The Family Office Exclusion from the July 19, 2011 Definition of - PDF document

The Family Office Exclusion from the July 19, 2011 Definition of Investment Adviser: The SEC Practice Groups: Investment Adopts a Final Rule Management Hedge Funds and On June 22, 2011, the Securities and Exchange Commission (“SEC”) adopted new Venture Funds Rule 202(a)(11)(G)-1 (the “Rule”) to define the term “family office” for purposes of excluding such Financial Services offices from the definition of an “investment adviser” under the Investment Advisers Act of 1940, as Reform amended (the “Advisers Act”). 1 The Rule provides three basic conditions for a qualifying family office, each of which is described in greater detail below: 1. The family office must provide investment advice only to “family clients” (as defined in the Rule); 2. Family clients must wholly-own the family office and Family Members and/or Family Entities (each as defined below) must exclusively control the family office; and 3. The family office must not hold itself out to the public as an investment adviser. The Rule also provides “grandfathering” relief for unregistered family offices that provide certain services prior to January 1, 2010. A family office that currently is unregistered in reliance on the former private advisers exemption of Section 203(b)(3) of the Advisers Act and Rule 203(b)(3)-1 thereunder (the “Private Adviser Exemption”), 2 but which does not meet the definition of “family office” as adopted in the Rule, must restructure to satisfy the definition, register as an investment adviser by March 30, 2012, or seek an exemptive order from the SEC staff. 3 Background The term “family office” generally refers to entities formed by high net worth families to provide a range of services to family members, including wealth and investment management, accounting, tax, and other services. Family offices generally meet the definition of “investment adviser” under the Advisers Act because the variety of services they provide often include providing securities advice to others for compensation. Traditionally, family offices have operated without registering as investment advisers in reliance on the Private Adviser Exemption. Some family offices that could not, or did not wish to, abide by the limitations of the Private Adviser Exemption applied for and received exemptive relief from the SEC declaring that they were not a person within the intent of the Advisers Act. The SEC has granted thirteen of these orders since 1940. Exemptive orders have distinguished between 1 Family Offices , Adopting Release, Investment Advisers Act Release No. 3220 (June 22, 2011), available here. The rule originally was proposed on October 12, 2010. Family offices that qualify for exemption from registration and regulation under the Rule also are exempt from state investment adviser registration, as are their representatives. 2 The private adviser exemption exempted an adviser that: (a) during any rolling 12-month period had fewer than 15 clients, (b) does not serve as an adviser to a registered investment company or business development company under the Investment Company Act of 1940, and (c) does not hold itself out to the public as an investment adviser. 3 The SEC has determined not to rescind existing family office exemptive orders, which may be broader than the Rule in some respects and narrower in others. The SEC points out in the release adopting the Rule that only family offices with exemptive orders can rely on such orders.

“family offices” that provide advice to one family and “family-run offices” that, though owned and controlled by one family, provide advice to multiple clients, including non-family members. With limited exceptions, the SEC has provided relief only to family offices that provide investment advice to a single family and their lineal descendants. In the release adopting the Rule (the “Release”), the SEC stated that a family’s investment and management of its own wealth is “not the sort of arrangement that the Advisers Act was designed to regulate.” Specifically, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd- Frank Act”) calls for the SEC to promulgate a rule to define the term “family office” that is “consistent with the previous exemptive policy of the SEC,” as reflected in its past exemptive orders, and that recognizes “the range of organizational, management, and employment structures and arrangements employed by family offices[.]” Three Requirements of the Rule 1. The family office must provide investment advice only to “family clients.” The Rule defines “Family Client” to mean: • Family members. “Family Members” are defined to include all lineal descendants (including adopted children, stepchildren, foster children, and an individual that was a minor when another family member became that individual’s legal guardian 4 ) of a common ancestor (who may be deceased and may change over time as the family office’s clientele shifts), including such lineal descendants’ spouses and spousal equivalents, 5 provided that the common ancestor is no more than 10 generations removed from the youngest generation of family members. 6 • Former Family Members. “Former Family Members” include spouses, spousal equivalents, or stepchildren that were Family Members but are no longer Family Members due to a divorce or other similar event. • Family Trusts and Estates. A Family Client includes certain family trusts and estates (“Family Entities”) established for testamentary and charitable purposes, including: o An irrevocable trust in which one or more Family Clients are the only current beneficiaries, 7 o A revocable trust of which one or more Family Clients are the sole grantors, and o An estate of a Family Member, Former Family Member, Key Employee (as defined below) and Former Key Employee (as defined below). 8 4 This includes only guardianships for minors; the SEC stated that guardianship relationships over adults are best dealt with on a case-by-case basis through the exemptive process. 5 The term “spousal equivalent” is defined to mean a “cohabitant occupying a relationship generally equivalent to that of a spouse.” The term “spouse,” however, is not defined, and the Release and Rule do not set forth the criteria that make a relationship “generally equivalent to that of a spouse.” 6 In response to comments, the SEC greatly broadened the definition of family member from the rule as it was proposed and gave family offices the flexibility to name and to change the common ancestor based on which the term “family member” is defined. The SEC provided a helpful diagram illustrating the workings of the common ancestor concept as Annex A to the Release. The SEC also notes that no formal procedures are required to appoint or change a common ancestor. 7 As adopted, the Rule ignores contingent beneficiaries (who may not be Family Clients) who are often named for estate planning purposes. 2