On July 22, 2021, New York Congresswoman Alexandria Ocasio-Cortez, a Member of the House Financial Services Committee, introduced HR 4620, the Family Office Regulation Act of 2021. HR 4620 would limit the use of the family office exclusion from the definition of “investment adviser” under the Investment Advisers Act of 1940 (the “Advisers Act”) to certain “covered family offices” -- i.e., family offices with $750 million or less in assets under management (AUM) that are not barred or subject to final orders for conduct constituting fraud, manipulation or deceit. Family offices with more than $750 million in AUM would be exempt from registering as investment advisers with the SEC under a new exemption, but would have to file reports with the SEC as “exempt reporting advisers” (ERAs). The bill would also repeal a grandfathering clause in section 409 of the Dodd-Frank Act that permitted family offices whose clients include persons that are not members of the family to qualify for the family office exclusion. Finally, the bill would authorize the SEC to further define a “covered family office” to exclude family offices that are below the $750 million threshold if they are highly leveraged or engage in high-risk activities.

Even though HR 4620 is likely to pass the House should it reach the floor, we believe that the prospects for eventual Senate passage of HR 4620 are currently very slim. That said, even if HR 4620 never becomes law, the positions taken by the bill’s supporters in the Financial Services Committee could significantly impact the way that the regulators at the SEC and CFTC choose to address regulation of family office issues.

Significant changes to current regulations could materially restrict the availability of the exemption for many family offices, thereby resulting in both a substantial invasion of their privacy and an impairment of their ability to fund startups and promote innovation. Given the importance of the current exemptions to family offices, we believe it is critical for family offices to begin a dialogue now with the regulators on any proposed changes to existing rules and exemptions.

If you’d like to learn more about our Family Office Policy Group and how we support family offices with their regulatory matters, please contact us at familyoffice@dentons.com.

Background

In late March 2021 Archegos Capital Management and its investment bank lenders started liquidating huge stock positions at enormous losses, causing considerable turbulence in the capital markets. The defaults by Archegos resulting from its use of, and economic exposure to, equity total return swaps with brokers—swaps not then and not now subject to regulation by the SEC—caused several large broker-dealers to incur significant losses. Six major banks are reported to have lost more than $10 billion when Archegos defaulted on a margin call in March 2021.

The use of equity total return swaps allowed Archegos to receive economic exposure to the relevant stocks without directly owning them, thus avoiding direct-ownership-based disclosure requirements These losses are now subjecting many single family offices to increased and unwanted legislative and regulatory scrutiny simply because of the manner in which such offices are organized.

It appears that the equity total return swaps used by Archegos were not reported because, under the current rules. total return swaps are exempt from many reporting requirements under the federal securities and commodities laws. regardless of whether Archegos was an exempt family office or a registered investment adviser.

Nonetheless, because Archegos has said that it operated as a single family office, both Democratic legislators and federal regulators at the CFTC and the SEC have raised questions about whether Archegos properly qualified for the family office exclusion and whether the scope of the family office exclusion under the Dodd-Frank Act should be narrowed or repealed altogether. They make this case even though family offices are investment firms that solely manage the wealth of family clients or the manager’s own money.

Some commentators, asserting somewhat hyperbolically that unregulated family offices threaten to sink the US economy, have proposed subjecting most, if not all, family offices to regulation as investment advisers under the Investment Advisers Act of 1940 (Public Law 76-768). Critics of this generation of family offices argue that many successful hedge funds closed their doors to external money and restructured as a family office as a way to avoid federal regulation.

On May 6, 2021, in testimony before the House Financial Services Committee, SEC Chairman Gary Gensler noted that: "At the core of that story was Archegos' use of total return swaps based on underlying stocks, and significant exposure that the prime brokers had to the family office. Under Dodd-Frank, Congress gave the SEC rulemaking authority to extend beneficial ownership reporting requirements to total return swaps and other security-based swaps. Among other things, I've asked staff to consider recommendations for the Commission about whether to include total return swaps and other security-based swaps under new disclosure requirements, and if so how."

Moreover, the SEC has identified "Amendments to the Family Office Rule" as one of its key regulatory priorities for 2021. Nonetheless, the SEC has yet to implement any new disclosure requirements for total return swaps or modified any rules with respect to family offices.

Similarly, on May 1, 2021, CFTC Commissioner Berkowitz stated, "The Archegos failure highlights the importance of strengthening the Commodity Futures Trading Commission's (CFTC) oversight of [family offices].”

The Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) gave the SEC broad rulemaking authority to exempt family offices from the Investment Advisers Act of 1940. Section 202(a)(11)(G) of the Investment Advisers Act excludes from the definition of an investment adviser, and therefore from all of the requirements of that Act, "any family office, as defined by rule, regulation, or order of the Commission."

Under SEC Rule 202(a)(11)(G)-1, adopted in June 2011, a family office is excluded from the investment adviser definition if it:

• manages the wealth and other affairs of a single family;
• provides investment advice only to family clients;
• is wholly-owned by family clients and exclusively controlled by family members and/or certain family entities; and
• does not hold itself out to the public as an investment adviser.

Currently, neither the family office’s total AUM, nor the nature of those assets (such as the amount of leverage utilized or the exposure of any counterparties to its positions), nor the number of family members participating in it are disqualifying factors for the exemption.

The Dodd-Frank Act gives the SEC broad authority to expand or restrict this definition, and the SEC is currently considering whether to do so. While a case can clearly be made for regulating family office transactions that pose systemic risk to the financial system, there is no reason to believe that the transactions that led to Archegos’ losses posed any systemic risk or financial stability concerns whatsoever.

New legislation proposed for family offices

Nonetheless, on July 22, 2021, New York Congresswoman Alexandria Ocasio-Cortez, a Member of the House Financial Services Committee, introduced HR 4620, the Family Office Regulation Act of 2021. The Financial Services Committee held a markup on July 28 and July 29, at which several bills including HR 4620 were considered. Immediately, before being debated on July 28 an amendment in the nature of a substitute to HR 4620 was offered and approved by voice vote to become the base text of the bill.

HR 4620 as amended would limit the use of the family office exclusion from the definition of “investment adviser” to “covered family offices” -- i.e., offices with $750 million or less in AUM and that are not barred or subject to final orders for conduct constituting fraud, manipulation or deceit. Family offices with more than $750 million in AUM would be exempt from registering with the SEC under a new exemption enacted under the Advisers Act but would have to file reports with the SEC as “exempt reporting advisers” (ERA). The bill would also repeal a grandfathering clause in section 409 of the Dodd-Frank Act that permitted family offices that have clients who are not members of the family to qualify for the family office exclusion. Finally, the bill would authorize the SEC to further define a “covered family office” to exclude family offices that are below the $750 million threshold, if they are highly leveraged or engage in high-risk activities. The SEC’s rule further defining the term “covered family office” will likely include provisions to determine when a family office is highly leveraged or engaged in high-risk activities.

HR 4620 was debated for about 30 minutes on July 28 with all Democrats who spoke offering their support and all Committee Republicans who spoke opposing the bill. Reiterating a theme first expressed in the Financial Services Committee’s markup memo in support of HR 4620, the bill’s supporters argued that family office regulation was warranted because the “recent meltdown of the Archegos Capital Management family office demonstrated that family offices can be deeply interconnected with the rest of the financial markets and their activities could affect the stability of financial markets.” The position of the bill’s opponents was summarized in the following July 28 tweet from Financial Services Committee Republicans: “The Committee has taken up H.R. 4620, a partisan bill that would do nothing to protect consumers. Rather, Democrats want to control how American #investors manage their own family investments by requiring registration and disclosure. “

On July 29, at the last item of business in the long-delayed completion of the Financial Services Committee’s markup, by an en bloc, party-line vote of 27-22, HR 4620 was reported favorably by the Committee to the full House of Representatives, along with HR 4618, the Short Sale Transparency and Market Fairness Act, and HR 4619, a bill to amend the Securities Exchange Act of 1934 to prohibit trading ahead by market makers, and for other purposes.

It is possible that the House will return to Washington, DC, for legislative business during August or early September if legislative activity in the Senate makes it necessary or proper to do so. However, barring that turn of events, the chamber, which is now on its summer recess, will not reconvene for legislative business until September 20.

Expected actions on HR 4620

Given the number of pressing items currently on the House’s legislative agenda for when it returns to Washington, DC, and the improbability of HR 4620 being passed by the House under suspension of the rules with a two-thirds vote required, it is not clear whether, or if so when, HR 4620 will be considered by the House. Should the bill reach the House floor, the House is likely to pass it. However, given the level of Republican opposition to the bill and the need for support from at least 10 Republicans in the Senate to end debate on the bill and get to a vote on passage, the prospects for eventual Senate passage of HR 4620 are very slim. That said, even if HR 4620 never becomes law, the positions taken in the Financial Services Committee by the bill’s supporters could significantly impact the way regulators in the SEC and CFTC choose to address regulation of family office issues.

Historically, family offices have largely focused on family wealth preservation and management for wealthy families. But the profile of family offices has changed somewhat in recent years as they have grown in number and size. While few, if any, family offices have adopted trading policies and practices as aggressive as that of Archegos, several firms have adopted “get wealthy” policies that are far more aggressive than the “stay wealthy” policies of most family offices. Yet, standing alone, the existence of some family offices with more aggressive investment strategies surely is not a sufficient reason to subject most family offices to the information disclosure, compliance expense and potential disclosure of proprietary trading strategies that comes with federal regulation.

As SEC Commissioner Hester Peirce and CFTC Commissioner Brian Quintenz put it, in pertinent part, in a June 24, 2021, Bloomberg Opinion piece:

Many policy makers and commentators have used the Archegos event to fault current systemic-risk safeguards and call for increased scrutiny for, or even direct regulation of, family offices. Yet the systemic impact on the financial system of the Archegos-fueled losses was zero. Indeed, even the most directly affected firms easily weathered the event.

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[F]amily offices are organizations set up and overseen by wealthy individuals to manage their own money. Generally only family members or key employees of the family office are allowed to co-invest, which means the fund’s investors are also insiders. Family offices, regardless of their size, generally are not required to register with either the SEC or the CFTC. The investment adviser registration and regulatory regimes focus on investor protection, with a specific emphasis on protecting outside investors through disclosures, fiduciary-duty obligations and reporting requirements. Such protections are unnecessary when the investors are all in the family.

Regardless, investment adviser regulatory regimes are not designed to prevent investors — particularly sophisticated investors — from the consequences of their poor investment decisions. Events like this one are useful reminders of the importance of risk management for Archegos and other market participants. Rather than looking to their regulators to tell them how to avoid such losses in the future sophisticated market participants should take an introspective look at their own risk-management systems, firm cultures and incentive structures.”

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Any large loss to banks from a single investment firm always provokes thoughtful debate around the adequacy of existing prudential and financial market regulations and the efficacy of market participants’ risk-management programs. Given the lack of systemic impact from the Archegos losses, the misalignment of family office structures with the rationale for investment firm regulation, and the swaps oversight regimes currently in place or being brought online by market regulators, absent additional information, the Archegos case does not justify new regulation for family offices.

Key considerations for family offices

Significant changes to current regulations could materially restrict the availability of the exemption for many family offices, thereby resulting in both a substantial invasion of their privacy and an impairment of their ability to fund startups and promote innovation. Given the importance of the current exemptions to family offices, we believe it is critical for family offices to begin a dialogue now with the regulators on any proposed changes to existing rules and exemptions.

Questions about this bill or any other family office matters? Please contact us at familyoffice@dentons.com or reach out directly to any of the key contacts listed on this client alert.