The new definition of “family office” under the Dodd-Frank Act will force many family offices to make difficult choices. While the definition of a “family” has become broader, the ability to include non-family members and still retain family office status has been lost. Family offices have until the end of March to make adjustments to avoid new regulations or register and reveal many details of their assets. David Guin, a partner at the New York-based law firm Withers Bergman, has been helping clients navigate the reforms and he spoke to FINalternatives’ Senior Reporter Mary Campbell recently about the implications for wealthy families.
So, to start with the basics, what are family offices?
Family offices, in the context that we’re speaking of them today, are sort of private investment advisors; they are charged with managing a family’s assets…Families that have sufficient wealth have…their own dedicated set of professionals who manage their assets and do the accounting for them—family offices often provide ancillary services like bill-paying services and tax preparation services, sometimes concierge services.
And these services are provided to family members only?
[Laughs] That’s where the rub comes in. There are two types of family offices…one is a single-family office and that would be a family office that is dedicated to the needs of a single family, [the other is] a multi-family office, and that is really more along the lines of a professional investment advisor…
[From] the Dodd-Frank Act prospective, the only service that family offices provide that we are concerned with is the investment advice. So all the concierge services, and bill-paying services, the tax-preparation and accounting they can continue to do and it’s not affected by the Dodd-Frank Act.
Is there a limit to number of families that can be served by a multi-family office?
Under the old rules, before the Dodd-Frank Act, they had an exemption called the private advisor exemption…a private advisor was any investment advisor who had fewer than 15 clients. And the way they allow you to count clients, a lot of family members and family entities could be collapsed; so, I may have four trusts and five family members but if they held those things in the right way, it would all count as fewer than nine clients.
Starting in the late ‘40s… a whole series of exemptive orders…were issued by the SEC, where families would write in and say, ‘We know that, technically, we have more than 15 clients, but we manage money for a single family’—and they would describe the family relations, it was usually a couple of generations and related entities, family limited partnerships and things like that—‘and we don’t think that the act was intended to get us to register, given the limited scope of our activities for one family.’ And generally the SEC would agree with them and would grant an exemptive order (an exemptive order basically says, ‘even though the law applies to you, we will exempt you from compliance’).
What changed this situation?
Along come things like [the] Bernie Madoff [scandal] and the SEC decides, not that they want to advise family offices so much, but that they want to regulate hedge fund managers—because hedge fund managers were also relying on the private advisor exemption.
Hedge fund managers would be limited to 15 clients?
It was the same limit but the important part about a fund manager is that the fund was a single client, not all the investors in the fund. So you could have a fund with 99 investors and $14 billion in assets under management and the fund manager wasn’t regulated.
So, in an effort to regulate…hedge fund and private equity funds, fund managers generally—Congress repealed the private advisor exemption. The intended target: fund managers. The unintended consequence: family offices.
The family office community catches wind of what is going on and organizes and lobbies Congress to create an exemption specifically for family offices to replace the private advisor exemption that was being taken away. That is the genesis of section 409 of the Dodd-Frank Act, which is the family office exemption.
And what is that definition?
The Dodd-Frank Act itself didn’t define what a family office was, it tasked the SEC to come up with a definition. So, in October of 2010, the SEC issued its proposed definition of a family office and it was, to put it mildly, a disaster….Probably about 95% of family offices would have failed the original definition.
For example, if I had a trust that was for the benefit of my family members while they were alive, but the American Red Cross once they died, well, the American Red Cross isn’t a family member so that trust would have caused my entire family office structure to fail the definition.
That’s just the most obviously wrong example—that can’t have been what was intended. So, in response to this proposed definition…about 70 comment letters were submitted to the SEC recommending changes to their proposed definition. The SEC actually did a pretty good job in paying attention to the comments they received and informing themselves better about personal planning structures, and in June 2011 they came out with a new definition—the final definition—of a family office, and it corrected many of the most glaring problems with the proposed definition. It changed the way you defined who a family member was, because it used to be very restrictive, now it’s very broad—if you look at the youngest living family member you can go 10 generations back to identify a common ancestor, and everyone who descends from that common ancestor is considered a family member…They really did do a good job in trying to craft a rule that would allow most family offices to qualify for the exemption.
But you say there are still problems with the new definition?
A lot of families, over the course of time, have let non-family members into their collective investment vehicle—so somebody’s good friend or neighbor or a relative slightly more distant than the rule allows has been let into a collective investment vehicle. We now have until March of 2012 to get the family office into compliance with the definition or they’re required to register; one or the other, either you satisfy the exemption or you have to register, and that date is now set at March 30, 2012. That said, some families are considering forming a private trust company as a means of avoiding SEC registration.
And satisfying the exemption, does that basically mean getting rid of anybody who’s not a family member?
Exactly…So…for example, we’ll go through with the family and we’ll say, ‘Okay, these five entities have non-family members in them, we need to get rid of the non-family members.’ What we find is, the documents, more often than not, were not drafted with the expectation that you would need the ability to kick somebody out…What are my options then? Well, my options are either to buy them out, and if they don’t want to go, I may have to pay them a premium to get them out.
…If I decide I’m not willing to pay a premium, and I can’t force them out, another option is to liquidate the entity. Well, that has its own set of problems—if the assets in that entity aren’t ready for liquidation, I’d have to sell them at a loss….that isn’t a very attractive alternative for two reasons: one, I don’t want to take a loss myself; two, one has to ask oneself, if I liquidate this partnership at a loss, because it is beneficial to me, because it allows me to avoid registration, but it’s bad for everybody else, did I breach a fiduciary duty to somebody? And have I somehow created an exposure that didn’t exist before?
Another situation where we find families sort of struggling is when you have a family that [as] part of their philanthropic commitment to their community is managing the endowment of a local charity. That isn’t a family client, but they want to do it, they think it’s part of what they give back to the community. However, now all of a sudden they’ve got to make a choice: either I register or I quit doing this thing that I think is beneficial to the community and its part of my giving back efforts.
Why would a family office would be reluctant to register with the SEC?
Privacy is by far the biggest concern…There’s no ‘registration lite’ for family offices—if you have to register, you have to register like any commercial entity…and that’s by filing a Form ADV. That will include information about the owners of your entity and other information about the business of the family office…the biggest one being the assets under management—no one is comfortable putting [that] in a document that, by the way, is publicly available on the SEC’s web site…
The second piece to the privacy issue is if you’re a registered investment advisor you’re subject to periodic SEC examinations and they come in and just ask for anything they want…because there’s no separate standard for family offices…So, all the things that they would look at for a major commercial investment advisor or fund manager—are their custody procedures okay? Are they reporting in the right way? Do they have the right policies and procedures in place? Are there any relationships with affiliated entities that may cause a conflict of interest? All that stuff is fair game for them.
And when you provide the information to the SEC you can request that it be treated confidentially, but the SEC doesn’t make a determination as to whether they actually agree with you or not until somebody actually requests the information.
Is there any chance the regulation could be changed at this stage?
For the time being it’s set. There’s still a couple of thorny interpretive issues, things about the final definition of family office that people didn’t like and the SEC has already been pretty clear that they’ve gone as far as they are willing to go at this point in time.
What kind of advice are you giving family offices these days?
The families we’re talking to tend to fall into one of three categories: either they’re going to restructure so that they qualify for the exemption, and the advice there usually is around identifying the non-family clients and coming up with the best course of action to remove them from the structures. That’s probably the overwhelming majority of family offices, I think that’s where they’re headed.
There’s a fairly small minority of family offices who say, ‘You know what? We’re just going to register. We have too many problems, it’s either we have too many problems or we invited non-family members in to help defray the cost of running the family office and we don’t want to bear the entire expense ourselves, we’re not that worried about the privacy issues, so we’re just going to go ahead and register so we can keep these non-family clients.
Then the third category, again it’s a decided minority but possibly a little bit bigger than the minority of family offices that are going to register, are people that are thinking about whether there are ways to register an affiliated RIA, so I’m going to leave my family office unregistered and I’m going to create an affiliated entity and I’m going to register than affiliated entity.