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News July 11, 2011 Issue

Family Office Rule Arrives

Formerly existing only as a web of exemptive relief, the "family office" exception from adviser registration now has its own home in the law.

Section 409 of the Dodd-Frank Act (DFA) established a statutory exemption from adviser registration for family offices. The SEC was charged with rulemaking under that mandate consistent with previous policy, "as reflected in exemptive orders for family offices in effect on the date of enactment" of the DFA.

On June 22, the SEC adopted new rule 202(a)(11)(G)-1 to fulfill the DFA mandate.

Here are the contours of the new rule that exempts qualifying "family offices" from registration under the Advisers Act.

Family office structure and scope of activities.

As proposed, the rule has three basic elements:

  • The family office must serve only specific "family clients," multiple unrelated families may not be advised by any one family office;
  • Family clients must wholly own the office, and the office must be controlled directly or indirectly by family members and/or family entities; and
  • The family office cannot hold itself out to the public as an investment adviser.

The rule also incorporates grandfathering provisions for certain previously existing family offices, as required by the DFA.

Family clients.

Family clients include:

  • Current and former family members;
  • Certain employees, and under certain circumstances, former employees;
  • Charities funded exclusively by family clients;
  • Estates of current and former family members or key employees;
  • Trusts existing for the sole current benefit of family clients, or, if both family clients and charitable and non-profit organizations are the sole current beneficiaries, trusts funded solely by family clients;
  • Revocable rusts funded solely by family clients;
  • Certain key employee trusts; and
  • Companies wholly owned exclusively by and operated for the sole benefit of, family clients (with certain exceptions).

Family member.

It’s a brave new world we live in, and families have evolved in a variety of ways. The family office rule acknowledges that evolution and seeks to permit a more expansive related group than provided in the original rule proposal.

Relation to a family "founder" in the proposed rule has given way in the final rule to connection within ten generations to a "common ancestor." Current and former spouses and spousal equivalents are included, as well as all children by adoption, foster children, and current and former stepchildren. Including such individuals would not cause the family office to resemble a typical commercial investment adviser, said the staff.

The family office may choose its common ancestor (who may be living or deceased), and may also define permitted family members more narrowly than the rule allows. "This approach avoids any assumptions regarding the source of family wealth and the inconsistent treatment of extended family members compared to the approach we proposed," said the release.

The release noted that the common ancestor may be designated and redesignated by the family office and no formal documentation or procedure is required.

Involuntary transfers.

The final rule continues to prohibit a family office from managing for compensation family client assets that have been involuntarily transferred to persons or entities that are not qualifying family clients.

The staff originally proposed a four-month transition period during which the assets could remain under management in a family office until a transfer of such assets away from the family office could be arranged. Commenters successfully persuaded the staff that a longer period was required. The final rule allows a transition period of one year, which begins from the time legal title of the assets is transferred to the non-family individual or entity.

Assets transferred to individuals and entities that are not family clients may remain with the family office provided no compensation is taken for managing those assets.

The release notes that "if the involuntary transferee does not receive investment advice about securities for compensation from the family office, then the availability of rule 202(a)(11)(G)-1 would be unaffected."

Family trusts and estates.

The final rule expands the types of trusts allowed in a family office, consistent with common estate planning and charitable giving plans. Generally, contingent beneficiaries are disregarded under the rule when determining the qualifying nature of the trust.

For example, an irrevocable trust is treated as a family client provided only one or more family clients are the only current beneficiaries of the trust.

Similarly, a revocable trust will qualify as a family client provided the grantor or grantors of the revocable trust are also considered a family client. The contingent nature of the beneficiary’s "expectation that it will benefit from the trust’s assets" supports disregarding such beneficiaries under the exclusion, said the staff.

The final rule treats as a family client the estate of any current or former family member or key employee. Any non-family executor is seen as acting in lieu of the deceased family member and advice provided by the family office to the executor "is equivalent to providing advice to that family client."

Non-profit and charitable organizations.

To be clear across meanings used in both trust and estate and tax law, the final rule includes non-profit organizations in its interpretation of charitable organizations. The staff also clarified the inclusion of charitable lead trusts and charitable remainder trusts as potentially qualifying family clients.

The consistent criteria applied to these non-profit and charitable entities is that they are currently funded exclusively by one or more family clients. "[A]s long as all the funding currently held by the charitable organization came solely from family clients, the individuals or entities that originally established it are not of import for our policy rationale," said the staff.

The exclusion’s underlying rationale recognizes that the Advisers Act is not designed to regulate families managing their own wealth, the staff observed.

The staff recognized that some non-profit or charitable organizations have accepted and currently hold funding from non-family clients. To provide time to spend the non-family funding so that none of it is "currently held" by the organization, the rule delays the effectiveness of this particular provision of the rule until December 31, 2013. A family office may not accept further funding from a non-family client after August 31, 2011, unless that funding is in fulfillment of a pledge made prior to August 31, 2011, and is during the transition period that expires December 31, 2013.

Other family entities.

This category includes companies and pooled investment vehicles such as hedge funds and private equity funds, provided the entity is wholly owned, directly or indirectly, by one or more family clients and operated for the sole benefit of family clients. "We believe that the elements of ownership and benefit are important to ensuring that the policy objectives underlying the family office exclusion are preserved," said the staff.

Importantly however, the staff determined that control of these types of family client entities was not critical to the policy considerations underlying the family office exclusion. As a result, the staff eliminated the requirement for control of other family entities by one or more family clients in the final rule.

Key employees.

Key employees are:

  • Executive officers, directors, trustees, general partners, or other person serving in a similar capacity at the family office or an affiliated family office; or
  • Any other employee of the family office who as part of their regular functions or duties participates in the investment activities of the family office or affiliated family office, and has been performing such duties for at least twelve months whether at the current family office or in a substantially similar fashion elsewhere.

Employees performing solely clerical, administrative or secretarial functions are not considered key employees.

The family office may also provide advice to a key employee’s spouse or spousal equivalent who holds a joint, community property or other shared interest with that key employee. Otherwise, spouses, spousal equivalents and family members of the key employee are not permitted clients of the family office. Only a key employee trust of which the key employee generally is the sole contributor and sole authorized decision-maker will be a permitted family client.

Key employees are also treated as family clients for purposes of investing in private funds, charitable and non-profit entities, and other family entities in accordance with the other provisions of the family office rule.

Once a key employee leaves the employment of a family office, he or she is no longer eligible to make additional investments, but may maintain any accounts held with the family office.

The final rule also permits "knowledgeable employees" of an affiliated family office to be treated as a key employee of the family office. The staff agreed with commenters that "those employees should be in a position to protect themselves in receiving investment advice from a family office excluded from regulation under the Advisers Act."

Executive officer is defined in the rule, and is "virtually identical" to Rule 205-3 (the capital gains rule) under the Advisers Act and Rule 3c-5 (the knowledgeable employee rule) under the Investment Company Act.

Multifamily offices.

Multifamily offices are excluded from the rule. The SEC’s release clarified that multiple separate family offices managed by the same or substantially the same employees create a de facto multifamily office. Because Advisers Act Section 208(d) prohibits doing indirectly anything that would be unlawful for such person to do directly, such family offices may not claim the family office exclusion.

Grandfathering provisions.

Provided the family office’s services were engaged prior to January 1, 2010, three types of clients are grandfathered in pursuant to the DFA:

  • Officers, directors, and employees who are accredited investors;
  • Any company owned and controlled by one or more family members is a family client, even if it is not operated solely for the benefit of family clients; and
  • Any SEC registered adviser to a family office that has offered investment opportunities to family clients and has co-invested with them in those opportunities "on substantially the same terms," provided such co-investments do not exceed five percent of the family office’s assets under management.

Transition period.

As noted above, charitable and non-profit organizations will have until December 31, 2013 to "spend" funds contributed to them by clients that will not qualify as family clients under the new rule, provided no new funds are invested by such clients after August 31 of this year unless the funding of the investment was committed to prior to August 31 and can be spent by the December 31, 2013 deadline.

Family offices currently exempt from registration pursuant to section 203(b)(3) of the Advisers Act will have until March 30, 2012 to register with the SEC if they cannot meet the new family office exclusion.

Previous exemptive orders remain in effect.

Various family offices may continue to rely on the relief granted to them and their employees acting within the scope of their employment that declares them not to be advisers under the law. In some cases, the relief is broader than the new rule, said the release. All commenters supported allowing prior orders to stand, observed the staff. "Thus, family offices currently operating under these orders may continue to rely on them."

However, the staff was "troubled" by information it received through the comment process that indicated some family offices were operating consistently with relief granted to other family offices without obtaining exemptive relief of their own. The staff specifically noted that, unlike no-action relief granted by the Division of Investment Management to a third party, an adviser may not "rely" on exemptive orders issued to other persons.

De-registering advisers may rely on the new rule.

An adviser de-registering in reliance on the new rule will not be prohibited from doing so solely because the adviser held itself out to the public while registered. The staff clarified this point at footnote 112 of the release in response to commenter request.

The rule is effective on August 29.

Subject to the transition exceptions described above, family offices have until August 29 to determine if the new rule works for them and if so, to get moving on a plan to ensure compliance.