Family Offices and Regulatory Scrutiny Following Archegos Capital Management Implosion

August 26, 2021

By Shweta Mehta

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Introduction

Family offices are private wealth management advisory firms which are established by high net worth individuals to manage their own family wealth and provide other services to their own family members, such as tax and estate planning services. Historically, family offices have not been required to register with the SEC under the Investment Advisers Act namely because of an exemption provided to investment advisers with fewer than fifteen clients, among other exemptions.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) implemented rule 202(a)(11)(G)-1 approved by SEC on June 22, 2011, repealing the above-fifteen-client exemption to enable the SEC to regulate hedge fund and other private fund advisers. In addition, the Dodd-Frank Act includes a new provision requiring the SEC to define family offices in order to exempt them from regulation under the Investment Advisers Act. The new rule, as defined below, adopted by the Commission enables those managing their own family’s financial portfolios with family offices to determine whether their family offices can continue to be excluded from regulation under the Investment Advisers Act.

Family offices that are excluded from Investment Advisers Act under the new rule are as follows:

Any company that:

  • Provides investment advice about securities only to “family clients,” as defined by the rule;
  • Is wholly owned by “family clients” and is exclusively controlled by “family members” and/or “family entities,” as defined by the rule; and
  • Does not hold itself out to the public as an investment adviser.

Implosion in Archegos

Bill Hwang founded hedge fund manager Tiger Asia Management in 2001. In 2012, he pleaded guilty to insider-trading charges tied to Chinese bank stocks, paying millions of civil and criminal penalties to the SEC and the U.S. Justice Department. Despite settling charges related to insider trading with the SEC in 2012, he was able to set up his family office, Archegos Capital Management.

Archegos managed up to $10 billion of Hwang family’s wealth, but due to arrangements with major investment banks and brokers, the fund was able to borrow and hold economic interests of many multiples its total size across concentrated positions in U.S. and Chinese media and technology companies. Archegos doesn’t appear to have ever filed a Form 13F or 13D with the SEC: Due to an exemption in the Dodd-Frank Act, which exempts family offices because of their lack of public investors and because they manage solely their own finances, they don’t need to register under the Investment Advisers Act of 1940.

Forms 13F and 13D both are public documents that reveal big stock holdings of hedge funds and mutual funds. Investment firms that own shares worth at least $100 million must file a Form 13F detailing their portfolios every quarter, while firms file a Form 13D once their stake in a single corporation exceeds 5%, which alerts their investors that they may be pursuing a hostile takeover or the breakup of the company.

Archegos grew its fund in a handful of stocks with a strategy of increasing its stake through an arrangement with various brokers in complex positions like swap transactions. Since Archegos leveraged an enormous amount through multiple brokers, it was riskier in a way. If the prices of shares in which they have invested unexpectedly falls, then Archegos would have to pay to brokers to cover the losses or be quickly wiped out due to having to sell off holdings (depending upon the losses that may occur).

One company, where Archegos held shares, announced its plan to raise further funds through selling of shares and the company thought that Archegos would be the anchor investor. However, it turned out that Archegos did not invest further. This news influenced the company’s share price drastically, as existing investors lost the trust in the company and started to sell the stocks which resulted in steep decline in price. Furthermore, the decrease in stock prices triggered the need of margin calls on the swap transactions from various brokers which Archegos defaulted upon, forcing the sale of underlying securities resulting in the loss of billions of dollars by multiple brokers. This incident grabbed the attention of regulators and raised scrutiny of Archegos (which, remember, was a family office).

In the wake of market volatility emerging from Archegos Capital, American for Financial Reform (AFR), a nonprofit which lobbies for stricter Wall Street regulation, wrote a letter to the SEC dated March 31, 2021, “urging action to improve transparency with enhanced 13F disclosures and investigate any regulatory gaps created by the registration exemption for large family offices. There is no reason why large investors whose decisions can significantly impact other investors and companies should be able to avoid the same scrutiny other investors face simply because of how they choose to structure their trade or their investment firm.”

SEC’s Investigation Continues

The SEC officials are exploring how to increase transparency for the types of derivative bets that sank Archegos. Among issues the SEC is evaluating are whether filings should include derivatives and short positions, and if firms should submit Form 13Fs more frequently than every three months. Regulators have not yet accused Archegos or its banks of breaking any laws in their dealings, as they are currently evaluating the regulatory gap created by the registration exemption for family offices.


Our Current Issue: Q3 2021

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