family office at the time they cease being a family member. However, the proposed rule would limit former family members from making any new investments through the family office. Please note that the proposed rule would permit the family office to provide investment advice with respect to additional investments that the former spouse or spousal equivalent was contractually obligated to make and that relate to a family office advised investment existing prior to the time the person ceased being a spouse or spousal equivalent.
Key employees – The Proposed Rule 202(a)(11)(G)-1(d)(6) would permit the family office to provide investment advice to any natural person who is (i) an executive officer, director trustee, general partner or person serving a similar capacity of the family office or (ii) any other employee of the family office who, in connection with his or her regular duties, has participated in the investment activities of the family office or duties for or on behalf of another company for at least twelve months. The Commission is creating a new standard that would limit employee participation to those employees that are likely to be in a position or have a high level of knowledge and experience in financial matters sufficient to be able to evaluate the risks and take steps to protect themselves. This new definition of key employees is based on the “knowledgeable employee standard” currently contained in Rule 205-3(d)(iii) of the Advisers Act, which specifies the types of clients to whom advisers may charge performance fees. Similar to its treatment of former spouses, spousal equivalents and step-children, the proposed rule would not permit former employees to make additional investments through the family office but would not require them to liquidate or transfer their investments out of the family office.
Ownership and Control – Proposed Rule 202(a)(11)(G)-1(b)(2) provides that, in order to qualify for exemptive relief, the family office must be wholly owned and controlled, either directly or indirectly, by family members. The previous tests regarding profit generation and fees are no longer applicable. The sole standard will be ownership and control by family members. The Commission is seeking comment whether it should permit minority ownership interest by non-family members.
Holding Out – The prohibition that a family office not hold itself out as an investment adviser is consistent with current practice.
In accordance with the provisions of the Dodd-Frank Act, all existing family office persons not registered or required to be registered on January 1, 2010, may continue to provide investment advice without registration under the Advisers Act provided that prior to January 1, 2010, they provided such advice (i) to natural persons who have already invested with the family office and who are accredited investors as defined in Regulation D under the Securities Act of 1933; (ii) to any company owned exclusively and controlled by one or more family members; or (iii) to any investment adviser registered under the Act that provided investment advice to the family office. Please note that to the extent a family office is exempt from the definition of “investment adviser” by virtue of the grandfathering provision, the family office will nevertheless be deemed an investment adviser for purposes of certain antifraud provisions of the Advisers Act, namely Sections 206(1)(2) and (4) thereunder.
Should you wish to comment on the Proposed Rule, you have until November 18, 2010. If you need assistance in that process, please feel free to contact Stephen Cohen at email@example.com or 212.407.4279.
Loeb & Loeb's Financial Reform Task Force monitors key issues surrounding approval of the Dodd-Frank Wall Street Reform and Consumer Protection Act that are relevant to a broad spectrum of firm clients in the financial services industry. The multidisciplinary Task Force is comprised of attorneys across core practice areas - including general corporate, private equity, securities, mergers and acquisitions, consumer protection and banking and finance - who are focused on analyzing the historic legislation and interpreting the significant business implications for financial institutions and commercial companies nationwide. For more information about the content of this alert, please feel free to contact any member of our Financial Reform Task Force.
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