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

The Family Office Exclusion from the Definition of Investment Adviser: The SEC Adopts a Final Rule

On June 22, 2011, the Securities and Exchange Commission (“SEC”) adopted new Rule 202(a)(11)(G)-1 (the “Rule”) to define the term “family office” for purposes of excluding such

• ffices from the definition of an “investment adviser” under the Investment Advisers Act of 1940, as

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

• ffice” 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

• thers 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

• riginally 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.

July 19, 2011

Practice Groups: Investment Management Hedge Funds and Venture Funds Financial Services Reform

2 “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 guardian4) 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,
• r stepchildren that were Family Members but are no longer Family Members due to a divorce
• r 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:

• An irrevocable trust in which one or more Family Clients are the only current beneficiaries,7
• A revocable trust of which one or more Family Clients are the sole grantors, and
• 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.

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• Family Non-Profit and Charitable Organizations. A Family Client includes certain

family non-profit and charitable organizations, including any non-profit organization, charitable trust (including charitable lead trusts and charitable remainder trusts whose only beneficiaries are other Family Clients and charitable or non-profit organizations) or other charitable organization in each case funded exclusively by one or more Family Clients (also “Family Entities”). The SEC declined to permit family offices to treat as Family Clients non- profit and charitable organizations that are funded in part by persons or entities other than Family Clients, determining that permitting such entities to be advised by a family office would not comport with “the exclusion’s underlying rationale that recognizes that the Advisers Act is not designed to regulate families managing their own wealth.” Understanding that restructuring family non-profit and charitable organizations to exclude third-party money may take time, the SEC provided family offices a transition period to comply with this requirement.9

• Other Family Companies. A Family Client includes companies wholly-owned (directly or

indirectly) exclusively by, and operated for the sole benefit of, one or more other Family Clients (also a “Family Entity”).10

• Key Employees. A Family Client includes certain key employees of the family office (“Key

Employees”), meaning any natural person (including such a person’s spouse, spousal equivalent who holds a joint, community property or other similar shared ownership interest with that person) who is:

• an executive officer, director, trustee, general partner or person serving in a similar capacity
• f the family office or affiliated family office; or
• any other employee of the family office or affiliated family office11 (other than employees

performing solely clerical, secretarial or administrative functions with regard to the family

• ffice) 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 performed 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.

• Former Key Employees. A Family Client includes former Key Employees, provided that
• nce such Key Employee is no longer employed by the family office, the Key Employee may

8 This provision permits a family office to advise the estate of a deceased Family Member, Former Family Member, Key

Employee or Former Key Employee until distribution of assets even if the assets of such estate are to be distributed to Non-Family Clients.

9 A family office will have until December 31, 2013 to comply with this provision; provided, however, that a family office

may not accept additional investments from such non-profits and charitable organizations after August 31, 2011 (other than funding received prior to December 31, 2012 that is made in fulfillment of a pledge made prior to August 31, 2011).

10 This could include a pooled investment vehicle, so long as the vehicle is excepted from the definition of “investment

company” under the Investment Company Act of 1940.

11 “Affiliated family office” means a family office wholly-owned by family clients of another family office and that is

controlled (directly or indirectly) by one or more family members of such other family office and/or family entities affiliated with such other family office and has no clients other than family clients of such other family office. The Release notes that family offices may establish more than one family office for tax and other structuring reasons.

4 not receive investment advice from the family office (or invest additional assets with a family

• ffice-advised trust, foundation or entity) with respect to any new investments.12

Subject to the grace period described below, a family office may not provide advice to clients that are not Family Clients under the Rule, even if those clients received investments as a result of an involuntary transfer from a Family Client, such as through gift or bequest either by a Family Client or his or her estate. In such a situation, the family office can provide advice with respect to the investment for one year after the date of the involuntary transfer.13 The SEC believes this grace period will give clients that are not Family Clients opportunities to dispose of the investment, restructure the investment, transfer the investment or seek exemptive relief. The SEC elected not to permit a family office to provide advice to multiple families or to other categories of non-family persons or entities other than Key Employees and related persons described

• above. The SEC noted that various commenters requested expansions to the scope of the types of

persons a family office could advise, but the SEC felt such expansions did not comport with the purpose of the family office exclusion and legislative instructions given by Congress to the SEC. The SEC also noted that a purported family office could not attempt to circumvent the limitations on the types of persons a family office can advise through, for instance, setting up a series of separate family

• ffice entities, each advising a different family but all of which operate from a single office with

shared personnel.

• 2. The family office must be wholly-owned by Family Clients and exclusively

controlled (directly or indirectly) by Family Members or Family Entities. To qualify as a family office under the Rule, a family office must be wholly-owned by Family Clients and exclusively controlled, directly or indirectly, by Family Members or Family Entities. The Rule permits Key Employees to own an interest in the family office. Commenters had convinced the SEC that many family offices permit Key Employees to own an equity stake in the office as an incentive to attract talented personnel. In addition, expanding the categories of permitted owners to encompass Family Clients permits a family to own the office for tax and other purposes through a variety of trusts, entities and intermediate companies that constitute Family Clients. The term “exclusively” with respect to control is intended to clarify that control cannot be shared with persons other than Family Members or Family Entities.

• 3. The family office must not hold itself out to the public as an investment adviser.

A family office, managing the wealth and investments of Family Clients, would have little reason to hold itself out to the public or to maintain any significant public presence whatsoever. The Release states that holding out to the public would suggest “that the family office is seeking to enter into typical advisory relationships with non-family clients[.]” This prohibition on “holding out” is consistent with the SEC’s exemptive orders for family offices.

Grandfathering Relief

The Dodd-Frank Act requires the SEC’s family office rule to define those offices that are excluded from the definition of investment adviser to include certain family offices that were not registered or

12 This does not include investments a former Key Employee is contractually obligated to make, and that relate to a family-

• ffice advised investments existing prior to the time the person became a former Key Employee.

13 The adopted Rule increases this transition period from four months to one year.

5 required to be registered on January 1, 2010 and that would meet all the requirements of the Rule, except that such offices provide (and were engaged to provide prior to January 1, 2010) investment advice to:

• Natural persons who at the time of their investment were officers, directors or employees of the

family office that invested with the family office prior to January 1, 2010 and who were “accredited investors” as defined in Regulation D under the Securities Act of 1933, as amended;

• Any company owned exclusively and controlled by one or more Family Members; or
• An investment adviser registered under the Advisers Act:
• that provides investment advice to the family office and identifies investment opportunities

for the family office,

• that invests in such opportunities on substantially the same terms as the family office,
• that does not invest in funds advised by the family office, and
• whose assets as to which the family office directly or indirectly provides investment advice

represent, in the aggregate, not more than 5% of the value of the total assets as to which the family office provides investment advice. A family office that is “grandfathered” under the Rule would be subject to Sections 206(1), (2) and (4)

• f the Advisers Act, which provide certain of the anti-fraud provisions of the Advisers Act.

Authors:

• J. Matthew Mangan

matthew.@klgates.com +1.415.249.1046 Jarrod R. Melson jarrod.melson@klgates.com +1.202.778.9349

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