The family office industry has grown by leaps and bounds since the turn of the decade. A 2019 study by FOX estimated that there were 3000-4000 family offices in the United States alone, excluding the ones that have been established but not yet licensed, that manage over $179 billion worth of assets. However, despite being such a massive financial services industry, it wasn’t until 2011 that specific efforts around family office regulations were made to enforce compliance into their operations.
The 2011 Family Office Rule
According to the 1940 Advisers Act, the Securities and Exchange Commission defines an investment adviser as “a person or a firm that, for compensation, is engaged in the business of providing advice to others or issuing reports or analyses regarding securities.” Family offices fell within the broad definition of investment advisers which requires them to be registered with the SEC for all their operations. In October 2010, a new rule was proposed to exclude family offices from the regulations proposed within the Advisers Act. This new rule, 202(a)(11)(G), was termed the “The Family Office Rule” and was officially adopted by the SEC on July 21, 2011.
In order to qualify for the Family Office Rule, a firm must satisfy three general conditions:
- The Clients – A family office must not have any clients other than “family clients” which include all lineal descendants from a common ancestor, their related trusts, estates, or companies, and any employees or ex-employees of the family office.
- Ownership and Control – The firm must be entirely owned by its family clients and be exclusively controlled by one or more family members or entities. However, key employees of the family office are allowed in the management of the firm as long as their positions are limited to a minority of the governing board.
- Representation to the Public – A family office cannot represent itself, or hold out as an investment advisor to non-family clients or entities. This is especially important since, according to 220(a), family offices do not have to abide by the many restrictions enforced on public investment advisers.
The Archegos Collapse and Regulatory Consequences
In March 2021, Archegos Capital Management, a family office with over $20 billion in AuM, collapsed causing several banks like Credit Suisse and Nomura to lose billions of dollars. This event served as an eye-opener for regulators, legislators, and US government representatives to the unregulated nature of the family office industry and the dangers of neglecting risk analysis. But what exactly went so wrong?
As mentioned above, since the new SEC rules of 2011, family offices are not subject to the same levels of prohibitions and restrictions as public investment advisers. This prompted several hedge funds to convert to a family office structure and employ high-risk investments free from regulatory quagmires. Bill Hwang, the founder of Archegos, too was an ex-hedge fund manager who shifted industries after an insider trading scandal. Between 2013 till 2021, he employed an extremely risky investment strategy by buying a handful of stocks and leveraging his exposure to them through total return swaps(TRS). It worked well for Hwang until the share prices of ViacomCBS, one of Archegos’ major investments, dipped sharply and he had to initiate a fire sale to cover his losses. Two of the firm’s prime brokers, Goldman Sachs and Morgan Stanley, realised the dangers of Hwang’s actions and offloaded their TRS shares from Archegos’ portfolio, plummeting its value. The firm failed to repay its debts to Credit Suisse and Nomura who suffered massive losses from the defaulting event.
The Archegos collapse was a chilling reminder of the 2008 financial crisis where leveraged hedge funds and risk analysis failures contributed to massive losses on systemically important financial institutions like the Lehman Brothers.
The fallout from the Archegos saga resulted in the tabling of the H.R 4260 bill by Congress which proposes to impose regulatory oversight on family offices, especially ones with over $750 million in AuM. If the bill is passed, all these family offices would have to register with the SEC as investment advisers and follow all the necessary regulatory and reporting rules. The SEC can then use the information reported by the family offices in the annual Form ADV to develop risk profiles based on their investment practices. This would bring some long-awaited oversight to the family office industry and give regulators the opportunity to identify high-risk practices that pose a threat to the financial system as a whole.