23 March 2018
On June 22, 2011, the US Securities and Exchange Commission (the “SEC”) issued Release IA-3220 (the “Final Release”) adopting rule 202(a)(11)(G)-1 (the “Final Rule” under the US Investment Advisers Act of 1940 (the “Advisers Act”). When compared to the SEC’s original proposal (the “Proposed Rule”), the Final Rule significantly expands the number of family offices that will be exempt from registration as investment advisers.
The Dodd-Frank Act, among other things, repealed the so-called “Private Adviser Exemption” that exempted advisers with fewer than 15 clients from SEC registration and regulation. Most family offices previously relied on the Private Adviser Exemption to avoid regulation as investment advisers. In place of the Private Adviser Exemption, the Dodd-Frank Act exempted family offices from regulation. The Final Rule defines the term “family office.” A family office that fails to meet the SEC’s definition would need to register with and become regulated by the SEC unless it could come within another exemption.As reported in our earlier Briefing Notes, the Proposed Rule contained a number of problems that would have required a majority of family offices to register with and become regulated by the SEC. The Final Rule addresses nearly all of these problems.
The Final Rule
Following is a sampling of the significant changes contained in the Final Rule.
Designating the Family Office
The Proposed Rule contained a rigid formula that would have required each family to select “founders” of the family office. In practice, this would have prohibited living relatives that were more distantly related than siblings from founding a family office. The Final Rule eliminates the concept of a family office ‘founder.’ Instead, the Final Rule allows the family office to provide investment advice to family members that are related by a a common ancestor, who need not be living, no more than 10 generations distant as the source for the familial relationship. In addition, as the group of family members served by the family office changes, the family office is permitted to select a new common ancestor. As a practical matter, this would allow, for example, two cousins to form a family office – a result that would not have been permitted under the proposed rule.
Ownership and Control
The Proposed Rule would have required the family office be wholly owned and controlled, directly or indirectly by family members – meaning natural persons. In practice, this would have prohibited ownership of the family office by trusts and foundations, as well as other ownership structures commonly employed by family offices.The Final Rule significantly expands the types of permitted ownership structures. Under the Final Rule, any individual or entity that can be served by a family office can also own the family office. The Final Rule retains the requirement that family members and their family entities (e.g., family trusts etc) control the family office. Some questions remain, however, over how this control should be vested within the family.
The Proposed Rule would have required charitable entities to which the family office provided investment advice to have been founded by, and funded exclusively by, family members – meaning natural persons. In practice, this would have prohibited funding of a family foundation using many common practices such a charitable lead annuity trusts and charitable remainder trusts. In addition, the Proposed Rule would have tainted the family office as a result of donations made to family-sponsored foundations by non-family members currently and in the distant past.The Final Rule significantly relaxes these requirements. It allows the charitable entity to be funded by any individual or entity that can be served by the family office, greatly expands the types of charitable entities that can be served by the family office and provides a specific mechanism for addressing historical donations made by non-family members.
Trusts and Estates
The Proposed Rule contained many significant problems relating to the treatment of trusts and estates. By way of example, it was not clear that a family office could provide investment advice to a trust for the current benefit of family members if the trust named non-family members or public charities as current or contingent beneficiaries.The Final Rule addresses these issues and expands the numbers of trusts and estates that may be served by the family office. As an example, it is now clear a trust qualifies as a family client if the current beneficiaries are family members and public charities.
Problem Areas Remain
Despite the successes, there remain a few issues of concern. The Final Rule allows the family office to serve key employees and their trusts. Unfortunately, the Final Rule significantly restricts the types of key employee trusts that may qualify. In order for the trusts to qualify, the key employee must have funded the trust (perhaps with a spouse) and retained power over all investment decisions with respect to the trust. This flies in the face of tax and estate planning goals that would require the key employee to relinquish such powers in order to gain the benefits for which such structures are established. In addition, the Final Rule’s treatment of involuntary transfers to non-family clients remains problematic. Although the Final Rule clarifies when such a transfer is deemed to occur, it still requires that any non-family client that receives an interest in an entity served by the family office must be expelled within one year or the family office will lose its exemption.
Any family office that is currently relying on the Private Adviser Exemption and that will be unable to rely on the new family office exemption will have until March 30, 2012 to register with the SEC. Additionally, if the only issue that disqualifies a family office from relying on the exemption is having accepted donations to a charitable entity from non-family members, the family office will have until December 31, 2013 to take corrective action.
The Final Rule is a vast improvement and demonstrates that the SEC carefully considered and acted upon the comments it received on its original Proposed Rule. We expect that many family offices will now qualify for exemption without the need for a significant restructuring. However, as noted above, there are continuing areas that must be addressed, in particular if you have Key Employees participating in the family office structure who have established their own estate planning structures.
If you have not already done so, we encourage every family office to review its structure to determine if you meet the definition set forth in the SEC’s Final Rule. Some minor modifications may still be necessary. In addition, if you conduct your review now, you may be able to identify areas that can be addressed through a clarification provided by the SEC before the March 30, 2012 deadline for registration.