In his successful attack against the SEC’s now infamous 2005 attempt to regulate hedge funds, hedge fund manager Phil Goldstein argues that each hedge fund should count as only one “client” of a hedge fund adviser for regulatory purposes. Even though a hedge fund might have dozens, even hundreds of clients, the courts eventually agreed with Goldstein that the Advisers Act essentially says that a hedge fund adviser’s fiduciary responsibility is to the fund itself, not to it’s unit holders (see related post here and the actual court decision here).
If this distinction were not made, the hedge fund adviser would face inevitable conflicts of interest – as detailed in the court’s decision:
“If the investors are owed a fiduciary duty and the entity is also owed a fiduciary duty, then the adviser will inevitably face conflicts of interest. Consider an investment adviser to a hedge fund that is about to go bankrupt. His advice to the fund will likely include any and all measures to remain solvent. His advice to an investor in the fund, however, would likely be to sell…While the shareholders may benefit from the professionals’ counsel indirectly, their individual interests easily can be drawn into conflict with the interests of the entity. It simply cannot be the case that investment advisers are the servants of two masters in this way”
Since the SEC’s hedge fund regulation rule was vacated, both regulators and legislators have been trying to come up with a Plan B. Apparently, all the regulators could come up with was a rule that simply reiterated the responsibilities of hedge fund advisors not to break the law. But legislators finally put the finishing touches on their Plan B and embedded it in the Dodd-Frank Act (signed into law last July).
Among a gajillion other consumer protection rules contained in it, the Act also repeals the so-called “15-client exemption” contained in the Advisers Act. Now, regardless of whether they allege to have one client or hundreds, hedge fund advisers will need to register with the SEC.
But a recent SEC Request for Comment shows that the repeal of the 15-client exemption might be about to throw out a baby with the bathwater. That baby is the – a fixture of the Hedgistanian elite for decades. According to the SEC:
“…another potential consequence, which Congress recognized, was that many family offices that have relied on that exemption would be required to register under the Advisers Act or seek an exemptive order before that section of the Dodd-Frank Act becomes effective.”
In other words, if you run a family office or are a hedge fund with family office investors, read on…
Knowing the impact on Dodd-Frank on these secretive pools of capital (you think hedge funds are secretive?), Congress created an “out” and basically charged the SEC with the nearly impossible task of defining “Family Office”.
We’ve heard a lot of financial advisers over the years describe themselves as family offices – “multi-“ family offices – mainly because the term is oozes with cache. But most, if not all, are better described as high net worth financial advisers than true family offices. Even advisory firms run by one or two families for a small handful of their friends aren’t really “family offices” – at least not using the SECs proposed definitions.
The heart of the matter revolves around two questions: 1) who are the clients of the family office and 2) who owns the family office?
You have until November 18, 2010 to get back to the SEC with your thoughts. Maybe this will help get you started…
The SEC is proposing that the clients of family offices must fall into one of the following categories:
- “family members”
- “certain employees”
- “charities established and funded exclusively by family members or former family members”
- “entities wholly owned and controlled exclusively by, and operated for the sole benefit of, family clients”, and,
- “under certain circumstances, former family members and former employees”
Of course, trying to define these would be like trying to untangle the sordid details of a day-time soap opera. Does Jimmy, that gold-digger former husband of the spoiled heiress get to remain invested in the family office? How about that young financial analyst we let go after we found he was stealing petty cash – but who still has those compromising photos from the family holiday party last year? And what about the step children from the patriarch’s hitherto unknown extra-marital affair in Australia?
These are all questions the SEC wants you to answer. (e.g. “Should include stepchildren? Are there any additional conditions we should impose if step children are included?” …Possible response: “Yes. Stop them from calling me in the middle of the night drunk with some story about how I never loved them as much.”)
The Commission also wants to know about the sticky issue of “spousal equivalents.” Although the Request for Comment does not address it directly, one might guess that this request is being made in part due to the the adoption of same-sex marriage in some states.
Then there’s the question of guardians. What if a grandchild now lives in Vevey with her Swiss Nanny while here cantankerous ne’er-do-well parents dual in divorce court. Should the Nanny be allowed to invest?
In general, the SEC wonders:
“Are we drawing the line too broadly or too narrowly regarding when the clientele of a family office starts to resemble that of a typical commercial investment adviser and not a single family?”
And even more importantly, when it comes to multi-family offices:
“Should we permit multifamily offices to operate under this exclusion from the Advisers Act? If so, how would we distinguish between a multifamily commercial office and an office more closely resembling those operating under our exemptive orders (except providing advice to multiple families)?”
But the bottom line, says the SEC, is that it doesn’t want to see the same fiasco regarding definitions that it saw with hedge funds:
“We note that as a family office extends its provision of investment advice beyond family members, it increasingly resembles a more typical commercial investment advisory business, and not a family managing its own wealth.”
The SEC proposes that any company with a family office exclusion from the Advisers Act must be “wholly owned and controlled dict rely or indirectly, by family members.”
But it’s not immediately clear from the SEC’s Request for Comment whether these “family members” must be, how shall we say, in good standing, or if they can be former or partial family members (see Jimmy, the Swiss Nanny and the Australian stepchildren above).
If the family office was owned by “non-family members” worries the SEC, it’s clients would then need certain “protections.” But as per the discussion of appropriate “clients” above, it’s very possible that while only a few “family members” would own the office, its clients include of wide range of hangers-on that could really benefit from SEC “protections.”
The SEC also wonders if it’s okay for a family office to “hold itself out” to as an investment adviser:
“Are there circumstances where a family office holding itself out to the general public as an investment adviser should nevertheless be excluded from the protections afforded to the investing public under the Advisers Act?”
In our opinion, one circumstance might be when they “hold themselves out” by, say, writing a guest article for AllAboutAlpha.com or speaking at a CAIA event. This may seem benign as long as the family office does not take on any outside clients – and it is. But remember that the SEC also prevented hedge funds from “marketing” even if they didn’t actually take on any ineligible clients (another move that stuck in Goldstein’s craw btw).
In the end, family offices could all just apply for exemptions. The SEC has handed out a number of them in the past to family offices. But allowing all family offices to avoid registration en masse would save a lot of time and money for everyone involved ($200,000 a pop according to the SEC’s calculation. Those who don’t meet the strict definition of a family office would have two choices: register or delicately break the news to non-family, non-employee outsiders that they should start looking for another money manager.
Addendum: If you’re doing research on family offices, here’s a great report for you.