08 April 2020 - Article
On October 12, 2010, the U.S. Securities and Exchange Commission (the “SEC”) issued Release IA-3098 setting forth its proposed definition of “family office.” In this Briefing Note, we will describe the most significant provisions of the SEC's proposed definition and then highlight what we consider its positive and negative aspects.
As reported in our previous updates, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) eliminates the private adviser exemption under the Investment Advisers Act of 1940 (the “Advisers Act”). Many family offices have relied on this exemption to avoid registration with and regulation by the SEC as an investment adviser. With this change, however, the Dodd-Frank Act adds a “family office” exclusion from the definition of “investment adviser,” relieving organizations that fall within the exclusion from potentially cumbersome SEC regulation. The SEC was directed to adopt a definition of “family office” that “recognizes the range of organizational, management and employment structures and arrangements employed by family offices.”
The Proposed Definition
Under the SEC's proposed definition, a family office is a company (which would include corporations, general and limited partnerships, limited liability companies, trusts and similar organizations) that:
(i) provides investment advisory services only to “family clients”;
(ii) is wholly owned and controlled (directly or indirectly) by “family members”; and
(iii) does not hold itself out to the public as an investment adviser.
As anticipated, the exclusion applies only to single family offices and will not be available for multi-family offices.
For purposes of the proposed definition, “family clients” includes any: (i) family member, (ii) key employee, (iii) charitable foundation, charitable organization, or charitable trust established and funded exclusively by family members or former family members; (ii) trust or estate that exists for the sole benefit of other family clients; and (iii) any company wholly owned and controlled by family clients. Key employees are limited to executive officers, directors, trustees, general partners or other similar individuals, or family office employees who, in connection with their regular duties, have participated in the office's investment activities for at least twelve months.
The term “family member” as used in the proposed definition is limited to: (i) the founders of the family office (which includes the natural person and his or her spouse or spousal equivalent for whose benefit the family office was established), their lineal descendants, and such lineal descendants' spouses or spousal equivalents; (ii) the parents of the founders; and (iii) siblings of the founders and such siblings' spouses or spousal equivalents and their lineal descendants and such lineal descendants' spouses or spousal equivalents. Lineal descendants include children by adoption and stepchildren, although the SEC has requested comments as to whether stepchildren should, in fact, be included in the definition or if conditions should be imposed on their inclusion. The SEC also has requested comments as to the definition of “spousal equivalent.”
Former family members and certain former key employees may retain certain investments held through the family office, but they will not be permitted to make any new investments through the family office once their status as family members or key employees is terminated.
Finally, the SEC has indicated that it will consider exemptive requests outside the proposed rule.
Positive Aspects of the Proposed Definition
The proposed definition includes some fairly expansive provisions. For example, stepchildren, spousal equivalents, nieces and nephews are included within the scope of permitted family members. Additionally, the SEC recognized the important role played by non-employee family members and included key employees within the scope of permitted family clients. In addition, former family members and former key employees are permitted to remain in the family office structure after their status changes – although no new investment will be permitted after that time. Finally, the provision specifically providing that involuntary transfers to non-family clients will not endanger the family office exclusion provided the non-family clients are removed within four months of the involuntary transfer provides welcome clarity.
We note, however, that the SEC has specifically requested comments with respect to its treatment of stepchildren and former family members, as well as the definition of spousal equivalents. We also question the fairness of the involuntary transfer rule. It can place the family at a serious disadvantage in its negotiations to acquire the “prohibited interest” given the rules' short four month window and the significant consequences in failing to acquire the interest.
Negative Aspects of the Proposed Definition
While helpful, we have serious concerns that the SEC's proposed definition severely limits its benefit to the family office community. In this regard, we believe the proposed definition falls short of the congressional mandate that the SEC adopt a definition that “recognizes the range of organizational, management and employment structures and arrangements employed by family offices.”**
In the first instance, the requirement that a family office be wholly owned and controlled, directly or indirectly, by family members could limit the availability of the exclusion in situations where such limitation does not appear warranted. Some families have adopted structures where the family office entity is owned by a family trust with an independent trustee. Such a trust could potentially fail the ownership and control requirement in two ways. In such situations, it could be argued that the family office is not owned by family members as the U.S. securities laws do not generally treat trust beneficiaries as the owners of the trust assets. Additionally, even if it is appropriate to look through the trust to its beneficiaries for purposes of the “ownership” test, it would appear trust ownership would fail the “control” test in that the power to exercise a controlling influence over the management and policies of the family office rests with the independent trustee. We believe that such an ownership structure is within the congressional mandate, and it is not clear that the narrowly drafted ownership and control tests provide any additional benefits or protect against any abuse.
Likewise, limiting the definition of “family client” to allow only charitable entities that are established and funded exclusively by family members will very likely preclude many families from qualifying for the family office exclusion. Many families, as part of their charitable or philanthropic endeavors, will name an unaffiliated charity as a beneficiary of a family trust (e.g., an alma mater, the American Red Cross or the Susan G. Komen Breast Cancer Foundation). Because such a charity accepts donations or funding from non-family members, it will be excluded from the category of a family client – thereby causing the trust from which it benefits to also be excluded. Again, such a limitation does not appear warranted.
Finally, including the concept of “founders” in the proposed definition could cause unintended complications. Under the proposed definition, it is important to determine when, by whom and for whose benefit a particular family office was founded. In multigenerational families served by an existing family office, this may not be an easy task. Further, on a forward looking basis, this concept could prevent the formation of a family office by the generation that followed after the creators of the wealth (or alternatively by wealth creators who are relatively young) as the concept of the “founders” does not permit the participation of the aunts, uncles or cousins of the founders.
Final Definition and Exemptive Orders
Following a public comment period, the SEC will adopt a final definition of family office. The SEC has specifically stated that, in the event your family office fails to meet the technical requirements of the final definition, you may continue to submit, and the SEC will consider, requests for exemptive orders.
Comments on the proposed rule must be received by the SEC on or before November 18, 2010. If you have any questions, or if you think you may be interested in submitting comments, we would be pleased to discuss the impact of this proposed rule on your (or your clients') particular family office structure.
The SEC has indicated that it will not rescind prior exemptive orders that it has issued to family offices with respect to treatment under the Advisers Act. The SEC also has indicated that it will still consider exemptive requests outside the proposed rule.