Since the March 2021 collapse of Archegos Capital, a New-York-based wealth management firm, family offices have been under renewed scrutiny by the SEC and legislative bodies.
Archegos, a family office that invests primarily in the US, Chinese, and Japanese stock markets, was forced into a fire sale of securities worth about $20 billion after some of its portfolio stocks experienced a significant fall.
Archegos borrowed money from banks and invested it in the stock of prominent publicly traded companies—such as ViacomCBS and Discovery Communications—often using an instrument called “total return swaps” that concealed Archegos’s positions. When the investments lost money, the banks called in the loans, and Archegos had to sell large blocks of stock at a loss quickly.
When the proceeds of these sales couldn’t cover the losses, some banks sold their positions, causing the stocks’ prices to fall even further. Although nothing Archegos did was illegal, the firm’s collapse sent reverberations throughout the financial industry.
What does the Archegos fiasco mean for family offices? Will it lead to tighter regulations? This article will offer a breakdown of the circumstances around potential new regulation as well as how family offices can prepare with risk management.
Evolving Family Office Regulation Efforts
The goal of a family office is to grow and transfer a family’s wealth across generations.
The first family office dates back to the DuPont family in 1934. Today, the heirs to the DuPont chemical company, one of America’s oldest corporations, number around 4,000.
Over the past decades since 1934, as entrepreneurship and significant liquidity events have occurred, there has been a considerable increase in the number of family offices and an evolution of the structures and assets under management.
Financial industry experts estimate that the current number of family offices in the US is anywhere between 3,000 and 5,000. According to Family Office Exchange, the actual number is closer to 6,000 because family offices do not have to be licensed or registered.
Over the years, there have been continuous efforts to define and regulate single-family offices. A major step in regulation happened on June 22nd, 2011 when the SEC adopted rule 202(a)(11)(G)-1 that defines “family offices” and provides that if the family office manages a single family, they would be excluded from the regulation under the Investment Advisers Act of 1940. Before 2011, family offices did not need to register.
Current rules for family offices include:
- The office must provide investment advice about securities only to family clients.
- The office must be wholly owned and exclusively controlled by family members and family entities.
- The office must not hold itself out to the public as an investment adviser.
The 2011 rule defined permissible clients as family members, key employees, and other family clients—such as non-profit or charitable organizations funded by family clients. Estates of family members, key current and former employees, family client trusts, and any company wholly owned by and operated for the benefit of family clients are also allowed under the rule.
Recently, the US House of Representatives Committee on Financial Services passed H.R. 4620, a bill to amend the Investment Act of 1940 to impose additional regulatory oversight of family offices. If Congress passes the bill, “covered” family offices with more than $750 million in assets under management will be required to register with the SEC.
Additionally, family offices with less than $750 million 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.”
Whether or not the Senate passes this bill, it is clear that political pressure is mounting for greater disclosure by family offices. One interesting statistic from a study by Fintrx published by Charles Schwab is that only 31.6% of family offices have external board seats. Perhaps we will see family offices follow the trend for independence that public and private companies have faced over the past few decades.
Managing Risks as a Family Office
Unfortunately, we can only speculate about what new regulations will affect family offices. Some legal experts maintain that narrowing the definition of what is and is not a family office is the answer. For example, under stricter parameters, Archegos would not have properly qualified for the family office exemption.
In the meantime, family offices need to find ways to reduce their exposure to risk. Family offices face new and complicated risks that didn’t even exist 10 to 15 years ago. And, whenever a family office experiences a significant event arising out of a risk, it will face more scrutiny from the SEC. As we have seen, more scrutiny often leads to more regulation.
Given the broad definition of “family” and the services of a family office, the crafting of risk management programs can become complicated. A recent study by Boston Private identifies a shift in mindset for family offices and the need to examine today’s evolving risks.
History has shown that with new regulation comes uncertainty. In the case of attempts to further regulate family office’s more questions than answers arise:
- What is high-risk behavior?
- Is investment in volatile cryptocurrencies high risk?
- Does a catastrophic cyber event elevate to high-risk behavior?
- Does a lack of independent board structure potentially create new exposures?
- How will the SEC track family offices under $750 million for the purposes of “high-risk activity?”
Cyber risks and associated liability exposures are now recognized by family offices as a top exposure because of the enormous amount of sensitive data. Research published in the Boston Private study indicates that 26% of family offices have experienced a cyber attack. Depending on the size of a family office, 38% to 51% of them expect to experience a catastrophic cyber event.
This looming threat increases the need for assessment of risk management techniques and insurance portfolios such as directors and officers to have liability, errors and omissions, and cyber and crime policies for family offices. The danger of a cyber attack also impacts how insurance must be structured and the already limited number of insurers willing to insure family offices.
Additionally, as the definition of family office broadens to encompass more entities and a greater variety of clients, understanding the complex nature of the risk is crucial.
Insurance brokers utilize many different policies to tailor coverages to meet the needs of family office clients.
The challenge is in the details. Each policy and underwriting standard comes with stock policies that need to be individually negotiated. For example, a policy’s terms and exclusions may make sense for the industry for which they were created, but they might have a significant impact on a family office if not appropriately revised.
As family offices connect with numerous vendors to track investments and related performance, many of them are focusing on cryptocurrency. According to a recent report on family offices published by Bloomberg, a Goldman Sachs survey shows that 15% of today’s family offices have invested in cryptocurrency assets, and 45% of family offices who participated in the survey are planning to invest in cryptocurrencies.
Given the complexities of this rapidly changing regulatory environment, family offices should make it a priority to consult with risk management specialists to develop strategies to protect their assets.
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