SEC Adopts Family Office Rule

Transcription

1 SEC Adopts Family Office Rule Presented By: The Securities and Futures Regulation Group

2 On June 22, 2011, the Securities and Exchange Commission ( Commission ) adopted Rule 202(a)(11)(G)-1 under the Investment Advisers Act of 1940 ( Advisers Act ), effective August 29, 2011 ( Family Office Rule ). 1 The Family Office Rule excludes family offices from the definition of investment adviser in Section 202(a)(11) of the Advisers Act, thereby excusing them from registration under the Act and from those provisions in it that apply to advisers, whether registered or not. The compliance date for the rule is March 30, Background Previously, many family offices had been exempted from registration as advisers by virtue of (a) having fewer than 15 clients and not holding themselves out to the public as investment advisers, or (b) having obtained an exemptive order from the Commission under Section 202(a)(1) of the Advisers Act, which permits the Commission to exclude from the definition of investment adviser any person that it concludes is not within the intent of the definition. The typical basis for such exemptive orders has been that, in the Commission s view, family members securing investment management of their own wealth (through, for example, pooled investing, tax planning and charitable giving) through family offices is not the sort of arrangement that the Advisers Act was designed to regulate. 2 The Family Office Rule was proposed in anticipation of the repeal by the Dodd-Frank Wall Street Reform and Protection Act ( Dodd-Frank Act ), effective July 21, 2011, of the 15- client or private adviser exemption from registration contained in Section 203(b)(3) of the Advisers Act. While the repeal was intended to permit the regulation of certain hedge funds, this action would have had a significant impact on traditional family offices that rely upon the private adviser exemption. Accordingly, Congress specifically included in the Dodd-Frank Act an exclusion from the Advisers Act for family offices, to be defined by the Commission in a manner that is consistent with the exemptive positions previously taken and taking into 1 See Investment Advisers Act Release No. 3220, 76 FR (June 22, 2011) ( Adopting Release ). In the final rule, the Commission responds to the many comments it received on the rule as proposed in Investment Advisers Release No (Oct. 12, 2010), 75 FR (Oct. 18, 2010) ( Proposing Release ). 2 Adopting Release at

3 account the range of organizational, management, and employment structures and arrangements employed by family offices. 3 Family offices not able to rely on the new Family Office Rule, and that otherwise conduct their affairs in a manner that comes within the definition of investment adviser in Section 202(a)(11) of the statute, will either need to comply with the Advisers Act (including registering as investment advisers, if required) or obtain from the Commission an exemption from application of the Advisers Act to their activities. The Family Office Rule To qualify for the new exclusion afforded by Section 202(a)(11)(G) of the Advisers Act, a family office must satisfy three general conditions: First, the family office may provide advice about securities only to certain persons and entities that are family clients, as defined by the Commission. 4 Second, family clients must wholly own the family office and family members and/or family entities must control the family office. Third, the family office may not hold itself out to the public as an investment adviser. The rule also includes a grandfathering provision for family offices operating prior to January 1, 2010, as described more fully in Section F. The key terms used in these general conditions are explained below. A. Family Clients These include: 1) Current and Former Family Members. A family member includes all lineal descendants of a common ancestor (who may be living or deceased) as well as current and former spouses or spousal equivalents of those descendants, provided 3 See Section 409(b) of the Dodd-Frank Act, which created Rule 202(a)(11)(G) under the Advisers Act. 4 Rule 202(a)(11)(G)-1(b)(1) and (d)(4). 3

4 that the common ancestor is no more than 10 generations removed from the youngest generation of family members. 5 The Commission specifically notes that all children by adoption and current and former stepchildren are considered family members, as are foster children and children who were minors when a family member became their guardian. 6 The Commission moved away from a definition of family member that was tied to the founder of the family office and instead adopted one that permits a family to choose a common ancestor (who may be deceased) and define family members by reference to the degree of lineal kinship to the designated relative. 7 2) Family Trusts and Estates. Family trusts and estates established for testamentary and charitable purposes are treated as family clients. These include (i) irrevocable trusts in which one or more family clients are the only current beneficiaries; 8 (ii) irrevocable trusts funded exclusively by one or more family clients in which the current beneficiaries, in addition to other family clients, are charitable and non-profit organizations (including charitable foundations and charitable trusts); 9 (iii) any revocable trust of which one or more family clients are the sole grantors; 10 and (iv) estates of current and former family members See Adopting Release at and Rule 202(a)(11)(G)-1(d)(6). 6 Id. 7 See Adopting Release at The common ancestor may be redesignated over time but may not be more than 10 generations removed at any given time. 8 Rule 202(a)(11)(G)-1(d)(4)(vii). For purposes of this definition, contingent beneficiaries are disregarded. Should the contingent beneficiary become an actual beneficiary and is not an eligible family client, the rule provides for an orderly transition of the assets. See discussion in Section E, Involuntary Transfers. 9 Rule 202(a)(11)(G)-1(d)(4)(v). If a charitable or non-profit organization has accepted funding from non-family sources, the family office may continue to advise the organization until December 31, 2013 to allow time to restructure or transition the advisory arrangement. See Rule 202(a)(11)(G)-1(e)(1). 10 Rule 202(a)(11)(G)-1(d)(4)(ix). It is irrelevant whether the beneficiaries are family members. 11 Rule 202(1)(11)(G)-1(d)(4)(vi). Estates are included even if distributions are to non-family members. 4

5 3) Current and Former Key Employees. Key employee is defined to include (i) an executive officer, 12 director, trustee, general partner, or person serving in a similar capacity at the family office or its affiliated family office or (ii) any other employee of the family office or its affiliated family office (other than an employee performing solely clerical, secretarial, or administrative functions) who, in connection with his or her regular functions or duties, participates in the investment activities of the family office or affiliated family office, provided that such employee has been performing such functions or duties for or on behalf of the family office or affiliated family office, or substantially similar functions or duties for or on behalf of another company, for at least twelve months. 13 Spouses and spousal equivalents of key employees are included only if they have a shared ownership interest with the key employee (i.e., hold a joint, community property or other similar shared ownership interest with the key employee). The rule covers key employees estates 14 and trusts, provided the employee is the sole contributor to the trust and the sole person authorized to make decisions with regard to the trust, 15 and any indirect advice the employee may receive through investment in a family office-advised entity as a family client. 4) Companies. Family clients may include companies that are wholly owned exclusively by, and operated for the sole benefit of, family clients (with certain exceptions). 16 Eligible companies need not be controlled by family clients, however. The companies covered by the rule include pooled investment vehicles, provided they are not investment companies under the Investment Company Act of The rule limits the scope of those executive officers included to those with enough financial experience and sophistication to invest without the protections of the federal securities laws. 13 Rule 202(a)(11)(G)-1(d)(8). 14 Rule 202(a)(11)(G)-1(d)(4)(vi). 15 Rule 202(a)(11)(G)-1(d)(4)(x). 16 Rule 202(a)(11)(G)-1(d)(4)(xi). 5

6 B. Ownership and Control As noted above, to satisfy the conditions of the Family Office Rule, a family office must be wholly owned by family clients and exclusively controlled, either directly or indirectly, by family members and their related entities (i.e., their wholly owned companies or family trusts). 17 According to the Commission, this assures that the family is in a position to protect its own interests and is therefore less likely to need the protection of the federal securities laws. The final rule is not limited to family offices that operate on a not-for-profit basis. C. Holding Out The final condition is that a family office may not hold itself out to the public as an investment adviser. 18 According to the Commission, holding out suggests that the family office seeks non-family clients (i.e., it is in the business of being an investment adviser), much like a typical commercial investment adviser, and allowing family offices to do so would be inconsistent with existing exemptive orders. D. Multifamily Offices Some family offices currently serve more than one family as a cost-saving measure and to achieve economies of scale. In the Commission s view, however, a multi-family office more resembles a typical commercial investment adviser that should be subject to the Advisers Act. Thus, under the Family Office Rule, a family office could only serve members of a single family Rule 202(a)(11)(G)-1(b)(2). The Commission expanded the ownership provision from family members to family clients in response to comments that observed that the office may, in some cases, be wholly or partially owned by a family trust or certain key employees may have an ownership interest. However, it declined to similarly expand the control provision and specifically noted that control may not be shared by non-family members or family entities (defined to exclude key employees and trusts solely for purposes of this provision). 18 Rule 202(a)(11)(G)-1(b)(3). 19 The Commission notes that it would not be permissible to establish several separate family offices staffed by substantially the same individuals as this would be a de facto multifamily office. 6

7 E. Involuntary Transfers The Commission notes several instances where persons may inadvertently become clients of the family office or where persons initially covered under the Family Office Rule may no longer be family clients. In the first instance, the rule includes an exception for circumstances where a person may become a client of the family office by virtue of an involuntary transfer as a result of death or other involuntary transfer by a family member or key employee. The family office may continue to provide investment advice with respect to the assets for one year while an orderly transition of those assts to another investment adviser is effected or the family office comes into compliance with the Advisers Act. 20 The second scenario contemplates the case where a key employee may leave the family office. Under the rule a former key employee is not required to liquidate investments but may not make additional investments through the family office. 21 F. Grandfathering Provision As noted above, the Dodd-Frank Act directs the Commission not to exclude from the Family Office Rule, or to grandfather, those family offices that otherwise would satisfy all of the conditions of the rule but for their provision of investment advice to certain specified clients before January 1, These clients include: 1) persons who, at the time of their investment, were officers, directors or employees of the family office who had invested with the family office before January 1, 2010 and who met the definition of accredited investor under Regulation D of the Securities Act of 1933, which is a broader group of individuals than those covered by the definition of key employees in the Family Office Rule; 20 Rule 202(a)(11)(G)-1(b)(1). The Commission extends the period from four months to 12 months in the final rule. Importantly, if the transferee does not receive investment advice for compensation from the family office (key components to advisory services), then the exclusion is not affected. 21 Rule 202(a)(11)(G)-1(d)(4)(iv). 22 See Section 409(b)(3) of the Dodd-Frank Act; Rule 202(a)(11)(G)-1(c). 7

8 2) any company owned exclusively and controlled by one or more family members, which allows that such companies may be operated for the benefit of others beyond the family clients permitted in the new rule; and 3) any investment adviser registered under the Advisers Act that provides investment advice and identifies investment opportunities to the family office, and invests in such transactions on substantially the same terms as the family office invests, but does not invest in other funds advised by the family office and whose assets as to which the family office directly or indirectly provides investment advice represents, in the aggregate, not more than 5% of the value of the total assets as to which the family office provides investment advice, which is a category of persons not included in the new rule. Family offices eligible for the exclusion from the Advisers Act registration requirements on the basis of this grandfathering provision will nevertheless be deemed to be investment advisers for purposes of the anti-fraud provisions of Advisers Act Sections 206(1), (2) and (4). G. Reliance on Current Exemptive Orders The Commission states that family offices relying on orders from the Commission that declare them not to be investment advisers within the intent of the Advisers Act may continue to rely on such orders even though such orders may be broader than the current rule. 23 Compliance Date The Family Office Rule includes a transition period for those investment advisers that may require time to evaluate their operations and take appropriate action prior to the repeal of the private adviser exemption on July 21, Entities that do not satisfy the conditions of the new Family Office Rule may continue to operate as a family office until March 30, 2012 when they must register with the Commission or change their operations to qualify under 23 Adopting Release at

9 the exclusion. 24 In order to take advantage of this transition period, however, the family office must not have had more than 15 clients in the previous 12 months and must not hold itself out to the public as an investment adviser nor serve as such to any registered investment company or business development company. * * * * * If you have any questions concerning this client alert, please call any of the following members of our Securities and Futures Regulation Group: Marguerite C. Bateman mbateman@schiffhardin.com Melody R. Cross mcross@schiffhardin.com Paul E. Greenwalt, III pgreenwalt@schiffhardin.com Jon K. Jurva jjurva@schiffhardin.com Michael L. Meyer mmeyer@schiffhardin.com Chip Presten cpresten@schiffhardin.com Robert B. Wilcox Jr. rwilcox@schiffhardin.com Craig Bridwell cbridwell@schiffhardin.com Paul E. Dengel pdengel@schiffhardin.com Stacie R. Hartman shartman@schiffhardin.com Jacob L. Kahn jkahn@schiffhardin.com Carlos M. Morales cmorales@schiffhardin.com Laura S. Pruitt lpruitt@schiffhardin.com Michael K. Wolensky mwolensky@schiffhardin.com Ethan H. Cohen ecohen@schiffhardin.com Jack P. Drogin jdrogin@schiffhardin.com Allan Horwich ahorwich@schiffhardin.com Andrew M. Klein aklein@schiffhardin.com Debra M. Patalkis dpatalkis@schiffhardin.com Carl A. Royal croyal@schiffhardin.com John S. Worden jworden@schiffhardin.com Rule 202(a)(11)(G)-1(e)(2). The Commission points out that, since initial applications to register can take up to 45 days to be approved, family offices that determine that they must register should submit their applications at least by February 14,

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