EDITOR'S NOTE: I spoke to a friend recently who works in the prime brokerage services of an investment bank everyone heard of. My friend told me about many large hedge funds, which are currently converting to family offices to evade regulations imposed by Dodd-Frank. The funds are most concerned about form PF, which requires hedge funds to disclose assets on a quarterly basis. It would be illegal to disclose any names of the funds, but expect to see some news on this front shortly.
Hedge Funds, Family Offices and Dodd-Frank
Much of the blame for the recent economic woes in the United States and around the world has been placed on Hedge Fund investors. Hedge Funds provide serious investors the ability to invest large amounts of capital in a very wide range of investment instruments, thus protecting themselves from market volatility and at the same time providing an opportunity to realize positive financial return. The beginning of today’s Hedge Fund markets began in 1949 with A.W. Jones & Company, growing today to over 12,000 Hedge Funds in financial markets all around the world. The primary issue that traditionally separated Hedge Funds from mutual funds is the level of governmental regulatory control. If might be fair to say that Hedge Fund investing is a reflection of the American desire to make a living and prosper with the least possible level of government interference.
Part of the vilification of hedge funds is based upon the efforts by politicians to find economic institutions to blame for the economic difficulties the country is facing. Blaming wealthy investors for our economic difficulties resonates with many people in society. People who have lost their homes and their jobs are looking for answers to why all of their troubles have come upon them. The outcome of the effort to reign in hedge fund investing is the Dodd-Frank Wall Street Reform and Consumer Protection Act that created The Consumer Financial Protection Bureau. This fearsome sounding agency has far reaching regulatory authority over bank credit card operations, mortgage operations and financial market operations.
For Hedge Fund managers, the most important feature of this legislation is the new registration requirements. According to an article written for the National Law Review by Ethan W. Johnson, Monica Lea Parry and, Trina C. Winkelmann, the Securities and Exchange Commission Chairman set a deadline for meeting the registration requirements.
The newly adopted rules require, for the first time, certain investment advisers to register with the SEC or a state securities regulator, allow other advisers to remain unregistered, and cause yet other advisers "close to the line" to consider whether to restructure their operations to qualify for an exemption from registration. Certain advisers eligible for an exemption from registration because they advise qualifying venture capital funds or less than $150 million in qualifying private fund assets (as further described below) will nonetheless have to keep records and file annual reports with the SEC-a requirement that two Commissioners voted against. Other advisers with between $25 million and $100 million in assets under management will have to switch from SEC to state regulation. The SEC also adopted a rule regarding the treatment of family offices. Finally, SEC Chairman Mary Schapiro announced that the deadline for investment adviser registration for advisers previously relying on former Section 203(b)(3) of the Investment Advisers Act of 1940 (Advisers Act)-the 14-client exception-would be March 30, 2012, meaning that these advisers would need to file Form ADV no later than February 15, 2012.
This far reaching Act creates a number of special exemptions for investment advisors operating in what are called Family Offices. According to the National Law Review article, the SEC clarified the definition of a family office.
The SEC also adopted a rule exempting a "family office" from registration under the Advisers Act, implementing Section 409 of the Dodd-Frank Act. A "family office" is an entity providing investment advisory services that also meets each of the following criteria:
- Its only clients are "family clients" (family members and certain alter-ego entities formed for tax, charitable, or estate planning purposes).
- It is wholly owned by family clients and controlled by family members.
- It does not hold itself out to the public as an investment adviser.
The obvious question for Hedge Fund investors desiring to use a family office for their investments is how far does the definition of a family member reach? In an official policy statement released June 22, 2011, the SEC provided guidance for the definition of a family member.
Family members include all lineal descendants (including by adoption, stepchildren, foster children, and, in some cases, by legal guardianship) of a common ancestor (who is no more than 10 generations removed from the youngest generation of family members), and such lineal descendants’ spouses or spousal equivalents.
The most intriguing part of the definition is the “10 generation” rule. Depending on which authority you quote, the definition of a generation may be up to 70 years. This means that savvy investors who are related in any way to a family office Hedge Fund manager should be able to find a way to legally circumvent the new registrations rules under the Dodd-Frank Act. The reporting exemptions allowed under the family office provisions have invigorated the family office investment industry. According to information provided by the New York Times, the investment company Soros Fund Management operated by George Soros is being converted to a family office. This conversion will require Soros Fund Management to return all investment capital to investors who cannot meet the definition of a family member of this company.
Because of the exemptions provided by the family office provisions, there is a movement among major Hedge Fund investors to find “family” connections in the investment industry that allows them to place their money in investment offices that are exempted from the reporting requirements of the Dodd-Frank Act. Investors who have family office connections should be able to place their capital in investment opportunities that will bring them the greatest possible return, control their exposure to the volatility of the global financial markets and limit their exposure to regulatory requirements.
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