The Securities and Exchange Commission (the “SEC”) has adopted a new rule, defining the term “family office” for purposes of exempting family offices from registration under the Investment Advisers Act of 1940, as amended (the “Advisers Act”). Rule 202(a)(11)(G)-1, and Release No. 1A-3220.
In adopting the final Rule, the SEC considered approximately 90 comment letters, including one from our law firm. While significant improvements have been made over the initial proposal, the SEC is still taking a somewhat restrictive approach to the exemption, as described below.
The definition has three basic requirements. First, the family office must provide securities advice only to “family clients.” Second, family clients must wholly own the family office and family members and/or family entities must control the family office. Finally, the family office must avoid holding itself out to the public as an investment adviser.
“Family clients” include current and former “family members,” certain key employees of the family office (and certain former key employees), charities funded exclusively by family clients, estates of current and former family members or key employees, trusts existing for the sole current benefit of family clients or, if both family clients and charitable and non-profit organizations are the sole current beneficiaries, trusts funded solely by family clients, revocable trusts funded solely by family clients, certain key employee trusts, and companies wholly owned exclusively by, and operated for the sole benefit of family clients (with certain exceptions).
“Family member” now includes all lineal descendants of a common ancestor (living or deceased) as well as current and former spouses or spousal equivalents of the descendants, provided that the common ancestor is no more than 10 generations removed from the youngest generation of family members. Adopted children and current and former stepchildren qualify as family members. The common ancestor need not have generated the family’s wealth.
If there is an involuntary transfer by a family member to a non-family member, the Rule provides a one-year transition period before the exemption is lost. (The SEC noted our suggestion of a two-year transition period and others’ recommendations of one to three years.)
Notably, the SEC declined to exempt any “multi-family” offices.
The Rule permits the family office to advise irrevocable trusts funded exclusively by family clients in which the only current beneficiaries, besides other family clients, are non-profit organizations, charitable foundations, charitable trusts, or other charitable organizations. We and others had suggested that the requirement of exclusive funding was unnecessary but the SEC (noting our request) declined to accept this proposal. If a family office now advises a charity or non-profit organization that has accepted funding from non-family clients, the arrangement must be changed prior to the end of 2013 to preserve the exemption.
The Rule permits “key employees” of the family office, their estates and certain of their investment vehicles to count as “family clients.” Key employees may not control the exempt family office, however. Generally, the SEC has adopted the approach reflected in the “Knowledgeable Employee” definition in the rules under Section 3(c)(7) of the Investment Company Act. The Rule permits the family office to advise a natural person (including a spouse or spousal equivalent with a joint interest) who is an executive officer, director, trustee, general partner or person serving in a similar capacity, or any other employee (excluding an employee performing solely clerical, secretarial or administrative functions) who regularly participates in the family office’s (or affiliate’s) investment activities (and has done so for such office or another company, for at least one year). Trusts for which the key employee is the sole person making investment decisions are also eligible. Former employees are not eligible.
Effective Date and Grandfathering
Non-exempt family offices must generally register by March 30, 2012. Family offices operating pursuant to previously granted SEC exemptive orders may continue to operate on that basis even if they do not meet the new exemption.
In addition, pursuant to the Dodd-Frank Act, a family office which was exempt as of January 1, 2010 will remain exempt if its clients are limited to officers, directors and employees of the family office who invested before such date and are accredited investors, companies exclusively owned and controlled by family members, and (generally) an investment adviser who advises and co-invests with the family office and whose share of the invested assets does not exceed 5%.