Interpretive Letter to Elliott R. Curzon, Dechert LLP

A “family office,” as defined in the Advisers Act, may be considered an “investment adviser” for purposes of meeting the limited exception of FINRA Rule 5131.02.


May 9, 2017

Elliott R. Curzon
Partner
Dechert LLP
1900 K Street, N.W. 
Washington, D.C. 20006

Re: Request for Interpretive Guidance Under FINRA Rule 5131 (New Issue Allocations and Distributions)

Dear Mr. Curzon: 

In your letter dated May 4, 2017, on behalf of Private Investor Coalition (“PIC”),1 you request interpretive guidance regarding the term “investment adviser” as used in FINRA Rule 5131.02(b) (Written Representations – Indirect Beneficial Owners). Specifically, you ask whether, for purposes of Rule 5131.02(b), a “family office,” as defined under the Advisers Act, is considered an “investment adviser.” For the reasons discussed below, FINRA staff interprets the term “investment adviser” to include a family office solely for purposes of the limited exception set forth in Rule 5131.02(b).

Analysis

Rule 5131 addresses abuses in the allocation and distribution of “new issues.” Paragraph (b) of the rule prohibits the practice of “spinning,” which occurs when an underwriter allocates new issue shares to executive officers and directors of a company as an inducement to award the underwriter with investment banking business, or as consideration for investment banking business previously awarded. The spinning provision generally provides that no member or person associated with a member may allocate shares of a new issue to any account in which an executive officer or director of a public company2 or a covered non-public company,3 or a person materially supported4 by such executive officer or director, has a beneficial interest5: (1) if the company is currently an investment banking services client of the member or the member has received compensation from the company for investment banking services in the past 12 months; (2) if the person responsible for making the allocation decision knows or has reason to know that the member intends to provide, or expects to be retained by the company for, investment banking services within the next three months; or (3) on the express or implied condition that such executive officer or director, on behalf of the company, will retain the member for the performance of future investment banking services.

To address concerns regarding the difficulty involved in obtaining, tracking and aggregating information from accounts regarding indirect beneficial owners, such as participants in a fund of funds, for use in determining an account’s eligibility to receive a new issue allocation, Rule 5131.02(b) provides a limited exception to the spinning provision. Specifically, Rule 5131.02(b) permits firms to rely upon a written representation obtained within the prior 12 months from a person authorized to represent an account that does not look through to the beneficial owners of any unaffiliated private fund invested in the account, except for beneficial owners that are control persons of the investment adviser to the private fund, if the unaffiliated private fund meets the following conditions: (1) is managed by an investment adviser; (2) has assets greater than $50 million; (3) owns less than 25 percent of the account and is not a fund in which a single investor has a beneficial interest of 25 percent or more; and (4) was not formed for the specific purpose of investing in the account.

The conditions of Rule 5131.02(b) were designed to ensure that the important protections of the rule are preserved, while offering meaningful relief for members and investors in situations where spinning abuse is not likely.

As you note, Rule 5131 does not define “investment adviser” for purposes of the rule or the limited exception set forth in Rule 5131.02(b). In addition, though family offices may manage private funds, they are excluded from the definition of “investment adviser” in the Advisers Act.6 As a result, if the term “investment adviser” in Rule 5131.02(b) is interpreted to exclude family offices, then the limited exception would be unavailable with respect to a private fund managed by a family office, even when the exception’s remaining conditions are met.

We do not believe that excluding family offices from the term “investment adviser” in the context of the limited exception of Rule 5131.02(b) serves the purposes of the rule.

To satisfy the exception under Rule 5131.02(b), firms must obtain a written representation from an account regarding the conditions of the exception. To be able to provide such a representation to firms, the account must obtain control person information for the investment adviser to the private fund so that it can establish the fund’s “unaffiliated” status. A private fund is “unaffiliated” with an account only if the private fund’s investment adviser does not have a control person in common with the investment adviser to the account.7 The condition that the private fund be managed by an investment adviser that is unaffiliated with the account’s investment adviser seeks to ensure the structural independence of the respective advisers and, along with the condition that the fund was not formed for the specific purpose of investing in the account, guards against collusive conduct aimed at furthering spinning by a firm.

In addition, the exception under Rule 5131.02(b) does not cover control persons of the investment adviser to the private fund who are also beneficial owners of the fund. Therefore, the account must identify whether any control persons of the investment adviser to the private fund are also beneficial owners of the fund and, if so, it must identify whether such person is an executive officer or director of a “public company” or a “covered non-public company” as defined under Rule 5131, or a person materially supported by such executive officer or director. If such person is an executive officer or director of a public company or a covered non-public company, or a person materially supported by such executive officer or director, the account also must identify the company on whose behalf the executive officer or director serves. Moreover, this information must be included in the account’s written representation to firms.

Family offices are excluded from regulation under the Advisers Act for policy reasons that are unrelated to the concerns addressed by the rule.8 Further, despite their exclusion from the definition of “investment advisers” under the Advisers Act, family offices may perform equivalent functions to regulated investment advisers, including investing the assets of a pooled investment vehicle or providing other forms of investment advice. Accordingly, we believe that, notwithstanding the fact that family offices are not “investment advisers” for purposes of the Advisers Act, family offices may be considered “investment advisers” solely for purposes of Rule 5131.02(b).

Finally, we note that, in order for firms to rely on the exception under Rule 5131.02(b), the remaining conditions of the rule must also be satisfied, including that the fund invested in the account and managed by the family office: (1) is an “unaffiliated private fund” as defined in the rule;9 (2) has assets greater than $50 million; (3) owns less than 25 percent of the account and is not a fund in which a single investor has a beneficial interest of 25 percent or more; and (4) was not formed for the specific purpose of investing in the account.

We trust that this letter is responsive to your request. Please note that the opinions expressed herein are staff opinions only and have not been reviewed or endorsed by the FINRA Board of Governors. This letter responds only to the issues raised based on the facts as you have described them, and does not address any other rule or interpretation of FINRA, or all the possible regulatory or legal issues involved. In addition, you should be aware that any changes in the facts as you have described them will require further consideration and may cause us to reach a different conclusion.

If you have any questions on this matter, please do not hesitate to contact me at (202) 728-8018.

Sincerely,

 

Meredith Cordisco

cc:    Afshin Atabaki, FINRA


1 Your letter represents that PIC is an association of family offices, as defined in Rule 202(a)(11)(G)-1 of the Investment Advisers Act of 1940 (“Advisers Act”), and a non-profit corporation that operates as an exempt organization pursuant to Section 501(c)(6) of the Internal Revenue Code of 1986.
  
2 A “public company” is any company that is registered under Section 12 of the Securities Exchange Act of 1934 or files periodic reports pursuant to Section 15(d) thereof. See Rule 5131(e)(1).
     
3 The term “covered non-public company” means any non-public company satisfying the following criteria: (i) income of at least $1 million in the last fiscal year or in two of the last three fiscal years and shareholders’ equity of at least $15 million; (ii) shareholders’ equity of at least $30 million and two-year operating history; or (iii) total assets and total revenue of at least $75 million in the latest fiscal year or in two of the last three fiscal years. See Rule 5131(e)(3).
  
4 The term “material support” means directly or indirectly providing more than 25 percent of a person’s income in the prior calendar year. Persons living in the same household are deemed to be providing each other with material support. See Rule 5131(e)(6).
  
5 The term “beneficial interest” has the same meaning as in FINRA Rule 5130(i)(1) and means any economic interest, such as the right to share in gains or losses. See Rule 5131(e)(2).

See Advisers Act Rule 202(a)(11)(G)-1(a) (excluding family office from the definition of “investment adviser” for purposes of the Advisers Act). A “family office” is defined as “a company (including its directors, partners, members, managers, trustees, and employees acting within the scope of their position or employment) that: (1) has no clients other than family clients; provided that if a person that is not a family client becomes a client of the family office as a result of the death of a family member or key employee or other involuntary transfer from a family member or key employee, that person shall be deemed to be a family client for purposes of this section for one year following the completion of the transfer of legal title to the assets resulting from the involuntary event; (2) is wholly owned by family clients and is exclusively controlled (directly or indirectly) by one or more family members and/or family entities; and (3) does not hold itself out to the public as an investment adviser.” See Advisers Act Rule 202(a)(11)(G)-1(b).
     
7 A control person of an investment adviser is a person with direct or indirect “control” over the investment adviser, as that term is defined in Form ADV. See Rule 5131.02(b). In general, control persons of a private fund’s investment adviser are readily identifiable. For instance, with respect to a private fund identified on Schedule D of Form ADV of the fund’s investment adviser, control persons of the adviser are also identified in Form ADV.
  
8 Family offices have generally not been viewed as arrangements that the Advisers Act was designed to regulate because, for example, disputes among family members relating to the operation of the family office could be resolved within the family unit or through state courts. See Investment Advisers Act Release No. 3220, Family Offices, 76 FR 37983, 37984 (June 29, 2011).
  
9 To establish the fund’s “unaffiliated” status, the account that is making the representation to firms must have information identifying the control persons of the family office equivalent to the disclosure that is required of registered investment advisers on Form ADV. Family offices are not required to file Form ADV and, as a result, control person information may not be readily available to the account, unless furnished to the account by the family office.