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Will regulation be the ultimate ball and chain?

Proposals in the US to regulate private wealth managers could have a profound effect on family offices the world over 

Legislation in the pipeline in the US that will likely be adopted by mid-year has important implications for family offices as both investors and investment managers. The US is not alone in pressing ahead with financial reforms. In Europe, a controversial directive introduced last May would also affect family offices. And jurisdictions farther afield are undoubtedly watching to see how these efforts play out before initiating their own reforms.

"Politically, there is a huge amount of pressure to implement some of these things with all that has been happening through 2008 and 2009, and even before then," says Yogesh ('Yogi') Dewan, chief executive of Hassium Asset Management, a multifamily office in London.

Set the pace

In December, the US House of Representatives passed the Private Fund Investment Advisers Registration Act as part of an omnibus bill called the Wall Street Reform and Consumer Protection Act. The Senate is now considering similar proposals. A key difference between the House and Senate versions is how family offices will be treated. The House clearly intends for family offices to be subject to regulation, based on statements by key members of the chamber, whereas the Senate would leave it to the Securities and Exchange Commission to decide what a family office is and whether it should be exempted from registration.

The two chambers will have to reconcile their separate versions and approve the final one before submitting it to the White House for President Obama's signature.

David Guin, a partner at the law firm Withers Bergman LP in New York, believes that family offices will eventually be regulated, and his firm, which has a large international family office practice, is advising its clients to start preparing now for that eventuality. If required to register with the SEC, family offices with assets of $150 million or more would be treated like any other professional investment advisor. 

They would have to file form ADV – which contains information about the advisor's education, business and disciplinary history, as well as information on the advisor's services, fees and investment strategies – and be subject to periodic SEC examinations. Family offices with less than $150 million in assets would still be required to file annual reports with the SEC.

"Our clients are most concerned about the potential loss of confidentiality," says Guin. "If they're over $150 million and have to file form ADV, that information is publicly available on the SEC's website in an electronically searchable format." Guin says it's uncertain at the moment how much of the information included in the reports by family offices with less than $150 million would be publicly available because a registration system for them is yet to be created.

Even if the Senate version were ultimately to prevail and exclude family offices from regulation, the Senate proposal does not define the term "family office," specifically leaving that to future SEC interpretation. Based on exemptive orders it has issued going back to 1940, the SEC's definition has been limited to a single family office, the lineal descendants of a single individual, says Guin. "So, a multifamily office is automatically out," he says.

Family offices are also concerned about proposals that would require private funds in which they invest and the private advisors who manage their assets to provide information to the SEC and other governmental agencies about their investors and clients, says Guin. Worse, in their view, the proposals would eliminate existing prohibitions on investment advisors revealing the identities of their advisory clients.

If such legislation is passed in the US, experts expect it will have a trickle effect globally. "That's a disaster for Europe, and a disaster for many investors around the world who just do not want that level of transparency in the way they operate," says Dewan.

Besides the potential loss of confidentiality, family offices would incur significant costs in registering with the SEC. "Many offices that are not registered underestimate the impact upon a family office of being registered," says Jack Polsky, chief executive of William Harris Investors, a 50-year-old Chicago-based family office that has been registered with the SEC for more than two decades.

"A lot of people focus on the SEC exam, but the exam itself is the tip of the iceberg," he says. "It is true that many of the policies we have adopted as a Registered Investment Advisor have enhanced our operations, and some of these more rigorous standards simply make for sounder business practices. However, the requirements of the Investment Advisers Act do not always mesh with the unique operational needs and idiosyncrasies of family offices, and certain compliance requirements are costly to implement and their value to the business is difficult to quantify.

"While some of our operational disciplines simply represent good business practices, as an RIA we have had to create a compliance department, and have hired a former law firm partner to serve as our chief compliance officer; that's very expensive. In addition, each of our 15 internally managed funds gets audited annually, and these audits cost anywhere between $15,000 and $30,000 per fund. Of course, these costs exclude all of the costs associated with hiring, training, and supervising a robust staff that is sufficiently qualified to handle the policies and procedures that accompany SEC registration, from trading to custody to advertising.

"Our staff also needs to track investments and account for capital flows across literally hundreds of accounts, implement and adhere strictly to a broad array of investment and operational policies, manage multiple technology platforms, and back-up and ensure the accuracy of all of our data and systems on a daily basis. These costs tend to mount rather quickly."

What about smaller family offices with fewer resources? "They're terrified," says Polsky. "A couple have said to me, 'We fear that if we are required to register, it will make us uneconomic to operate.' I think that very well may be true."

International family offices would also be affected by the new US regime, according to Guin. Both the Senate and House legislative proposals create a new category of advisor called a "foreign private advisor". This is defined as any company that has no place of business in the US and fewer than 15 US clients, does not hold itself out to the public generally in the US as providing investment advisory services and has assets attributable to US clients of less than $25 million. 

The last point is especially problematical because neither the House nor the Senate version attempts to define what "attributable to US clients" means, says Guin. And there is a great deal of concern that the SEC will take this opportunity to reconsider its current definition of "US client" under the Investment Advisors Act. The big concern is that the regulator will adopt either look-through or attribution principles. "Under current rules, an individual is a US client if they are resident in the US," says Guin.

"I think that with respect to individuals, it's likely they'll leave rules as they currently are, so it's going to be a residency-based test," says Guin. "But for trusts and entities, they could either adopt a pure look-through rule and look at the residency of all of the owners of the entity or the officers and directors of the entity. For trusts, they could look through at where the beneficiaries are. If that's the case, there are a lot of international family office structures where the vast majority of family members are outside the US, but they have some US-resident family members that could pull the family office structure within the scope of the SEC regulation."

Europe's alternative plans

In Europe, meanwhile, the EU's Alternative Investment Fund Managers directive is intended to ensure that proper regulation over alternative investment managers, according to John Langan, partner in the London office of Withers. This would inevitably sweep up family offices that offer alternative products.

In its present form, the AIFM would require family offices with €100 million or more of assets under management in alternative products or €500 million if those products are un-leveraged to register with regulatory bodies in their home countries. They would then have to ensure that their alternative products comply with the requirements of the directive, such as leverage, custody and valuation. 

A particular burden would fall on Europe-based managers that have fund structures set up in non-European jurisdictions, such Cayman, BVI and Isle of Man. Those jurisdictions would have to have legislation in line with the standards set by unspecified international organisations or the manager would have to demonstrate that its funds comply with those standards and that cooperation agreements exist between the jurisdiction and the home country.

According to Langan, expediency might prompt many family offices that come under this regime to set up hedge funds in European jurisdictions, mainly Ireland or Luxembourg, or create the more constrained vehicles that would qualify for Ucits III designation.

Being a multifamily office that advises a small number of very large European families, Dewan naturally welcomes the legislative initiatives in the US and Europe. "It's a healthy, positive thing," he says. "I think investors need a form of protection, and politically I think it's going to be forced through sooner rather than later. It's got momentum, and I think a lot of asset management businesses will welcome it because it will separate the men from the mice."

He says Hassium would not change the way it invests for its clients, even in the face of an intrusive SEC. "We will continue to look for really good managers, and we welcome the disclosure issues that are out there. But I can see it causing a lot of problems for investors, particularly in Switzerland, who are using a Swiss platform because they want secrecy and they don't want to be exposed to the US authorities in any form whatsoever." He thinks people will pull money from products that come under the SEC's umbrella and allocate to other products and asset classes that are not affected.

Next steps

So what are the next steps? Guin says Withers is telling family office clients that although it's uncertain exactly what the rules are going to be, they need to start doing a couple of things. First, take inventory of the family office structure: Who are the people, where are they located and what are their relative economic interests in the various entities within the family office? Second, assess what various people's roles are. Whether a professional employee or one of the family members is actually providing the investment advice may become important in the future. "Once they decide what the role of individuals and entities are, they need to document those in written agreements," says Guin. "Absent written agreements, the SEC could decide differently, which could create unintended implications for the structure."

Withers is advising clients to take inventory now so that once the final rules are known, they can decide exactly what they need to do. "There are all types of estate planning, gift tax planning and income tax planning that have already been done that might be adversely affected by changes you want to make in respect to these new regulations," says Guin. "If you wait to start the process until we know what the rules are, you may not have time to complete whatever it is you want to do before the rules become effective."

Consequently, there appear to be three options open to family offices from hereon in: 

  • One, a family office can do nothing and just register with the SEC.
  • Two, a family office can either create a new entity or designate an existing one as the investment advisory entity within the family structure. "We're telling people that at a minimum they should do that," says Guin. "If they decide to create a new entity, they should consider not only legally separating that entity, but physically separating it from the rest of the family office so that when the SEC comes in for their review, they're not looking at all the files relating to the family, they're only looking at the files relevant to the regulated service."
  • Three, a family office can outsource the investment advisory services. Withers identifies two subcategories to its clients, says Guin. "One is to move to a multifamily office group, which we think some of our clients would be more comfortable with because they're like-minded individuals with like concerns; or alternatively go to a professional investment advisor who runs managed accounts for all kinds of people." The benefits of outsourcing are twofold, he says. "You're shifting the administrative burden and expense to someone else; and you're not losing as much confidentiality."

Guin says planning now is especially important for international families because they could find themselves unexpectedly subject to the regulations. For example, a child who comes to the US to study is not considered a US resident while a student, but if they decide to stay and work after finishing, the family structure suddenly has a US resident in its midst. "For international families, one of the things we're telling people is that we need to consider creating dual structures for the US and non-US sides of family so that if part of the family becomes subject to regulation, the entire family isn't."

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