Wealth of Knowledge - November 2011 - Dodd-Frank Act Update: Impact of Rules on Family Offices


On June 22, 2011, the Securities and Exchange Commission (“SEC” or the “Commission”) issued the much-anticipated final rules governing family offices (the “Family Office Rule”) under the auspices of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).

The former rules exempted private investment firms (the “Firms”) from regulation if they had fewer than fifteen clients (the “Private Firm Exemption”).  When a Firm, established by a wealthy family to manage its wealth and provide other services to family members, fell outside of the Private Firm Exemption, the SEC would routinely grant an order under the Investment Advisers Act of 1940 (the “Advisers Act”), exempting it from regulation.

Over the years, many Firms have morphed into larger hedge funds and private equity funds with complex organization and management structures, providing investment advice to individuals and entities with no family relations - and no SEC oversight under the Advisers Act.

The Family Office Exclusion Exemption 

The Family Office Rule, codified as Rule 202(A)(11)(g)-1 of the Advisers Act, has sweeping implications for many Firms.  For the first time since enactment of the Advisers Act, the SEC has carefully defined the “Family Offices” that will be excluded from the stringent registration requirements and regulations of the Investment Advisers Act, as amended by the Dodd-Frank Act.  Specifically, the SEC concluded that a Family Office is a Firm that:

  • Provides investment advice 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; and
  • Is not held out to the public as an investment adviser.

Over ninety comment letters were sent to the SEC urging the Commission to adopt expansive definitions of the terms “family clients” and “family member,” relevant to the Family Office Rule.  As a result, the Family Office Rule defines “family clients” broadly to include:

  • Current and former family members;
  • Certain current and former employees (under specific circumstances);
  • Charities funded exclusively by family clients;
  • Estates of current and former family members or key employees;
  • Trusts existing for the sole benefit of family clients;
  • Trusts whose sole current beneficiaries are both family clients and charitable non-profit organizations;
  • Trusts funded solely by family clients;
  • Certain key employee trusts; and
  • Companies wholly owned exclusively by, and operated for, the sole benefit of family clients (with certain exceptions).

The term “family member” includes all lineal descendants of a common ancestor as well as current and former spouses or spousal equivalents of those descendants, provided that the common ancestor is no more than ten generations removed from the youngest generation of family members.  The Firm needs to designate an ancestor and define family members by reference to the degree of lineal kinship to the designated relative.  Families can change the common ancestor along with the family members served by the office.

The SEC attempted to modernize its definition of family member for the purposes of the Family Office Rule.  Thus, all children by adoption, current and former stepchildren, foster children and persons who were minors when another family member became their legal guardian, are all considered family members.  Further, the Commission included current and former spouses as well as current and former spousal equivalents, defined as “a cohabitant occupying a relationship generally equivalent to that of a spouse.”

With its broad definitions of family client and family member, including expansive treatment of trusts and family-owned businesses, the Family Office Rule provides many opportunities for Firms and their constituent clients to structure their estate planning, business planning and charitable giving plans without becoming suddenly subject to the Advisers Act.  A Firm should consult with a qualified professional who can help it navigate through the Family Office Rule in order to maximize the planning opportunities available.

Considerations for the Family Office 

If a Firm cannot satisfy the definitional rubric of the Family Office, it must consider carefully and, in consultation with its qualified team of professionals, determine how registration will impact its day-to-day business and operational costs.  Registration requires strict adherence to the compliance rules of the Advisers Act, as amended by the Dodd-Frank Act (together, the “Act”).  Among other requirements the Act mandates that a Firm:

  1. Adopt written compliance policies and procedures reasonably designed to prevent violations of the securities laws, rules and regulations by the adviser and its supervised persons;
  2. Perform a review, at least annually, of the adequacy of such policies and procedures and the effectiveness of their implementation; and
  3. Designate a chief compliance officer responsible for administering the compliance program.

It is vital for a Firm considering registration to engage professionals who can help the Firm to comply with the complex procedural rules of registration with the Commission.    

In general, the Firm must comply with the Rules for Registration with the SEC:

  1. Policies and procedures should be tailored to the business of the Firm;
  2. The Compliance Manual should be maintained as a dynamic document;
  3. Proper implementation of the policies and procedures must be an important part of the program;
  4. The chief compliance officer should be knowledgeable and have required authority; and
  5. The Firm's employees should be adequately trained and encouraged to internalize the importance of compliance.

Conclusion: Understanding the Alternatives 

Though the Commission did incorporate many of the comments it received, some Advisers who manage the investments of Hedge Funds and Private Equity Funds that were previously excluded from registration under the Private Firm Exemption may now be subject to the Advisers Act under the newly minted Family Office Rule.

The change has prompted many Firms to reconsider how they wish to proceed.  In widely publicized cases, Firms are openly considering whether to liquidate and return funds belonging to persons who would cause the Firm to fall outside the Family Office Rule or to register the Firm with the SEC, losing its privacy and becoming subject to the stringent regulations under the Act.

Either alternative has the potential to cause tremendous strain and financial loss to the Firm and its investors.

Fortunately, there are alternatives.

A Firm may engage a third-party financial firm that already works within the regulatory structure to provide all investment advice and related services on behalf of the family members.

This will protect both the Firm's assets and its privacy - and it could even help to formalize how the Firm will manage its investments, potentially increasing the wealth of its investors.

Only the Firm, in close consultation with a competent team of advisers who understand the complexities of the Family Office Rule and the Dodd-Frank Act, can determine whether and how the Firm should handle these changes.

EisnerAmper's A Wealth of Knowledge - November 2011: 

Have Questions or Comments?

If you have any questions about this media item, we'd like to hear your opinion. Please share your thoughts with us.

Contact EisnerAmper

* Required