On June 22, 2011, the U.S. Securities and Exchange Commission (the “SEC”) adopted Rule 202(a)(11)(G)-1 (the “Rule”) under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), to define family offices for purposes of excluding them from the definition of “investment adviser.”1
Historically, family offices have been structured to rely on the former “private adviser exemption” from SEC registration for investment advisers with fewer than 15 clients (the “Private Adviser Exemption”) or on exemptive orders granted by the SEC. The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) repeals the Private Adviser Exemption, but creates a new exclusion2 from the definition of investment adviser under the Advisers Act for family offices, as defined by the SEC.
Under the Rule, a family office is defined as a company that:
has no clients other than “family clients;”
is wholly-owned by family clients and exclusively controlled3 (directly or indirectly) by one or more “family members” or family entities; and
does not hold itself out to the public as an investment adviser.
Definition of Family Client
The Rule defines “family client” to include any (i) family member; (ii) former family member; (iii) key employee4; (iv) former key employee, provided that upon the end of such individual’s employment by the family office, the former key employee shall not receive investment advice from the family office other than with respect to assets advised by the family office immediately prior to the end of such individual’s employment; (v) non-profit organization, charitable foundation, charitable trust or other charitable organization, in each case for which all the funding of such entity came exclusively from one or more other family clients; (vi) estate of a family member, former family member, key employee or former key employee (subject to certain conditions as described below); (vii) irrevocable trust in which one or more other family clients are the only current beneficiaries; (viii) irrevocable trust funded exclusively by one or more other family clients in which other family clients and non-profit organizations, charitable foundations, charitable trusts or other charitable organizations are the only current beneficiaries; (ix) revocable trust of which one or more other family clients are the sole grantor; (x) trust of which the trustee and all persons who have contributed assets to the trust are key employees; and (xi) company wholly owned exclusively by, and operated for the sole benefit of, one or more other family clients, provided that if any such entity is a pooled investment vehicle, it is excepted from the definition of “investment company” under Section 3(c)(1) or 3(c)(7) the Investment Company Act of 1940, as amended (the “Investment Company Act”).
The Rule defines “family member” to mean all lineal descendants (including by adoption, stepchildren, foster children and individuals that were a minor when another family member became a legal guardian of that individual) of a common ancestor (who may be living or deceased), and such lineal descendants’ spouses or spousal equivalents; provided that the common ancestor is no more than 10 generations removed from the youngest generation of family members. The Release notes that a family office will be able to choose the common ancestor and may change that designation over time such that the family office clientele is able to shift over time.
Former Family Members and Former Key Employees
Diverging from its former exemptive policy, the SEC has included former family members in the definition of family client. The Release notes that former family members’ arrangements often remain intertwined with those of the family, particularly if they provided for children who remain family members.
Additionally, the SEC has included former key employees in the definition of family client, but would prohibit such persons from making any new investments with the family office.5 The limited inclusion of former key employees is designed to prevent a separation that results in harmful investment or tax consequences, while recognizing that former key employees are no longer employees of the family controlling the office, and thus would not be subject to the protections the SEC assumes accompany employment by a family.
Multiple Family Offices
The Rule does not extend the family office exclusion to family offices serving multiple families, as such family offices, even though owned and operated by single families, more closely resemble for-profit investment adviser firms.
The Rule allows a family office to continue to provide investment advice with respect to assets that have been involuntarily transferred from a family client to a non-family client for one year from the date of the transfer of assets resulting from the involuntary event. This approach would allow a family office time to orderly transition a client’s assets to another investment adviser, seek exemptive relief or otherwise restructure its activities to comply with the Advisers Act.
The SEC excludes from its definition of family office persons not registered or required to be registered with the SEC on January 1, 2010 that would meet all of the required conditions under the Rule but for their provision of investment advice to certain persons affiliated with the family office. Specifically, these person include (i) natural persons who, at the time of their investment, are officers, directors, or employees of the family office who have invested with the family office before January 1, 2010 and are accredited investors, as defined in Regulation D under the Securities Act of 1933, as amended; (ii) companies owned exclusively and controlled by one or more family members; and (iii) SEC-registered investment advisers that provide investment advice and identify investment opportunities to the family office, and invest in such transactions on substantially the same terms as the family office invests, but do 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 represent, in the aggregate, not more than 5% of the value of the total assets as to which the family office provides investment advice. Grandfathered family offices would still be considered investment advisers for purposes of the anti-fraud provisions of the Advisers Act.
Any company existing on July 21, 2011 that would qualify as a family office under the Rule but for it having as a client one or more non-profit organizations, charitable foundations, charitable trusts or other charitable organizations that have received funding from one or more individuals or companies that are not family clients shall be deemed to be a family office under this section until December 31, 2013; provided that such non-profit or charitable organizations do not accept any additional funding from any non-family client after August 31, 2011 (other than funding received prior to December 31, 2013 and provided in fulfillment of any pledge made prior to August 31, 2011).
Any company engaged in the business of providing investment advice, directly or indirectly, primarily to members of a single family on July 21, 2011, and that is not registered with the SEC in reliance on the Private Adviser Exemption on July 20, 2011, is exempt from registration with the SEC until March 30, 2012; provided that the company: (i) during the course of the preceding 12 months, has had fewer than 15 clients; and (ii) neither holds itself out generally to the public as an investment adviser nor acts as an investment adviser to any investment company registered under the Investment Company Act or a company that has elected to be treated as a business development company under the Investment Company Act and has not withdrawn its election.
Exemptive Relief Still Available
The Release notes family offices would remain free to seek an SEC exemptive order to advise an individual or entity that does not meet the family client definition. Moreover, the SEC will not rescind prior exemptive orders that it has issued to family offices, as the policy underlying them does not differ substantially from that of the Rule.
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1 Family Offices, Investment Advisers Act Release No. IA-3220 (June 22, 2011) (the “Release”).
2 The consequences of a family office being excluded from the definition of “investment adviser” are that (i) it would not be subject to any of the provisions of the Advisers Act, and (ii) no state can require it to register as an investment adviser.
3 “Control” means the power to exercise a controlling influence over the management or policies of a company, unless such power is solely the result of being an officer of such company.
4 The definition of “key employee” under the Rule is based on the definition of “knowledgeable employee” in Rule 3c-5 under the Investment Company Act, and includes any natural person (including any key employee’s spouse or spouse equivalent who holds a joint, community property, or other similar shared ownership interest with that key employee) who is an executive officer, director, trustee, general partner or person serving in a similar capacity of the family office or its affiliated family office or any employee of the family office or its affiliated family office (other than an employee performing solely clerical, secretarial, or administrative functions with regard to the family office) 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 and 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 12 months.
5 A former key employee, however, would be permitted to receive investment advice from a family office with respect to additional investments that (i) the former key employee is contractually obligated to make and (ii) relate to a family-office advised investment existing prior to the time the person became a former key employee.