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New SEC Rule Affects Charitable Organizations as Clients of Family Offices

Tax-Exempt Organizations Law Update John P. Vail

Many wealthy families have established family offices that provide various services to family members. Often they have personnel that provide investment advice to family members, companies and other entities owned and controlled by family members and charitable organizations that family members have established or funded. Historically, many family offices have been able to avoid the registration and other requirements of the Investment Advisers Act of 1940 (the "Advisers Act") in one of two ways. Some offices complied with a long-existing exemption from the Advisers Act for advisers that during the course of the preceding 12 months had fewer than 15 clients and who did not hold themselves out to the public as investment advisers. This exemption was commonly referred to as the "private adviser" exemption. Other family offices sought and obtained exemptive orders from the Securities and Exchange Commission ("SEC") declaring the offices as not being within the intent of Section 202(a)(11) of the Advisers Act. The SEC has over the years viewed the typical single-family office as not the sort of arrangement that Congress intended to regulate. It also tried to avoid application of the Advisers Act to family offices because of its potential intrusion on the privacy of family members.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act") repealed the "private adviser" exemption and substituted in its place a new exclusion from the Advisers Act for family offices.[1] However, Congress left the definition of a family office to SEC rulemaking. On June 22, 2011, the SEC adopted a final rule (the "SEC Rule")[2] defining the term "family office" and acknowledging the exclusion of a family office from the definition of an investment adviser under the Advisers Act. The SEC Rule limits the non-profit and charitable organizations that may be advised by a family office that is eligible for the exclusion.

Definition of Family Office

The SEC Rule defines a "family office" as a company (including its directors, partners, members, managers, trustees and employees acting within the scope of their position or employment) that:

  1. Has no clients other than family clients;

  2. Is wholly owned by family clients and is exclusively controlled (directly or indirectly) by one or more family members and/or family entities; and
  3. Does not hold itself out to the public as an investment adviser.

Charitable Organizations as Family Clients

Family offices eligible for the exclusion can, therefore, provide investment advice only to "family clients." The term "family client" is defined in detail in the SEC Rule and includes family members, various family entities and related organizations. With respect to charitable entities, a family office can advise only:

"any non-profit organization, charitable foundation, charitable trust (including charitable lead trusts and charitable remainder trusts whose only current beneficiaries are other family clients and charitable or non-profit organizations), or other charitable organizations, in each case for which all the funding such foundation, trust or organization holds came exclusively from one or more other family clients." [Emphasis added.]

The important requirement is that all funding must have come exclusively from one or more other family clients. The definition of a "family client" in the SEC Rule not only includes individual family members, former family members, key employees and former key employees, but also includes family trusts, corporations and estates.[3] Thus, the permitted funding of a foundation, charitable trust or other charitable organization may come from one or more of these family entities in addition to or in lieu of coming from family members or other individuals.

In its Adopting Release, the SEC acknowledged that some family offices currently advise charitable or non-profit organizations that have accepted funding from non-family clients. For example, a family may have created a charitable organization but then accepted or even solicited contributions from non-family members. The Adopting Release also notes that some commenters on its proposed rule advocated for a broader definition of a family client that would allow a charitable organization funded by family members to receive some funding from non-family members, such as grants from government agencies. However, the SEC was not persuaded and did not broaden the funding provision. Instead, in order to give family offices time to comply with the funding requirement, the SEC adopted a transition period that allows family offices to have until December 31, 2013 to comply with the funding portion of the exclusion.

Transition Period

Charitable organizations that desire to be included in the family office exclusion from the Advisers Act will need to spend any non-family funding that has been received to date so that none of it is "currently held" by the organization prior to the deadline. Until December 31, 2013, a family office generally may rely upon the exclusion if its only reason for non-compliance with the SEC Rule is the funding requirement. However, to rely on the SEC Rule during the transition period, a non-profit or charitable organization advised by the family office must not accept any additional funding from any non-family clients after August 31, 2011, except that during the transition period the non-profit or charitable organization may accept funding provided in fulfillment of any pledge made prior to August 31, 2011.

The SEC advises that only the actual contributions to the non-profit or charitable organization need to be examined for purposes of the funding requirement and not any income, gains or losses relating to those contributions. For purposes of determining whether funding provided by a non-family client to the non-profit or charitable organization is "currently held" by the organization, the non-profit or charitable organization may offset any spending by the organization occurring at any time in the year of that non-family client contribution or any subsequent year against the non-family client contribution. In other words, the organization may treat the non-family client contributions as the first funding spent.

Quarles & Brady LLP Comments

Each family office that provides investment advice to family clients and is not registered as an investment adviser should review the SEC Rule very closely. Its definitions are very detailed and beyond the scope of this update. Upon evaluation, some family offices may find the SEC Rule to be too restrictive and may need to consider restructuring their offices if they desire to remain within the exclusion to Advisers Act registration. A family office may find that certain recipients of the family office's investment services are no longer permitted under the SEC Rule.

Family offices that include non-profit or charitable organizations will need to determine whether each of those organizations currently satisfies the exclusive funding requirement of the SEC Rule. If not, they will need to consider whether the organizations will stop accepting non-family client funding and spend down the external funding prior to December 31, 2013, in order to fall within the SEC Rule's exclusion or if the family office will cease providing investment advice to such charitable organizations. Presumably, any such charitable organization would then enter into an advisory relationship with a third-party investment adviser or rely solely on its board members or trustees to make decisions concerning its investments without outside advice.

Family offices that are currently exempt from registration under the Advisers Act in reliance on the "private adviser" exemption and that do not meet the new family office exclusion are not required to register with the SEC until March 30, 2012. Also, family offices currently operating under exemptive orders may continue to rely on them for an indefinite time period. However, this may be an appropriate time for a family office to review whether its investment advisory activities continue to conform to the facts that were the basis of its SEC exemptive order.

If you have any questions regarding these matters, please contact John Vail at (312) 715-5042 / [email protected] or your Quarles & Brady attorney.

[1] Public Law 111-203, 124 Stat. 1376 (2010) at Section 409.
[2] Rule 202(a)(11)(G)-1.
[3] The definition of a "family client" is a very detailed one that relies for its meaning on a number of other terms that, in turn, have detailed definitions. It is beyond the scope of this client update to define all of the terms used in the definition of "family client."
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