Family offices face a number of new regulatory requirements under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), signed into law in July. How some of these requirements are interpreted is now up to the SEC, but that doesn’t mean family offices should wait to act.
Under Title IV of the Dodd-Frank Act, the Private Fund Investment Advisers Registration Act of 2010, investment fund managers must register with the Securities and Exchange Commission (SEC) and make significant changes to their operations. The new law also repeals the private adviser exemption to the registration requirement, which enabled many family offices to avoid registration with the SEC. Title IV takes effect immediately, although it includes a one-year transition period. While the Dodd-Frank Act provides new ways to avoid registration, including one specifically for family offices, the SEC is empowered to define their scope and terms. Until the SEC acts, the true impact of the Dodd-Frank Act will be unknown.
Still, family offices should take action now rather than wait until a final law is in place. The SEC should hear from family offices during the rulemaking process to ensure that the final regulations accommodate the full range of approaches family offices employ. Meanwhile, those family offices that believe they may not qualify for the new family office exclusion should begin triage efforts, including consideration of whether non-family investors may continue to invest with the family (some may be grandfathered) and what kinds of restructuring will enable them to avoid registration (for example, by spinning off venture capital (VC) investments, redeeming certain non-family investors and providing alternative compensation for non-family employees, officers or directors).
Alternatively, families may consider transferring their investment management to a private family trust company, which will continue to be exempt from registration.
Private Adviser Exemption
Under the Investment Advisers Act of 1940 (the Advisers Act), all investment advisers are required to register with the SEC, unless the adviser qualifies for an exclusion from the definition or an exemption from registration, as discussed below. The Advisers Act defines an “investment adviser” as:
any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities….
The definition of investment adviser specifically excludes certain persons, including certain regulated trust companies.
If an adviser meets the definition of an “investment adviser” and must register as such under the Advisers Act, the adviser must file Form ADV with the SEC and update the form annually. Form ADV includes information on the ownership of the adviser (if not an individual), the adviser’s structure and the value of assets under management (AUM). A registered investment adviser also must, among other requirements, prepare annual disclosure documents for its clients, appoint a chief compliance officer, maintain SEC compliant books, records, and operating guidelines and procedures and undergo periodic examinations and audits by the SEC.
The Advisers Act also includes several exemptions from the requirement to register as an investment adviser. In the past, investment advisers commonly avoided registration under Section 203(b)(3), which exempts from registration an investment adviser who has no more than 14 clients and doesn’t hold himself out to the public as an investment adviser. This exemption, often referred to as the “private adviser exemption,” enabled many family offices and other managers to avoid registration because a single investment fund was counted as a single client, as long as the manager’s advice was provided to the investment fund alone and not to the fund owners.
Current Family Office Requirements
As considered here, a family office is an organization dedicated to managing the affairs of a single family, which typically either owns or controls the family office. Family offices provide a range of services, including investment and administrative services. Family office investment services range from oversight of third-party investment managers (that is, no direct investment management) to direct and active discretionary investment in stocks, bonds, exchange-traded funds, third-party investment funds (for example, hedge funds, VC funds, or private equity funds) and other investments.
Before the Dodd-Frank Act, a family office may have also avoided registration as an investment adviser because it was able to establish that it didn’t meet the definition of “investment adviser,” if, for instance, the family office (1) didn’t receive compensation for providing investment advice; (2) wasn’t “in the business of advising others” as to investments and didn’t provide investment advice “as a part of a regular business;” (3) wasn’t advising “others,” as its investment advice was limited to advising one family who owns or controls the family office; or (4) was a regulated trust company and thus qualified for the bank and trust company exclusion from the definition of an investment adviser.
The private adviser exemption, however, has been the simplest and least-restrictive exemption from registration as an investment adviser, not dependent on a facts and circumstances analysis. As a result, it has been widely relied upon by family offices.
As an alternative to the private adviser exemption, if a family office expects to have more than 14 clients, it could request an exemption order from the SEC. Indeed, since shortly after the enactment of the Advisers Act, the SEC has issued exemption orders to family offices despite their having more than 14 clients. More recently, however, this path came to be regarded as slow and somewhat restrictive in practice, and the SEC only grants a limited number of applications.
New Ways to Avoid Registration
The Dodd-Frank Act flatly repeals the private adviser exemption. Without this exemption, family offices will be required to register as investment advisers unless they qualify for another traditional exclusion from the definition of investment adviser (such as the bank and trust company exclusion) or for a new exclusion or exemption from registration created by the Dodd-Frank Act.
The Dodd-Frank Act provides three new avenues to avoid registration.
1. VC fund adviser exemption. The Dodd-Frank Act exempts advisers to VC funds from registration as an investment adviser. Congress has directed the SEC to define “venture capital fund.” The Report of the Senate Committee on Banking, Housing, and Urban Affairs to S.3217, the predecessor to The Dodd-Frank Act, provides some guidance. VC funds are described as “a subset of private investment funds specializing in long-term equity investment in small or start-up businesses.” This exemption is available to those advisers who provide investment advice only to such funds.
2. Private fund adviser exemption. The Dodd-Frank Act exempts advisers to “private funds” from registration as an investment adviser, if the adviser provides advice only to one or more private funds and has less than $150 million in total AUM in the United States. Congress also has directed the SEC to determine whether the size, governance or investment strategy of mid-sized private funds poses systemic risk and if so, to impose appropriate registration and examination procedures. The Dodd-Frank Act defines a “private fund” as one that would be considered an investment company under the Investment Company Act of 1940 but for Section 3(c)(1) or 3(c)(7) of that Act (that is, referring to companies with fewer than 100 owners, or companies owned entirely by qualified purchasers). A prior version of this exemption embodied in S.3217 and titled the “private equity fund adviser” exemption didn’t impose a ceiling on AUM, but required the SEC to define “private equity fund.” The S.3217 version would have been an attractive path for some family offices if it allowed a family office to spin out its VC investments and satisfy the VC fund adviser exemption, while fitting its remaining investments under the “private equity fund” exemption (with no limit as to AUM). By instead imposing the AUM ceiling for the private fund exemption, the Dodd-Frank Act limits its usefulness to families with greater than $150 million invested (other than in VC).
3. Family office exclusion. The Dodd-Frank Act excludes “any family office, as defined by rule, regulation, or order of the [SEC]” from the definition of an investment adviser under the Advisers Act. It directs the SEC to provide rules of general applicability defining an excluded “family office” and requires the SEC to:
“provide for an exemption that—(1) is consistent with the previous exemptive policy of the Commission, as reflected in exemptive orders for family offices in effect on the date of enactment of this Act and the grandfathering provisions in [the Dodd-Frank Act]; (2) recognizes the range of organizational, management, and employment structures and arrangements employed by family offices; and (3) does not exclude [certain grandfathered family offices] from the definition of “family office”, solely because such [family office] provides investment advice to [certain persons]….”
Grandfathering provisions in the Dodd-Frank Act provide that a family office that was not required to register as an investment adviser before Jan. 1, 2010 shall not be excluded from the new family office exemption solely because it continues to provide investment advice to: (1) individual officers, directors or employees of the family office, as long as such individuals had invested with the family office before Jan. 1, 2010 and were, at the time of investment, accredited investors; (2) any company exclusively owned by the family associated with the family office; or (3) certain registered investment advisers who co-invested limited amounts with the family office.13
In the Report of the Senate Committee on Banking, Housing, and Urban Affairs to S.3217 (the Report), in discussing the family office exclusion, the Committee noted the history of the SEC’s exemption orders for family offices, and the Committee’s belief:
“that family offices are not investment advisers intended to be subject to registration under the Advisers Act. The Advisers Act is not designed to regulate the interactions of family members, and registration would unnecessarily intrude on the privacy of the family involved.”
In the Report, the Committee recognized that many family offices have non-family members as officers, directors and employees, and that such persons (and other persons who may provide services to the family) are at times permitted to co-invest with family members and specifically stated that such arrangements should not automatically exclude a family office from qualifying for the exclusion.
The text of the family office exclusion and the earlier Report on S.3217 indicate that, in defining the family office exclusion, Congress intended that the SEC not be limited to replicating the criteria for its past exemption orders and that it must take into account the fact that family offices vary widely in their organization, management and employment structures. The grandfathering provision is an interesting addition to this process because it appears to suggest that Congress wants the SEC to avoid disrupting certain existing family office structures and common arrangements, in the SEC’s determination of what type of family office will avoid being considered an investment adviser.
The Dodd-Frank Act also expands state regulatory oversight of investment advisers by raising the threshold for federal oversight of most investment advisers to $100 million. The Dodd-Frank Act provides, with some exceptions, that no investment adviser with AUM of between $25 million to $100 million shall be permitted to register as an investment adviser under the Advisers Act, unless as a result of this provision the adviser would be required to register with 15 or more states. Due to this change, state regulatory authorities will be responsible for oversight of most investment advisers with less than $100 million AUM. This increased state oversight doesn’t apply to investment advisers who are excluded from the definition of investment adviser under Section 202(a)(11) of the Advisers Act (for example, an adviser excluded from the definition under the bank and trust company exclusion or the new family office exclusion), but does apply to advisers who would otherwise be exempt under section 203 of the Advisers Act (for example, VC fund advisers or private fund advisers).
Because The Dodd-Frank Act provides enabling legislation, rather than actively defining the new family office exclusion from the definition of investment adviser and the new exemptions from registration as an investment adviser, a number of issues remain uncertain. But that is a subject for another column.