By Michael Murphy
Alexandria Ocasio Cortez (D-NY), who has been at the vanguard of the movement to eradicate preferential treatment for the rich, may soon score a win for that cause. In July 2021, the congresswoman introduced H.R. 4620, the Family Office Regulation Act of 2021. The bill, if enacted, would curb the preferential treatment family offices enjoy under the Investment Advisers Act of 1940. Over the past year, events in the family office industry reveal the possible exploitation of these entities, the potential risks to the financial system, and the need for reform.
What are family offices and why are they on Rep. Ocasio Cortez’s mind? Family offices are a little-known type of investment management entity that manage the assets of wealthy families. Only the owning family members may be clients of family offices and these entities may not hold themselves out as investment advisers to the public. Wealthy families enjoy the family office model because it offers highly customized wealth management. Furthermore, and key to the issue addressed by H.R. 4620, family offices do not need to register as investment advisers with the Securities Exchange Commission.
In March 2021, Archegos Capital Management, a family office managing $20 billion in assets suffered a dramatic collapse causing several banks, primarily Credit Suisse and Nomura, to lose billions of dollars. The failure of Archegos has focused the attention of regulators, legislators and financial industry participants on family offices, which remain largely unregulated.
The Investment Advisers Act of 1940 defines an investment adviser as “any person who, for compensation, engages in the business of advising others . . . as to the value of securities or as to the advisability of investing in, purchasing, or selling securities . . . .” Most investment management firms fall squarely within this definition. As a result, they are subject to the requirements and prohibitions imposed by the Advisers Act, including registration with and periodic examinations by the SEC. Family offices, like other private fund advisers of hedge funds, private equity funds, and venture capital funds, historically were exempt from registering with the SEC because these funds were not generally available to ordinary investors; the Advisers Act focus for protection. Private advisers could avoid registration with the SEC by accepting only accredited investors (high net worth individuals, investment professionals, or institutions), did not market their securities to the public, and constrained the resale of their securities. Although the Dodd-Frank Wall Street Reform and Consumer Protection Act repealed the private adviser exemption, it not only preserved favorable treatment for family offices, but it also directed the SEC to define “family office” and exclude it from the definition of the Advisers Act. The rationale for this carveout, the Family Office Rule, ostensibly was a recognition that “the Advisers Act is not designed to regulate the interactions of family members, and registration would unnecessarily intrude on the privacy of the family involved.” In reality, the Family Office Rule may have been the result of a successful lobbying effort by the family office industry.
The Family Office Rule has been tremendous boon to the family office industry. Family offices avoid the costly legal expenses associated with complying with the Advisers Act. Furthermore, family offices do not compromise their privacy by disclosing information about their investments to government regulators. Hedge fund investors have noticed the advantages family offices offer. Dozens of prominent hedge fund investors converted their funds into family offices. The family office model allows investors to take on more risk by abandoning cautious outside investors and avoiding any reporting requirements that may reveal risky investment strategies to regulators. Hedge fund investors have shown a willingness to return client funds to manage their own personal wealth under the family office model. The influx of former hedge fund investors into the family office space has led to more high-risk investments made by these entities.
No person typifies the recent transformation of the family office industry better than Bill Hwang, the founder of Archegos. Hwang is a former hedge fund manager who amassed a personal fortune. After an insider trading scandal earned him a five-year ban on managing client funds, Hwang founded Archegos which he incepted with $200 million of his own money. From 2013 to 2021, Hwang deployed a highly successful, but equally risky investment strategy. He invested his entire portfolio in a handful of stocks. He used leverage, in the form of total return swaps, to magnify his exposure to those stocks. Total return swaps are derivative contracts in which banks agree to own assets for an investor and make payments to the investor based on the asset’s performance in exchange for fixed payments made by the investor. Investors do not need the funds to pay for the actual assets; they only need money to pay the bank the fixed payments determined by the contract. If the asset’s performance suffers, the investor must further compensate the bank for the negative returns. If the bank fears that the investor is unable to meet its obligations under a total return swap, the bank may sell the underlying asset. In March 2021 the share price of ViacomCBS, a key Archegos investment, dipped sharply. Two of the banks holding total return swap agreements with Hwang knew that this imperiled Archegos’ portfolio and began selling the stocks, driving down the value of the Archegos portfolio. Other banks followed suit, but some acted too slowly. The diminished value of Archegos’ portfolio left Hwang unable to pay the banks what he owed, causing billions of dollars in losses.
When the dust settled, it became clear that Hwang had obfuscated an extremely risky trading strategy not just from his financial system counterparts, but also from virtually all financial regulators. Archegos’ failure was reminiscent of the 2008 financial crisis, where losses at highly leveraged hedge funds contributed to the crisis and the failure of systematically important financial institutions. The 2008 financial crisis spurred reform aimed at improving regulators’ insight into private fund activity. Some now feel that the Archegos saga demonstrates that regulators are not able to assess the systemic risk that family offices impose on the financial system. Legislators like Rep. Ocasio Cortez have stepped forward to address that problem.
H.R. 4620 limits the Family Office Rule to funds with $750 million or less in assets under management that are not subject to final orders for fraud, manipulation or deceit. The bill also excludes family offices that have less than $750 million in highly leveraged assets and those that the SEC determines engage in risky activities. If the bill becomes law, many family offices would be required to file an annual Form ADV, the registration statement that registered investment advisers complete each year.
H.R. 4620 is a well-crafted strategy to subsume family offices into the existing regulatory environment for investment advisers. It aligns the treatment of most family offices with the treatment applied to most investment advisers. By filing Form ADV, the SEC will have information about family offices including the identity of controlling persons, how operations are financed, the disciplinary history employees, and information about the private funds managed. The SEC uses the information on ADVs to develop risk profiles. It will conduct examinations on those family offices whose ADVs suggest misconduct or raise some other red flag. While no piece of legislation will ever completely eradicate wild risk-taking from the investment world, this measure could bring such activity in the family office industry out of the shadows and give regulators a fighting chance of addressing it before its negative effects are suffered throughout the financial system.