SEC Proposes Definition of “Family Office”

The Dodd-Frank Act amends the Investment Advisers Act to exclude “family offices” from the definition of investment adviser, and grants the SEC the rulemaking authority to define this term. On October 12, 2010, the SEC published proposed Advisers Act Rule 202(a)(11)(G)-1, which would define a family office as any company that: (i) has no clients other than “family clients”; (ii) is wholly owned and controlled, directly or indirectly, by “family members”; and (iii) does not hold itself out to the public as an investment adviser. The rule would also contain grandfathering provisions. Comments on the proposed rule must be received by the SEC on or before November 18, 2010.

Family Clients and Family Members

The proposed rule would require that all of a family office’s investment advisory clients be family clients, which would include: (i) family members and former family members; (ii) certain key employees and former key employees of the family office; (iii) charities established and funded exclusively by family members or former family members; (iv) trusts or estates existing for the sole benefit of family clients; and (v) entities wholly owned and controlled exclusively by, and operated for the sole benefit of, family clients.

Family members would include: (i) the founders of the family office; (ii) the founders’ spouses or spousal equivalents for whose benefit the family office was established and any subsequent spouse of such individuals; (iii) the founders’ parents; (iv) the founders’ lineal descendants (including by adoption and stepchildren), and such lineal descendants’ spouses or spousal equivalents; and (v) the founders’ siblings, and such siblings’ spouses or spousal equivalents and their lineal descendants (including by adoption and stepchildren) and such lineal descendants’ spouses or spousal equivalents. A spousal equivalent is a cohabitant occupying a relationship generally equivalent to that of a spouse.

Please note the following:

• The rule would not extend to family offices serving multiple families.
• Former family members (such as divorced spouses) would be permitted to retain their existing investments held through the family office, and make additional investments that the former family member was contractually obligated to make, and that relate to a family office-advised investment existing prior to the time the person became a former family member. A former family member would not be permitted to make new investments through the family office. Former key employees are treated in a substantially similar manner.
• In the event of an involuntary transfer of assets to a non-family client, a family office would only be able to continue to rely on the proposed rule for four months following the transfer, and would need to cease to provide advisory services to such non-family client after the four-month period.
• A key employee would be any natural person (including any person who holds a joint, community property or other similar shared ownership interest with that person’s spouse or spousal equivalent) who is an executive officer, director, trustee, general partner or person serving in a similar capacity of the family office or any employee of the 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, provided that such employee has 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.
• A pooled investment vehicle would be required to meet the ownership and control requirements above and be excepted from the definition of “investment company” under the Investment Company Act.
• The SEC is not proposing to rescind any exemptive orders it has already issued to family offices. Family offices can continue to rely on these exemptive orders.

The proposed rule would provide an exception for a family office from the definition of investment adviser under the Advisers Act. As a result, a family office would not be subject to any provisions of the Advisers Act (including the examination, books and records, and the anti-fraud provisions). In addition, directors, partners, trustees and employees would be excluded from regulation under the Advisers Act, but only when acting within the scope of their position or employment. Further, no state can require a family office to register as an investment adviser.

Grandfathering Provisions

The Dodd-Frank Act precludes the SEC from excluding certain offices from the definition of family office. The proposed rule provides that an office would be grandfathered into the definition if it was not registered or required to be registered under the Advisers Act on January 1, 2010, solely because the office provided investment advice to, and was engaged before January 1, 2010, in providing investment advice to: (i) officers, directors, or employees of the office who had invested with the office before January 1, 2010, and are accredited investors; (ii) companies owned exclusively and controlled by one or more family members; or (iii) investment advisers registered under the Advisers Act that provide advice to the office, identify investment opportunities to the office, invest in such transactions on substantially the same terms as the office invests (but do not invest in other funds advised by the office), and whose assets represent, in the aggregate (directly or indirectly), not more than 5% of the value of the total assets as to which the office provides investment advice. An office that meets the grandfathering requirements, but does not otherwise meet the definition of family office, would be subject to paragraphs (1), (2) and (4) of Section 206 of the Advisers Act (these are the general anti-fraud provisions).

Requests for Comment

The SEC has requested comment on virtually all aspects of the proposed rule, including:

• Whether non-family members should be permitted to have a minor ownership stake in a family office.
• Whether other types of individuals or entities should be permitted to invest through the family office.
• Whether the definition of family member is over- or under-broad, and whether certain types of guardianships should be included in the definition.
• Whether involuntary transfers should be permitted, or permitted but subject to certain conditions (such as a limit on the types of transferees).

In light of the proposed rule, family offices may be well-served by reviewing their clients, ownership and control to determine if they meet the definition above. A family office that does not meet any of the available exemptions will be required to review SEC and state registration requirements to determine if it is required to register (please note that the revised SEC registration requirements enacted pursuant to the Dodd-Frank Act go into effect on July 21, 2011). Alternatively, a family office could seek an exemptive order from the SEC relating to its specific facts and circumstances.

The full text of the proposal can be found at http://www.sec.gov/rules/proposed/2010/ia-3098.pdf.

For assistance, please contact the following lawyers in the Financial Services Area:

Roger P. Joseph, Practice Group Leader, Investment Management; Co-chair, Financial Services Area
roger.joseph@bingham.com, 617.951.8247

Amy Kroll, Partner, Broker-Dealer Group
amy.kroll@bingham.com, 202.373.6118

David Boch, Partner, Broker-Dealer Group
david.boch@bingham.com, 617.951.8485

Thomas John Holton, Partner, Investment Management
john.holton@bingham.com, 617.951.8587

Edwin E. Smith, Partner, Financial Restructuring; Co-chair, Financial Services Area
edwin.smith@bingham.com, 617.951.8615