SEC Proposes Rule Defining Family Offices

October 22, 2010

On October 12, 2010, the U.S. Securities and Exchange Commission (the “SEC”) proposed Rule 202(a)(11)(G)-1 (the “Proposed 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 current 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. The Dodd-Frank Act requires the SEC to adopt a definition of family office that is consistent with its previous exemptive orders and that recognizes the range of organizational, management and employment structures and arrangements employed by family offices.

The Proposed Rule

Under the Proposed Rule, a family office is defined as a company that:

  • has no clients other than “family clients;”
  • is wholly-owned and controlled3 by family members; and
  • does not hold itself out to the public as an investment adviser.

Definition of Family Client

The Proposed Rule defines “family client” to include “family members,” including extended family members, of the founders of the family office;4 key employees of the family office;5 charities established and funded exclusively by family members or former family members; trusts or estates existing for the sole benefit of family clients; family-owned companies, other than pooled investment vehicles relying on Sections 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940, as amended; former key employees; and former family members.

Inclusion of Spousal Equivalents

The Proposed Rule includes spousal equivalents in the definition of family client. A “spousal equivalent” is defined as a cohabitant occupying a relationship generally equivalent to that of a spouse. The Release notes that the SEC staff is not aware of any exemptive applicant requesting that a spousal equivalent be included as a permitted client of a family office, but believes that including spousal equivalents as family clients is appropriate in a rule of general applicability.

Former Family Members and Former Key Employees

Diverging from its former exemptive policy, the SEC has proposed to include former family members and former key employees in the definition of family client, but would prohibit such persons from making any new investments with the family office.6 The Release notes that the limited inclusion of former family members and former key employees is designed to prevent a separation that results in harmful investment or tax consequences, while recognizing that former family members and former key employees are no longer members or employees of the family controlling the office, and thus would not be subject to the protections the SEC assumes accompany membership in or employment by a family.

Multiple Family Offices

The Proposed Rule does not extend the family office exclusion to family offices serving multiple families. The SEC notes in the Release that such family offices, even though owned and operated by single families, closely resemble for-profit investment adviser firms.

Involuntary Transfers

The Proposed 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 four months 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.

Grandfathering Provisions

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 Proposed 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.

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 proposed 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 Proposed Rule.

* * * * *

Comments on the Proposed Rule must be submitted prior to November 18, 2010. If you have any questions or need more information, please contact an attorney in our Investment Management Group.

______________________________________________________

1 Family Offices, Investment Advisers Act Release No. IA-3098 (October 12, 2010) (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 or a company, unless such power is solely the result of being an officer of such company.

4 A “founder” is a natural person and his or her spouse or spousal equivalent for whose benefit the family office was established and any subsequent spouse of such individuals. “Family member” means the founders, their lineal descendents (including by adoption and stepchildren) and such lineal descendents’ spouses or spousal equivalents; the parents of the founders; and the siblings of the founders and such siblings’ spouses or spousal equivalents and their lineal descendents (including by adoption and stepchildren) and such lineal descendents’ spouses or spousal equivalents.

5 The definition of “key employee” under the Proposed Rule is based on the definition of “knowledgeable employee” in Rule 205-3(d)(iii) under the Advisers Act, and includes executive officers, directors, trustees, general partners of the family office and persons serving in similar capacities, provided, that such employees have been performing such functions and duties for or on behalf of the family office, or substantially similar functions or duties for or on behalf of another company, for at least 12 months.

6 A former family member or former key employee, however, would be permitted to receive investment advice from a family office with respect to additional investments that (i) the former family member or 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 family member or a former key employee.