Background

As indicated in a prior update, on June 22, 2011, the SEC adopted a rule (Rule) defining the term "family office" for purposes of identifying entities eligible for exclusion from registration as an investment adviser under the Investment Advisers Act of 1940 (Advisers Act).  In connection therewith, the staff of the Division of Investment Management (Staff) recently provided responses to select questions regarding the definition of a "family office" under the Rule.  Highlighted below are (i) summaries of the Staff's responses to a few of the more pertinent questions, and (ii) a reminder with respect to a few provisions of the Rule which may cause the unsuspecting family office to inadvertently fall outside of the registration exclusion. 

Composition of Board of Directors of a Family Office

One of the requirements that must be met in order to fit within the definition of a family office under the Rule is that the family office must be exclusively controlled by one or more "family members" (as defined by the Rule). 

Question 1:

A question was posed as to whether a family office which has a board of directors consisting of seven directors, four of which are family members and three of which are non-family members, satisfies the exclusively controlled requirement.  The Staff's response was that such a structure would satisfy the requirement so long as there were no special shareholder agreements or other arrangements giving a non-family member control over the management and policies of the family office. 

Question 2:

A question was posed as to whether a family office in which all of the members of the board of directors were non-family members, but was appointed by family members that have the right to appoint, terminate or replace the directors, satisfies the exclusively controlled requirement.  The Staff's response was that such a structure would not satisfy the requirement. 

Family Members

Another requirement that must be met in order to fit within the definition of a family office under the Rule is that the provision of investment advisory services by the family office must be limited to "family clients" (as defined by the Rule).  A subset of the term family client is "family member," which is defined to include all lineal descendants (including adopted children, stepchildren, foster children and, in some cases, legal wards) of a common ancestor (who is no more than 10 generations removed) and such lineal descendants spouses or spousal equivalents.

Question 1:

A question was posed as to whether in-laws related through spouses qualify as family members for purposes of the Rule.  The Staff's response was that such in-laws do not count as family members for purposes of the Rule.

Question 2:

A question was posed seeking examples of relationships that would qualify as spousal equivalents under the Rule.  The Staff responded that examples would include (i) an individual that is part of a same-sex couple that qualifies as a domestic partnership under state law, and (ii) same-sex domestic partners as well as opposite sex partners that have determined not to marry even though they live together in a relationship generally equivalent to married couples.

Traps for the Unwary

We also want to call particular attention to a couple of provisions of the Rule which may cause unsuspecting family offices who would otherwise seemingly qualify for the exclusion under the Rule, to not actually qualify.  As mentioned above, under the Rule, the provision of investment advisory services by a family office must be limited to family clients.  Qualifying as a family client could be particularly problematic with respect to the entity types listed below.

Nonprofit or Charitable Organizations

Nonprofit or charitable organizations of a family office can qualify as a family client under the Rule, but only to the extent that they are funded exclusively by family clients.  This exclusive funding requirement can be a problem for family offices, as any funding the nonprofit or charitable organization may receive from the general public (such as part of a fundraising event) or from family members who do not constitute family clients under the Rule (such as siblings and in-laws), will cause the family office in question to not meet the exclusion.  The SEC recognizes that a number of existing family offices have accepted funding from non-family clients with respect to their nonprofit and charitable organizations, and in response has provided a transition period until December 31, 2013 before family offices have to comply with this aspect of the exclusion.  Family offices who find themselves in this situation should begin the process of looking at strategies for addressing this issue in order to avoid having to register under the Advisers Act once the transition period ends.

Affiliated Companies

Affiliated companies that are wholly owned exclusively by, and operated for the sole benefit of, family clients qualify as family clients under the Rule.  This requirement may cause unsuspecting problems for a family office in situations where they form a special purpose entity to acquire and hold a particular asset with a sibling or an in-law who, while a family member in the common use of the term, does not qualify as a family member under the Rule (and hence does not qualify as a family client).  Another common example of where this requirement may cause problems for a family office is in a so-called "club" deal where a family office forms an entity in which a small group of friends and/or family pool their money to make a particular investment.  In addition, a family office which is embedded as an unincorporated division within an operating company raises issues under the Rule for the operating company.  All of the above situations could result in the family office (or the operating company) not being eligible for the exclusion from registration under the Advisers Act.  However, unlike the situation with nonprofit or charitable organizations, no transition period is provided by the SEC.  As a result, family offices who find themselves in these unwary traps only have until March 30, 2012 to meet the conditions of the exclusion.  Family offices who find themselves in these situations may have to restructure some of their existing entities to bring themselves within the exclusion under the Rule.  Hence, if they have not already, family offices should review their existing organization chart to make sure they are not unknowingly caught in one of these situations.

Additional Information

This update is intended only as a summary of the highlights of the Staff's responses and of the SEC’s adoption of the Rule.  Please note that the responses provided by the Staff do not constitute a rule, regulation or statement of the SEC and the SEC has neither approved nor disapproved the responses.  You can find the full text of the Staff's responses here, and the full text of the SEC's final rule here.  You can also find discussions of other recent cases, laws, regulations and rule proposals of interest to public companies on our website.

© 2012 Perkins Coie LLP