Being a compliance officer for a family office has never been more challenging. Last year’s implosion of a New York-based hedge fund structured as a family office, has legislators and regulators seeking new ways to protect investors.
The fund was forced to sell $20 billion in securities at a huge loss when it borrowed money from banks and invested in publicly traded companies. Instead of holding the stocks it invested in, the fund used a financial instrument called total return swaps where the banks held the securities to conceal highly leveraged bets the fund made in its portfolio.
A sudden drop in the value of the fund’s investments triggered a domino effect. The banks that held its securities had to liquidate billions of dollars’ worth of stocks when the fund failed to meet a margin call. The end result was $20 billion in losses and regulatory concern for family offices.
The Investment Adviser Exemption
The Dodd-Frank Act granted the SEC broad rule-making authority to exempt family offices from the Investment Advisers Act of 1940. Under SEC Rule 202, a family office is excluded from the investment adviser definition if it: (1) manages the wealth and other affairs of a single family, (2) provides investment advice only to family clients, (3) is wholly owned by family clients and exclusively controlled by family members and/or certain family entities, and (4) does not hold itself out to the public as an investment adviser.
Total assets under management and the number of family members participating are not disqualifying factors for the exemption. It’s too early to know how compliance for family offices will change. The regulatory definition of family office could tighten to eliminate the other possible risks.
Current rules for family offices have three requirements:
- Investment advice about securities can only be provided to family clients.
- The office must be wholly owned and exclusively controlled by family members and their entities.
- The office cannot present itself to the public as an investment adviser.
Family offices with less than $750 million in assets under management may still be required to register with the SEC if they “determine the family office is highly leveraged or engaged in high-risk activity that the commission determines warrants inclusions, as appropriate in the public interest or for the protection of investors.”
Risk Management
A recent study by Boston Private identified a shift in mindset for family offices and the need to reexamine today’s evolving risks. The firm cited three underlying issues that inhibit proper risk management:
- Underestimating and overlooking threats
- Frustration and perplexity concerning effective protective measures
- Having a reactionary mindset
In these changing times, a proactive step a family office can take is to work with outside counsel to create and maintain an effective compliance program. They can add value by reviewing your current policies and procedures instead of an employee whose familiar daily routine could miss a vulnerable area of risk.
Outside counsel can help financial advisors successfully manage risk by making a comprehensive assessment and then developing and implementing programs to mitigate those risks. Risk factors to monitor include the likelihood or impact of a negative event and your firm’s preparedness to respond to one.
Counsel can suggest many strategies to mitigate risk by reviewing policies, procedures, and processes and educating employees on appropriate safeguards. High-risk areas of focus include cybersecurity and reliance on third-party service providers.
Outside counsel can help draft and design policies and procedures that address critical questions you can expect regulatory bodies to ask. Executives and employees should be trained on how to handle day-to-day situations with compliance top of mind.
Advisory contracts can be the focal point of any regulatory examination because it’s at the forefront of what you’re doing for clients and what they can expect from your firm in terms of fees. The disclosure your firm uses must accurately reflect your business model.
It’s easy for family offices to overlook or underestimate new and complicated threats. Excessive risk can lead to greater scrutiny and more regulation.
Given the complexities of this rapidly changing regulatory environment, family offices should make it a priority to consult with outside counsel specializing in risk management. They can develop policies and procedures to protect assets.
For more information or to discuss your company’s strategy, contact our legal team here or at 619.298.2880.
