On Oct. 12, 2010, the Securities and Exchange Commission issued Proposed Rule 202(a)(11)(G)-1 (proposed rule) clarifying the family office exclusion under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). After soliciting and considering comments, the SEC issued its final rule on June 22, 2011 (final rule) in Release No. IA-3220 (the release), and in doing so, has provided much needed enhancements to the proposed rule.


Background

Historically, most single-family offices have been exempt from registration as an investment adviser under the Investment Adviser Act of 1940 due to the private adviser exemption (that is, being an adviser with less than 15 clients). However, the Dodd-Frank Act repealed that exemption and created new, narrower exemptions from registration, including the family office exclusion. As part of the Dodd-Frank Act, Congress directed the SEC to establish parameters for the family office exclusion, a process that it has now substantially completed.
In the proposed rule, the SEC intended to address the vast majority of traditional family office activities and structures. In defining those organizations that would qualify as exempt “family offices,” the SEC employed such concepts as “family members,” “family clients,” who “controls” the family office, who “owns” the family office and certain other definitions (for example, “key employee”) and concepts.


The Comment Process

The SEC requested comments on the proposed rule, and ultimately received approximately 90 comments, some short and others extensive, from a wide range of organizations. Committed to the comment process, the SEC duly considered that feedback as can be seen in the release. For the most part, the changes reflected in the final rule are improvements or enhancements to the proposed rule, rather than a wholesale change in approach.


Enhancements

We would generally classify the improvements to the proposed rule as follows:

  • adoption of a more commonly employed idea of family (that is, descent from a common ancestor);
  • expansion of those persons and entities that can be “family clients” of the family office;
  • enhanced flexibility with regard to who or what can own interests in the family office; and
  • relaxation of limitations on how the business of the family office is structured.


Idea of Family

As in its proposed rule, to qualify for the family office exemption, clients of a family office must be individuals related to one another (or must be entities created by or for such related individuals). The proposed rule required that the relation be centered around the identity of the “founders” of the family office. Many commentators, including our firm, encouraged the SEC to apply a definition that relied on a common ancestor, because among other reasons, that’s how most families define themselves. Accordingly, the final rule’s definition of “family member” (on which many other important definitions depend) includes lineal descendants (broadly defined) of a common ancestor and the spouses (or spousal equivalents) of those descendants. To ensure that there are practical limits to this concept, the SEC has required that the tracing back to a common ancestor encompasses no more than 11 family generations. Furthermore, the family office identifies the common ancestor and may change its designation from time to time.


Clients of a Family Office

The SEC provided much needed clarification in the final rule concerning what types of entities can be clients of the family office, such as family trusts, charities and other public-spirited entities. For example, in the proposed rule, the SEC had limited trusts that could be “family clients” to those “existing for the sole benefit of one or more family clients” (emphasis added). However, in the final rule, the SEC recognized that family trusts are often held not just for family but also for public charities entirely unrelated to the family at issue (for example, one’s alma mater). Moreover, the SEC determined to focus on “current beneficiaries” of trusts and to ignore contingent beneficiaries whose place in a trust is only as a last resort when there are no other beneficiaries to receive trust assets, but who are nevertheless considered to be beneficiaries for trust law purposes.

Similarly, with regard to charities and public-spirited entities, the proposed rule had allowed as family clients only foundations, organizations or trusts that were “charitable.” In the final rule, the SEC incorporated the concept of a “non-profit organization” to avoid the uncertainty inherent in the term “charitable.”


Ownership Interests

Perhaps the most important enhancements in the final rule come in the area of who may possess ownership interests in the family office. Under the proposed rule, a family office would have been disqualified unless it was wholly owned and controlled by family members. This requirement ignored the reality of many family offices in which key employees, who are often not family members, possess an ownership interest in the office. Under the final rule, the family office need be owned only by “family clients,” which is a broader term and is defined to include certain key employees as well as family members, thus allowing family offices to continue to attract talented, outside professionals as employees.

More critically, that requirement ignored the reality of many currently existing family offices in which “family members” have no ownership in the family office whatsoever, but instead entities (trusts, etc.) for the family own the family office for tax and other reasons. In response to much criticism by commentators, the final rule allows, in addition to family members and key employees, certain family-funded trusts, business entities and charities (which otherwise qualify as “family clients”) to own the family office.


Structure

Finally, the SEC also enhanced the proposed rule by allowing related family offices, for example, family offices that are structured like sister-brother companies, to share employees. As the SEC noted in its release, from time to time, separate family offices are created to serve the same family. The final rule accommodates a person being employed by one or more of such separate (but related) family offices, without adversely affecting the availability of the exclusion for each such office.


Transition Period

Of course, the SEC didn’t adopt all recommendations. For example, the SEC didn’t allow unrelated family offices to share resources by employing the same (or substantially the same) employees; the SEC considered this to be the equivalent of the employees running a multi-family office and thus not suited for the exclusion. Despite not adopting all the recommendations, the SEC did adopt a relatively generous transition rule for those family offices that need to restructure to qualify under the final rule: Generally, a family office has until March 30, 2012 (approximately nine months) to bring itself into compliance or to register.

Overall, the changes reflected in the final rule are quite welcome and will reduce the possibility of distortions to how family offices are structured and operated, as well as the need for family offices to request special, individual exemptions from the SEC.
For a more detailed analysis of the final rule, look for our upcoming article in the September issue of Trusts & Estates.