Tougher regulatory times

Family offices and hedge funds don’t have an awful lot in common, except that they both tend to be small outfits. That has meant that both of them have, until now, tended to fall outside the clutches of the Securities and Exchange Commission, the American financial regulator.

That’s because of a clause in the Investment Advisers Act of 1940, which said that if an adviser has fewer than 15 employees then it doesn’t have to register with the SEC. Many family offices deliberately kept themselves small to avoid regulation. But these days small no longer means irrelevant and most people agree that hedge funds, however many they employ, ought to be regulated.

The new, wide-ranging Dodd-Frank Act will therefore scrap the old 15-or-less rule, bring hedge funds under its auspices and introduce a new rule explicitly exempting family offices. There has been much head-scratching in family offices about exactly what will be classed as a family office. As of 29 August, we now know.

According to the SEC, a family office meets three criteria. Firstly, it provides investment advice only to “family clients”; secondly, it is wholly owned by family clients and controlled (directly or indirectly) exclusively by “family members” and/or “family entities”; and thirdly, it does not make itself available to the public as an investment adviser.

“Family clients” include current and former family members (for example, those who have divorced family members), current and former key employees, charitable organisations or trusts, estates of family clients and trusts created by or for family clients. There are various other quibbles over definitions and the rules will undoubtedly be refined, but that is the broad outline.

As is always the case with new regulations, these have not been universally popular. Oddly, in this case even the regulator seems to have no love for the rules, and has no interest in regulating family offices. A senior figure at the SEC who was involved in framing the rules admits that family offices have been caught in the crossfire of the regulator’s efforts to bring hedge funds into line, but says that the regulator had taken the views of the industry into account.

“Almost all the consultation responses we received came from family offices and they all wanted a wider exemption, which we accommodated to some extent in that we were asked to extend the rules to cover a broader definition of family members and structures under which they make investments. There is no restriction on the number of ‘clients’ the family office can look after as long as they fit the criteria. There was a great deal of consultation around the types of structures that could be accommodated and family offices focused on telling us about the variety of structures and why covering them should be consistent with our policy goals.”

She described the new rules as “levelling the playing field” for other advisory firms and family offices who were registered before the Dodd-Frank Act was created and says that while the rules affect family offices in other parts of the world who have US-based clients, they don’t necessarily impact on investments made in US funds by family offices based outside the US.

However that may be, critics think that the new regulations are a waste of time. Family office consultant Michael Hutchinson is concerned they will do little to prevent future financial scandals, and hopes the UK government will resist the temptation to pry into the affairs of family offices and their client families. Fellow family office consultant Jamie McLaughlin describes the rules as a “great over-reach” by Congress and agrees there was no need to look at family offices on the broader policy basis or presumption of systemic risk.

“I hope European regulators don’t put their heads into this issue,” he adds. “The SEC had to act because of Dodd-Frank but I still don’t think there was a case for policy intervention in terms of either the number of families or the amount of money involved.”

However, in the circumstances, the SEC seems to have done a good job. David Guin, a partner at law firm Withers Bergman, describes the consultation period as an educational process for the regulator in terms of what these entities do and how they service their clients. Even critics like McLaughlin commend the SEC for the work it has done in creating a definition of the family office.

“The SEC has listened to the industry and tried hard to create a reasonable standard. It was not easy to lobby for super-wealthy families but there were those who very effectively made the case for this group before Congress.” He says that family offices shouldn’t become alarmist about the new rules.

“If the SEC has been given authority by Dodd-Frank to stick its nose in the proverbial tent of family offices, they are within their rights to mitigate against the most meddlesome language – or worse, unintended consequences. Many families, largely shielded from any disclosure in the past due to a very liberal exemption standard, will now have to register with the SEC and disclose the size of their wealth and lose some privacy if they are providing investment strategy or advice to non-family members. I don’t find that disagreeable.”

This does not mean that anyone was doing anything wrong, he adds, “but such activity might have reasonably been subject to registration in the past. To come into compliance now is not unreasonable.”

Whatever family offices’ views on the regulations, they are currently expected to come into operation in March 2012. The SEC has suggested it will take a poor view of organisations that fail to either register or change their structure by that date, but it is doing its best to help, says the insider.

“There are people in the SEC who can advise on specific queries. For more general enquires we usually put together a list of frequently asked questions, which we will do for this area in due course. Sometimes we receive requests for meetings but most enquiries can be dealt with over the phone.”

It all sounds very reassuring. But in reality what do the new rules mean for family offices?
Paul Hecker, compliance officer at Stonehage Investment Partners, says UK family offices need to check carefully if the new rules bring them within the scope of SEC registration and keep track of the numbers of US clients and the aggregate assets under advisement.

“In our case, we look closely at whether the client is actually a ‘US person’” he says. “The fact that a beneficiary of a trust is a US resident would not bring the family office into the SEC’s scope if the beneficiary’s assets were advised through a trust with no US trustees.” Many family offices will try to arrange to be exempt from the rules by limiting – or eliminating – non-family clients wherever possible, according to Lynn Wintriss of law firm DLA Piper, who used to be the president of single family office Atapco Financial Services.

She says she is aware of two family offices that have already gone down this route. David Guin says that many family offices have until now allowed family friends and distant relatives – who don’t fit the SEC’s definition of family – to participate in collective investment vehicles. This might have to change. “All family offices are going through a review process if they haven’t already done so,” he says.

“We are also aware of several families who were operating a quasi-multi family office (for example, working with other families to share costs) and these arrangements are also being reviewed. Indeed, the SEC has made it clear that families cannot avoid registration by setting up a de facto multi family office – that is, by establishing separate family offices but staffing them with ‘the same or substantially the same employees’.

“Some will look at becoming profit-making ventures if they decide to register,” says Guin. One way to ensure that family offices don’t get caught in the SEC’s net would be to establish a separate registered investment adviser, which would then have to satisfy the SEC that it is a separate entity to the family office. “The SEC has set out the conditions for entities to be considered separate but these require some additional clarity,” says Guin.

There will be further guidance on ‘separateness’ from the regulator but there is no indication as yet whether this will prove to be better or worse for family offices. The SEC is always conscious of how rules can be used as loopholes to avoid regulation so it won’t reply with a rule of general applicability.”

One consequence of the new rules, says Stonehenge Asset Management co-founder Steve Michael is that there will simply be fewer family offices in the future. He reckons well-established family offices are likely to pursue full compliance, but that newer offices face a tougher choice. “These newcomers will find it hard to meet the costs of keeping their compliance in order. It will be tough because they are not used to this much regulation and the learning curve will be steep. There is a lot of regulation that is not easy to navigate because it is new and the costs of making a mistake will be high.”

Michael offers some limited comfort to those who feel they are being penalised for the perceived and actual sins of hedge funds. “Family offices are the collateral damage of the regulator’s attempt to over-regulate hedge funds. However, the compliance burden for family offices is much lighter than that for hedge funds, for whom compliance is a massive ongoing cost,” he says.

Clarity is still needed on some points. The Private Investor Coalition’s view is that most single family offices will be able to comply with the new rules, especially if one “apparently unintended flaw” can be fixed, says the lobby group’s counsel Martin Lybecker.

“Because the rule references a single common ancestor, at each level of the family’s development the non-lineal spouse’s own family and siblings are excluded from the existing definition of ‘family member’. The same is true of the common ancestor, who is not included nor is his spouse. We are in discussions with SEC staff to alleviate these flaws.”

Another issue, says Miles Padgett, partner at law firm Kozusko Harris etter Wareh, is the implication for joint ventures between unrelated but friendly families. An SEC-governed family office could elect not to receive compensation from non-qualifying clients for investment advisory services “although removing the compensation element may be problematic depending on the circumstances and the identity and other roles held by the decision makers”.

Lybecker adds that a bank or trust company is also excluded from the definition of an “investment adviser”, and that a family might consider the creation of a corporate trustee to serve as trustee for some or all of the family’s trusts. There are various ways to ensure compliance. A family office could attempt to avoid registration by taking non-family members off the books.

For example, says Robert Hille, general counsel and chief compliance officer at Laird Norton Tyee, they could relocate out of the US. But unless a large portion of the family already lives elsewhere, that might not be practical. “Family offices exist to serve families and moving could impact service, which in turn impacts the family office,” he says. “For families accustomed to virtual relationships relocation may be a possibility, but before making a decision, costs and convenience should be compared with the expense of registration.”

And anyway, Hille expects increased international collaboration in regard to investment adviser regulation, just as we see with anti-money laundering regulations. “Since the risks are essentially the same, it makes sense that European and US regulators would share similar concerns. It will be interesting to observe whether Europe’s old and venerable family offices object to or influence future regulations,” he says.

Seonaid MacKenzie, director of compliance consultant Sturgeon Ventures, reckons many US hedge funds will follow the lead of the Soros family and revert to single family office organisations to avoid SEC scrutiny. She say offshore management is an option for those who are determined to avoid registering with the SEC, although she is another who does not expect US family offices to relocate to different jurisdictions in large numbers as a result of the new rules.

Michael also thinks that relocation is not the answer, pointing out that “if you invest in US securities or exchange-traded products but are domiciled outside the US, you are not exempt from the new rules”, and believes the SEC is likely to put pressure on regulators in other jurisdictions to also regulate family offices more closely.

Yogesh Dewan, chief executive of Hassium Asset Management, thinks multi family offices and some alternative investment funds will look to change structure if they have a significant client base in the US. However, he does not expect US family offices to relocate on the basis that “regulation in other jurisdictions is just as rigorous – if not more so – and it would send the wrong message to their existing client base. Any change would also lead to significant operational costs, which ultimately will be borne by the client”.

Finally, some wonder whether the March 2012 deadline will even be met.
There is a great deal of scepticism – and indeed, downright cynicism – among the 340-plus family members of the Institute for Private Investors about this issue, says its founder and CEO Charlotte Beyer. She also worries about the quality of the regulation, saying that despite the large amount of money that was spent educating the SEC during the consultation process, many remain concerned that those drafting the regulation don’t have enough understanding of family offices.

And while the IPI’s member families are happy that changes were made as a result of these representations, they remain concerned that the uncertain political climate could impact on implementation. In late September, Republican presidential hopeful Rick Perry called for a moratorium on regulation, advocating a six-month suspension on all of Dodd-Frank’s pending regulations. Still, it’s best to assume that the deadline will be met, says Padgett.

That means that family offices should immediately start getting ready, creating a current and accurate family tree, identifying all clients and any persons to whom a family office executive or employee might be providing investment advice. “All of this information will be crucial in determining whether a family office qualifies for the exemption and, if currently qualified, for ensuring that it remains qualified,” he says. Hedge funds have a lot to answer for. 

Click here to read what Charles Lowenhaupt, of Lowenhaupt Global Advisors, thinks of the Dodd-Frank Act.

Click here to find out more about what the Dodd-Frank Act means for European family offices.