23 March 2018
On July 15, 2010, the U.S. Senate passed The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Reform Act”). Senate approval paves the way for the Reform Act to be signed into law by President Obama later this week.
In a significant win for family offices, the Reform Act exempts “family offices” from the definition of investment adviser under the U.S. Investment Advisers Act (the “Advisers Act”). For the most part, this legislative victory puts to rest fears that single-family offices would be swept up in the rush to regulate hedge funds and private equity funds. If family offices had not been exempted from the definition of investment adviser, most single family offices would have been subject to expensive, burdensome and intrusive regulation by the U.S. Securities and Exchange Commission (the “SEC”).
Unfortunately, some level of uncertainty remains. The Reform Act does not define the term family office but specifically leaves the definition to a subsequent SEC rulemaking proceeding – only directing the SEC to adopt a definition that is consistent with the SEC’s previous exemptive policy with respect to family offices and recognizes the range of organizational, management and employment structures and arrangements employed by family offices.
Generally speaking, the SEC has previously issued exemptive orders to family offices serving a single individual and his or her spouse, their lineal descendants and spouses and entities, including trusts, private foundations and charities, exclusively owned by, for the benefit of or funded by such individuals. The SEC has also typically required family offices that qualified for an exemption to be controlled by a Board of Directors or other governing body a majority of which consisted of family members. In light of the directions given to the SEC by Congress, it is anticipated that only single family offices will qualify for the exemption. Multifamily offices, most of which are already registered with the SEC, are expected to be subject to regulation as investment advisers.
The SEC has occasionally permitted exempt family offices to allow key executives and employees involved in investment decisions to participate in the family’s collective investment vehicles on a limited basis. However, the Congressional mandate to the SEC requires only that the definition of family office be consistent with, not identical to, the SEC’s previous exemptive policy. In that regard, we have highlighted that exemptive orders previously issued by the SEC applied only to the specific family office requesting the exemption. In the context of individual exemptive orders, the SEC could make determinations of limited application after analysis of all facts it considered relevant. When adopting a rule of general applicability, the SEC might be expected to adopt more restrictive requirements. In particular, we have expressed concern that the SEC would limit or eliminate the ability of family offices to provide co-investment opportunities to employees.
In an unexpected development, during the House/Senate conference process, an additional “grandfathering” provision was added to the SEC mandate. Under this provision, the SEC is not allowed to exclude an entity from the definition of “family office” simply because the entity had officers, directors or employees who co-invested with the family as of January 1, 2010. This “grandfathering” provision was clearly intended to protect family offices that currently allow employees to co-invest with the family as a means of incentive compensation. However, because the mandate is specifically limited to participation prior to January 1, 2010, it could create a negative implication that Congress specifically intended to prohibit family offices from allowing employee co-investment on a going forward basis.
While the initial battle over the exemption of family offices from SEC regulation is clearly won, the war is not yet over. The definition of family office adopted by the SEC will determine the practical effect of the Reform Act on the family office community. In addition to the potential limitations on employee co-investment, the SEC is likely to prohibit even limited participation by individuals who are not family members. In this regard, we anticipate that the SEC will adopt a typically complicated definition and that it will contain some unanticipated challenges.
The SEC is required to adopt a definition of family office in a formal rulemaking proceeding which includes releasing a proposed definition of family office for public comment. The schedule for this rulemaking has not yet been established, but we will continue to monitor this process and provide additional updates as events warrant.