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To Register or Restructure: Family Offices Affected by the Dodd-Frank Act

Client Advisory

October 11, 2011

Introduction

In July 2011, the legendary hedge fund manager George Soros announced his decision to close his private investment fund to outside investors and return their money, joining the move by other prominent hedge fund managers who have accumulated significant personal wealth. He explained that, in light of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”)[1], his fund may no longer manage non-family client assets and remain exempt from investment adviser registration and associated requirements. Mr. Soros stated that his multi-billion fund organization will operate as a family office excluded from the definition of an investment adviser under the Investment Advisers Act of 1940 (the “Advisers Act”). 

Family offices developed to serve the needs of families that accumulated great wealth. These offices may provide a variety of services, including investment advice, trust, fiduciary services and administration, bill paying, legal, accounting, insurance, real estate management, and even management of household staff. Over time, some family offices expanded to serve multiple families and registered as investment advisers, when required under the Advisers Act. Many others remained outside of the scope of the Advisers Act, in reliance on the “private adviser exemption” for advisers with fewer than 15 clients[2] or on individual exemptive orders from the Securities and Exchange Commission (“SEC”). 

Effective July 21, 2011, the Dodd-Frank Act repealed the private adviser exemption. However, it added a new exclusion for “family offices,” to be defined by the SEC in a manner consistent with its prior exemptive orders, enabling qualifying family offices to avoid the Advisers Act.[3] On June 22, 2011, the SEC adopted Rule 202(a)(11)(G)-1 (the “Family Office Rule”).[4]   A family office that does not meet the exclusion requirements set forth in the rule is required to register with the SEC as an investment adviser no later than March 30, 2012.

Under the Family Office Rule, a “family office” excluded from the definition of an investment adviser must (1) provide advice about securities only to “family clients”; (2) be wholly owned by “family clients” and exclusively controlled by “family members” or “family entities”; and (3) not hold itself out to the public as an investment adviser. The rule draws upon conditions imposed in several exemptive orders granted by the SEC over the years to certain family offices that filed applications for exemption from registration. (Section 206A of the Advisers Act permits the SEC to grant an exemption “when necessary or appropriate in the public interest and consistent with the protection of investors and purposes” of the Advisers Act.) We discuss below each element of the Family Office Rule and steps that a family office may take in response. 

The Conditions for Exclusion under the Family Office Rule

“Family Clients”.

A family office may not advise any client other than a “family client.” “Family clients” include current and former family members, certain key family office employees, foundations and other charities funded exclusively by family clients, estates of family members or key employees, certain trusts formed by or for the benefit of family members, and companies wholly and exclusively owned by and operated for family clients. 

“Family members” include all lineal descendants of a common ancestor, who may be living or deceased, current and former spouses and spousal equivalents of those descendants, provided that the common ancestor is no more than 10 generations removed from the youngest generation of family members. Adopted children, current or former stepchildren, foster children and individuals who were minors when a family member became their legal guardian are also treated as family members under the Family Office Rule. 

“Key employees” include personnel of the family office such as executive officers, directors, trustees and general partners and any other employee of the family office or its affiliated family office who, in connection with his or her regular functions or duties, have participated in the investment activities of the family office or affiliated family office for at least 12 months.[5] The Family Office Rule also permits family offices to advise trusts established by a key employee, but only if the key employee is the sole contributor to the trust and the sole person authorized to make investment decisions with respect to the trust. In addition, a former key employee may indirectly receive investment advice from the family office through investment in family office-advised private funds, charitable organizations, and other family entities. The rule prohibits a former key employee (or his/her estate) from making additional investments, other than pursuant to a contractual obligation entered into prior to the end of employment for an existing family-office advised investment. However, the former key employee is not required to liquidate or transfer investments already held through the family office. 

Non-profit organizations and charitable trusts and foundations must be funded entirely by family clients in order to be treated as “family clients” under the Family Office Rule. However, the rule does not require that a charitable organization be established by family members or family clients in order to receive investment advice from the family office. 

Only certain family trusts fall within the definition of “family clients”. An irrevocable trust is treated as a family client if one or more family clients are the only current beneficiaries. If an irrevocable trust is funded exclusively by one or more other family clients, the trust still qualifies as a family client if its only current beneficiaries are other family clients and non-profit organizations, charitable foundations, charitable trusts, or other charitable organizations, including public charities. A revocable trust is treated as a family client so long as family clients are the sole grantors of the trust. Estates of current or former family members, current key employees, or, subject to additional conditions, former employees are treated as family clients, and accordingly, executors of those estates may receive advice from exempt family offices, even if that estate will be distributed to non-family clients. 

Companies[6] that are wholly owned, directly or indirectly, by family clients and operated for the sole benefit of family clients, are treated as family clients. 

Ownership.

The Family Office Rule requires that the family office be wholly owned by family clients and exclusively controlled, directly or indirectly, by one or more family members or “family entities”[7].  The rule permits any family client, including non-family members, such as key employees of the family office, to have an ownership interest in the family office, so long as it is non-controlling.

Holding Out.

A family office relying on the Family Office Rule is prohibited from holding itself out to the public as an investment adviser. The “holding out” concept was a key element of the repealed private adviser exemption and prior exemptive orders and has therefore been incorporated in the new rule. Holding out means soliciting, advertising, and other marketing activities designed to attract clients. Examples include being listed in any phonebook as an investment adviser, having a publicly accessible website and attending investment-related conferences as a vendor. In the rule’s adopting release[8], the SEC noted that “Holding itself out to the public as an investment adviser suggests that the family office is seeking to enter into typical advisory relationships with non-family clients and thus is inconsistent with the basis on which we have provided exemptive orders.”  

Plan of Action for Family Offices

With the new Family Office Rule now in place, each family office must carefully evaluate its operations and determine whether it meets the terms of the exclusion from the Advisers Act. Many family offices that have previously relied on the private adviser exemption may have to restructure to comply with the rule. Otherwise, the family office must register as an investment adviser with the SEC and become subject to the Advisers Act. Alternatively a family office may consider seeking an individual exemptive order from the SEC, under Section 206A of the Advisers Act. Exemptive relief might be appropriate under highly unusual circumstances. For the time being, however, the SEC staff can be expected to ask for compelling reasons why a family office should not be required to function under the rule’s conditions. Also, it can take considerable time for the staff to evaluate and process an exemptive application.

Finally, while beyond the scope of this alert, some family offices might be able to operate as trust companies chartered under state banking laws, as the Advisers Act excludes banks and bank holding companies from the definition of investment adviser in Section 202(a)(11)(A).

Restructuring to Comply with the New Rule

Clients and Ownership. A family office may need to make changes so that its only clients are family clients as defined in the Family Office Rule. For instance, although the Family Office Rule treats the spouse of a family member as a family client, no one else from the spouse’s side of the family is a “family member,” as defined under the Rule, and therefore, the family office may no longer service them. The family office may have been providing advice to executives of a family company who hold shares of the family company or to entities that are partially owned by non-family clients. Consequently, the family office must stop providing services to these and other clients who are not family clients. A family office may have to return non-family client funds received by non-profit and charitable organizations it wishes to continue to advise. A family office may need to amend or re-establish trusts after examining the grantors and current beneficiaries of its trust-clients.

Family offices should examine the ownership structure and control of their offices and reorganize to eliminate non-family ownership interests, if necessary. 

Common Ancestor Flexibility. While assessing their operations and any required adjustments, family offices may consider options for flexibility allowed under the Family Office Rule. For instance, a family office may redesignate the common ancestor as necessary or desired over time without submitting any formal documentation to the SEC or following any formal procedure. Moreover, the designated common ancestor does not have to be the source of the family wealth. This key element of the rule allows family offices to continue to provide their services to subsequent generations of family members.

Transition Provisions. The Family Office Rule also allows a transition period of up to one year with respect to the involuntary transfer of a family client’s assets to a person who is not a family client, such as a bequest to a family friend. With respect to those assets, the family office may continue to provide advice during the transition period without losing its exclusion and make orderly transition of assets. 

Family offices providing investment advice to non-profit and charitable organizations that have received funding from non-family clients may continue to do so until December 31, 2013, so long as no additional funding from non-family clients is received after August 31, 2011.[9] Furthermore, for purposes of determining whether funding provided by a non-family client to the non-profit or charitable organization is “currently held” by the organization, the non-profit or charitable organization may offset any spending by the organization occurring at any time in the year of that non-family client contribution or any subsequent year against the non-family client contribution, as the first funding spent. 

Grandfathering Exemption. Finally, as required by the Dodd-Frank Act, the Family Office Rule provides a grandfathering exemption with respect to three types of clients who would not otherwise qualify as “family clients” under the Family Office Rule, so long as the family office was engaged to provide advice to the client before January 1, 2010. First, a family office may treat as a family client an officer, director, or employee of the family office who is an “accredited investor.”[10] Second, any company owned exclusively and controlled by one or more family members may be a family client, even if it is not operated for the sole benefit of one or more family clients. Third, any investment adviser to the family office that is registered under the Advisers Act, identifies investment opportunities to the family office, and co-invests in those opportunities with the family office on substantially the same terms may be a family client, so long as the adviser’s co-invested assets, in the aggregate, do not represent more than 5% of the value of the assets to which the family office provides advice.[11] Hence, family offices that would have met all of the required conditions under the Family Office Rule but for their provision of investment advice to those three types of clients on January 1, 2010, are allowed limited relief. 

Registering as an Investment Adviser. A family office that does not qualify for the exclusion through the Family Office Rule, absent another exemption or exclusion (for instance, an individual order of exemption from the SEC), will be required to register with the SEC as an investment adviser and be subject to the Advisers Act and its rules. For example family offices serving multiple families will have to restructure to serve only one family, or register, as the Family Office Rule does not allow unregistered family offices providing investment advice to multiple unrelated families to fall within the exclusion. As a registered investment adviser, the family office must comply with disclosure and reporting requirements, recordkeeping requirements and other Advisers Act provisions and rules. The family office will bear the compliance costs associated with meeting these requirements, including appointing a chief compliance officer (“CCO”) and instituting compliance policies and procedures. It will be subject to examination by SEC staff in the Office of Compliance, Inspection and Enforcement. Moreover, a family office that falls within the definition of an investment adviser becomes subject to the enforcement and penalty provisions of the Advisers Act, under which the SEC is empowered through an administrative proceedings or civil action to (i) censure an investment adviser by limiting its operations or suspending or revoking its registration; (ii) issue cease-and-desist orders against any person who is violating, has violated, or is about to violate any provision under the Advisers Act or any rules and regulations thereunder; and (iii) impose civil money penalties. The SEC may also seek criminal enforcement and penalties in federal court through the U.S. Attorney General. These provisions apply both to registered advisers, and those who are exempt from registration under the Advisers Act. 

Registration involves completing and filing Form ADV with the SEC, assuming the family office meets the minimum threshold of $100 million in assets under management (“AUM”) for federal registration. A family office with less than $100 million AUM, in most instances, will need to register in the state of its primary business location, also using Form ADV. It can take up to forty-five days for the SEC to process a new registration, with varying periods required for state registration. A family office seeking to register with the SEC must therefore file its Form ADV no later than February 14, 2012 to insure its registration will be effective by March 30, 2012, the deadline established by the SEC. The form consists of Part 1, requiring identifying and disciplinary information, Part 2A, a detailed narrative containing information considered important for clients to know, and Part 2B, a summary of the qualifications and background of personnel providing advice to clients. As part of the registration process, the family office must review its operations and establish the necessary compliance policies and procedures, along with appointing a CCO. It is important to begin planning well in advance of filing.

Conclusion

While the Family Office Rule has strict requirements, it provides a clear path for relief from the Advisers Act for those who are eligible for the exclusion from the definition of investment adviser. Alternatively, while registration as an investment adviser takes time and planning, and involves new and ongoing requirements, a family office that registers can to take on non-family clients and expand its business. Operating as a bank trust company might also be a possibility. The appropriate course of action will depend on each family’s circumstances and goals. We have significant experience in counseling families and their related enterprises, along with fiduciary institutions and trustees. We also regularly represent investment advisers and other asset managers, including assisting with SEC and state registration, and compliance matters. If you have questions, please contact one of the attorneys listed below, or your regular Carter Ledyard & Milburn LLP attorney.


Questions regarding this advisory should be addressed to Mary Joan Hoene (212-238-8791, hoene@clm.com), Jerome J. Caulfield (212-238-8809, caulfield@clm.com), or Theodore R. Wagner (212-238-8705, wagner@clm.com).

Endnotes


[1] Public Law 111-203, 124 stat. 1376 (2010)

[2] Former Section 203(b)(3) of the Advisers Act

[3] Section 202(a)(11)(G)-1 of the Advisers Act.

[4] SEC Release No. IA-3220, June 22, 2011

[5] The definition includes any key employee’s spouse or spousal equivalent who holds a joint, community property or other similar shared ownership interest with that key employee. The definition does not include employees performing solely clerical, secretarial, or administrative functions.

[6] The term “company” is defined in 202(a)(5) of the Advisers Act as “a corporation, a partnership, an association, a joint-stock company, a trust, or any organized group of persons, whether incorporated or not; or any receiver, trustee in a case under title 11, or similar official, or any liquidating agent for any of the foregoing, in his capacity as such.”

[7] Section 202(a)(11)(G)-(1)(b)(2) of the Advisers Act. A “family entity” is defined in Section 202 (a)(11)(G)-(1)(d)(5) any of the “trusts, estates, companies or other entities” defined as family clients, excluding key employees and their trusts.

[8] Id. Note 4

[9] However, the family office may accept contributions from non-family clients after August 31, 2011, and until December 31, 2013, without losing the exclusion if non-family client contributions are in fulfillment of any pledge made prior to August 31, 2011.

[10] As defined in Regulation D under the Securities Act of 1933.

[11]In this last case, the family office will be considered an investment adviser for purposes of the antifraud provisions of the Advisers Act (Sections 203(1), (2) and (4)) and subject to those provisions.



Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. © 2017 Carter Ledyard & Milburn LLP.
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