In the first of two articles looking at new SEC rules on family offices, this publication looks at what has changed ahead of the new regime in March next year.
In part 1 of this publication’s series on changes in family office structures due to new SEC rules, we discuss the background of the rule, the definition itself and what changed between the proposed and final rules. In part 2, we’ll discuss the options facing family offices and what they need to do before the final rule is implemented in March 2012.
When the Securities and Exchange Commission released its proposed rules on family offices in the wake of Dodd-Frank legislation in November last year, the worse-case scenario was on the table. Potentially, the final rule, if it included many of the provisions of the proposed rule, could have forced the extinction of many existing family offices, according to David Guin, partner, Withers Bergman in New York, NY.
“It was a disaster,” he says. “I think the SEC got more than 70 comment letters. Fortunately, they took many of those comments into consideration and the final rules were a vast improvement over what they had originally proposed. Under the proposed definition, about 95 per cent of our family office clients would have failed the definition for one reason or another. Under the new definition, a majority will be able to qualify without doing anything; the rest will mostly be able to restructure to fit within the exemption if they choose to do so.”
Previously, most family offices and hedge funds avoided registration under the federal Investment Company Act of 1940 by using an exemption available to firms with 15 or fewer clients, according to Steve Thayer, an attorney with Handler Thayer, LLP in Chicago. “If you look back to the Great Depression when many of these rules were created, there were also many exceptions to these rules and now with Dodd Frank and this new wave of regulation following the financial crisis, we are going back and throwing out those exceptions,” he says.
This exemption came under attack because many hedge funds use the same exception to avoid registration under the Investment Company Act and Congress was determined to subject hedge funds to further regulation, Thayer adds. Venture Capital funds were also within the scope of the rule, so the SEC had to figure out how to write new rules and which entities of what size and scope should be subject to those rules and which shouldn’t, he notes.
A number of complicated issues had to be decided in crafting these rules, according to Thayer. Originally, the rule was crafted extremely narrowly – as Guin notes – but in expanding the definition, the SEC wanted to be careful not to make it too broad.
“So the SEC had to decide about key employees, employees who had been awarded stock, should they be allowed in an exempt family office,” Thayer asked. “And what about former spouses? If someone gets divorced, but is no longer a member of the family but has some kind of stake in the family office, what happens then?”
The SEC did allow key employees and former spouses to be included as well as a fairly broad definition of the family, he says. “The final rule allows the family office to provide investment advice to family members who are related by a common ancestor, who need not be living, no more than 10 generations distant as to the source of the familial relationship, says Guin.
Equally important, Guin continues, “In addition, if the group of family members served by the family office changes, the family office is permitted to select a new common ancestor. As a practical matter, this would allow, for example, two cousins to form a family office – a result that would not have been permitted under the proposed rule.” Now, family offices can serve individuals who fund charitable entities through the office.
Another issue, notes Guin, was family offices that held trusts with third-party beneficiaries. “If a family office held a trust for the benefit of a charity, in case my child pre-deceased me - that benefitted, say the American Cancer Society - under the proposed rule that couldn’t have been a family office,” he says.
The SEC has clarified the permitted ownership structure in the final rule, according to Guin. The final rule permits trusts and foundations to own family offices as well as other types of structures such as partnerships.
Guin and his colleagues are still waiting for clarifications on some areas that the final rule didn’t explain thoroughly. While the SEC is answering questions, those answers are taking some time to get back to attorneys in this area. The SEC is also being careful not to be too broad in its answers, Guin notes.
“They don’t want to create any unintentional loopholes,” he believes. “They are looking at this through a different lens. I think they are being true to their word that they don’t want to regulate true family offices. They just don’t want to come up with interpretations that are expansive.
“I think people are generally annoyed at family offices that they have to worry about this at all, but I do think the SEC has done a decent job with the rules given what the statute says,” he adds.
Now that the SEC has defined the family office, it’s up to individual family offices to decide what to do and how to proceed under the new rule if they aren’t exempt. They have until 30 March 2012 to decide whether to register or take alternative actions, Thayer notes.
“I think that the final deadline does give family offices enough time to decide what to do,” says Guin. “People have time to figure out what their issues are and decide on a course of action. The solution itself may not be very palatable, but there is enough time for them to figure out what they need to do and implement that decision.”
In the next article, we’ll discuss the potential solutions for family offices within the scope of the final rule.