Although each is unique, family offices typically provide an array of services to members and affiliates of the founding family.

Although each is unique, family offices typically provide an array of services to members and affiliates of the founding family.  In the great majority of cases, these services include investment advisory services, as broadly defined by the Securities and Exchange Commission, as well as other financial, administrative and planning services. 

Most of the family offices we have represented or had contact with (over 100) serve multiple generations of adult family members. Until now, almost every family office that has not registered with the SEC as an investment advisor or formed a private trust company has been excused from registering by the “fewer than 15 clients” exemption from the definition of an investment advisor of the Investment Advisors Act of 1940.

The Dodd-Frank Wall Street Reform and Consumer Protection Act eliminates the fewer than 15 clients exemption effective July 21, 2011. As the result of a concerted lobbying effort by the family office industry, the same legislation added to the Advisors Act a new registration exemption for family offices. 

The inclusion of a definition of family office in the Dodd Frank Act that would be helpful to most real family offices was not politically viable, so Congress left it to the SEC to define by regulation. On October 12, 2010, the SEC issued a proposed rule defining family offices for this purpose.

The purpose of the proposed rule, according to the SEC, is to distinguish among the approximately 2,500 to 3,000 family offices in the United States managing more than $1 trillion in assets (an average of $517 million) [from] those that serve a typical family and those that “start to resemble a commercial advisor.” 

The proposed rule adopts a narrow definition of family office that is likely to significantly impact the scope, structure and services of many existing family offices, and determine the structure and scope of family offices formed in the future.  

We expect the final rule that will be adopted after the conclusion of a comment period to be both clearer and broader but not substantially so because of the policy constraint that a family office should not resemble a commercial advisor. 

Therefore we anticipate the exclusion of many current family offices from the scope of the final exemption. A proactive family wishing to influence the final rule’s definition of family office must file its comment (favorable or not) with the SEC by November 18, 2010.   

We recommend that every family office, even if it includes a registered investment advisor or a private trust company, thoroughly review its and its affiliates’ activities to make certain that no SEC-defined investment advisory services are performed by an entity that is not either exempt from registration as a family office or a PTC or registered with the SEC. 

For example, every general partner providing investment advice to a family investment fund will have to be a registered or exempt entity or cease providing such advice. Family offices have until next July to prepare for the repeal of the 15 or fewer exemption. Before then, they must determine whether their family office meets the definition of the proposed rule. If not, they have less than 9 months from now to:

-Restructure the family enterprise’s investment advisory activities to meet the definition

-Decide whether to and register as an investment advisor

-Or obtain a regulated trust company charter. 

Families should start now to evaluate the precise impact of the proposed rule on their operations. Waiting until the final rule comes out, which could be as late as shortly before the effective date of the repeal of the current exemption, and may be too late.

The Proposed Rule

The definition of family office reflects the SEC’s policy judgments that (1) the Advisors Act was not intended to regulate the interaction of family members in the management of their own wealth, but also that (2) no exemption is available to an entity, whether a family office or not, that engages in commercial investment advisory activities or whose clientele is starting to resemble that of a commercial investment advisor.

The proposed rule contains three general conditions, which must be satisfied by a family office in order for it to be exempt. First, a family office must limit its clients only to family clients. Second, the family office must be wholly owned and controlled (directly or indirectly) by family members. Third, the family office cannot hold itself out to the public as an investment advisor.  

Condition 1—Family Office Limited to Serving Family Members and Other Family Clients

Under the proposed rule, a qualifying family office serves only family clients, which may include both family members and key employees. Family members include the founders of the family office and their parents, children and other descendants. 

As we discuss when considering the definition of founder below, our reading of the SEC’s definition of family member excludes the cousins of the founders and their families.  

Key employees include executive officers, directors and other senior managers of a family office and employees providing investment advisory services who have been with the family office at least 12 months.  Additionally, a family office can serve former family members and former key employees so long as these individuals are prohibited from making further investments with the family office after they no longer meet the respective definitions. 

This will be limiting for family offices that manage the whole portfolio of former family members (e.g., ex-spouses and ex-step children). Employees of family businesses that do not qualify as family offices are also excluded.

Family clients can also include certain entities affiliated with the family subject to significant limitations. These limitations include that: (i) any trust or estate client be for the sole benefit of one or more defined family members, (ii) any charitable entity client be established and funded exclusively by one or more family members, and (iii) all other client entities be wholly owned and controlled (directly or indirectly) exclusively by, and operated for the sole benefit of, one or more family clients. Given our experience representing family offices, we believe these limitations will significantly narrow the entities an exempt family office can serve.  

Before considering the operational limits of this definition of family clients, a threshold problem exists of identifying who the founders may be with respect to existing family offices. It is questionable whether the proposed rule covers an existing family office where the founders are now deceased. 

But even if family members and family clients can be determined with reference to a deceased founder, it may be difficult or impossible as a practical matter to identify the founders of a family office formed decades and/or generations ago. Even if the founders can be identified, if the family office went through a reorganization or reincorporation other than by merger (e.g., in connection with a jurisdiction change), we do not think the original founders could be considered to be founders of this new entity.  

Given that the lineal relationships of eligible family clients are tied to the identity of the founders, these ambiguities present real difficulties.

The proposed rule also limits the entities (including charitable organizations and trusts), which can be served by the family office to those which are exclusively tied to family members. Though many family offices serve at least some of these exclusively family funded/controlled entities, there is a large universe of other common family office clients that fall outside of this definition.

For example, a trust established by a founder which in addition to benefiting family members also benefits her alma mater or a public charity (a common occurrence) could not be served by the family office. 

Or, a charitable organization established by a family member could not be served by the family office if it accepts any contributions from non-family members. We believe that forcing a family office to shed these types of clients to comply with the proposed rule will be a problem for most family offices, though such concerns may be addressed through the comment process.

Condition 2—Family Ownership and Control of the Family Office

The second condition requires that the family office be both “wholly owned and controlled (directly or indirectly) by family members.” Under this condition, individual family members must have the power to exercise a controlling influence over the management or policies of the family office separate from his or her role as an executive officer. 

Again, we think these limitations will have a significant impact on many current family offices.

Although a family office can be held indirectly by a family holding company, the ownership of both the family office and the parent entity must be solely in the hands of family members. This would exclude equity award programs for non-family management and will probably require family offices with non-family equity ownership (at any level in the corporate structure) to repurchase these interests in order to qualify.  

We also read the proposed rule to prohibit a trust from holding equity interests in the family office because a trust, which is not a natural person, cannot be considered either a family member or to be owned by a family member. There seems to be little policy justification for this limitation and it may simply be technical and unintended.

In addition to an ownership requirement, the second condition imposes a family member control requirement on the family office. Though not specifically stated in either the proposed rule or the accompanying release, we think it clear that this condition requires only a majority of family members on the board of directors of the family office and (likely) any parent company of the family office.

Condition 3—Holding out to the Public

Consistent with past exemptive orders, a family office cannot hold itself out to the public as an investment advisor. This condition should pose no compliance concerns for single family offices.

First Steps For Families and Family Offices  

Given the significant penalties associated with acting as an unregistered investment advisor and the current climate of increased regulatory scrutiny for all financial services providers, doing nothing is not an option.  Moreover, given both the short window for commenting on the proposed rule and the rapidly approaching effective date for the repeal of the “fewer than 15 exemption” from SEC registration, families need to determine their strategies quickly.

This process should begin with a detailed review of (i) the current investment advisory services the family office and all subsidiaries, affiliates and other family-related entities provide, (ii) the family office’s current clients in light of the proposal’s definition of “family clients”, and (iii) its ownership structures and operations, to determine whether any family- related provider of investment advisory services will not qualify as a “family office” and whether a solution other than registering with the SEC exists. 

The review should also include a review of trust instruments, corporate governance documents/ownership records, and donor records of charitable entities, in each case to establish the identity of family clients.  

Family offices and their advisors must also be aware that the repeal of the “fewer than 15 clients” exception may create other, unanticipated pitfalls even if the primary family office entity qualifies for the new exemption.  For example, a family-controlled entity serving as the general partner and investment adviser of a family-controlled pooled investment fund is considered an investment advisor to that fund. 

After July 21, 2011, the general partner entity will lose its registration exemption unless it qualifies as a family office or is otherwise exempt. We therefore recommend that families and their advisors undertake a detailed review of not only the family office, but also all of the family’s investment and investment advisory activities in light of the Dodd-Frank Act’s amendments to the Advisors Act.  

Options For Family Offices?

In the release accompanying the proposed rule, the SEC specifically requests comments on 14 specific subjects and also generally on the Proposed Rule.  Given the complexity (and ambiguity) of certain of the SEC’s definitions and the wide variety among the thousands of family offices that will be affected by this rule, we expect to see an exceptionally large number of comments for the SEC to ferret through.  

As a result, it is possible that the final rule will not come out for some time and may incorporate significant changes even though likely not to fundamentally broaden the scope of qualifying family offices. However, there is no way to predict the ultimate outcome of this back-and-forth process, and we recommend that family offices that do not fit within the current proposal not only comment but also begin to consider each of the options for responding to the requirements of the proposed rule that we set forth here.

Conformance. The first option is simply to conform the structure and clients of the family office to the SEC’s new requirements. For many, especially smaller and less complex family offices, this may be the easiest and best course of action. 

However, doing so will likely force even relatively new family offices serving smaller families to cease serving certain clients and potentially to restructure ownership, organization or even its trusts and affiliated entities. 

Registration. If limiting its client base or modifying its operations sufficiently to conform is not feasible for a family office, the option of registration with the SEC is always available. Although the registration process itself is fairly streamlined, registration comes with many (and ever increasing) regulatory burdens. Moreover, all investment advice provided by the family office/family enterprise will need to be provided by the registered entity or a subsidiary of it because of the repeal of the fewer than 15 exemptions. 

Private Trust Company.  Many family offices, especially larger and more complex ones serving more than one generation, should consider forming a regulated private trust company (PTC). As a regulated, state-chartered trust company, a properly formed PTC is exempt from the definition of investment advisor 7 and can provide investment advice to all clients of a family office. However, forming and operating a trust company is a significant undertaking and may not be a viable option for every family office. Many considerations can lead a family to organize a private trust company, but the necessity of otherwise becoming an SEC-regulated investment advisor has in the past and will continue to add considerable impetus to doing so for many family offices.

Exemptive Order. The SEC has specifically stated that it will continue to entertain requests for exemptive relief for family offices which otherwise do not comply with the family office exception. Historically, this has been a lengthy and expensive process with costs estimated by the SEC to be approximately $200,000 (though likely higher in many cases). It is likely to be even more difficult going forward since the new presumption that now will have to be overcome is that all family offices that are not within the definition of family office are more akin to commercial advisors.

Strategic Relationship with an Independent RIA.  Finally, we expect to see many family offices seeking out and retaining a highly focused, high-level primary registered investment advisor willing to step into the advisory shoes of the family office. We see this market expanding significantly in light of the proposed rule, and RIAs able to offer competent, flexible, targeted and individualized advice to family offices should find a new and receptive market for their services. The key for both family offices and RIAs will be for the advisor to have the capability and willingness to work extremely closely with the family in pursuit of its objectives, adopting an approach that is as close as possible to the family’s own, preferred ways of operating.