Best Practices for Family Offices & Private Foundations
By now we’ve all heard the story about Archegos Capital. In effect, Archegos operated similarly to a traditional hedge fund—making highly leveraged risky investments with other people’s money—at the reigns of a former hedge fund manager ousted by the SEC for insider trading. Under the SEC’s family office exemption, a fund that only manages the personal wealth of one or a few families is exempt from registering with the SEC and reporting its holdings. Archegos operated under this exemption.
But when the stock prices of the companies in its highly leveraged portfolio dropped steeply, Archegos couldn’t meet its lenders’ margin call requirements. Archegos’ lenders quickly sold their positions to cut their losses, causing share prices in those portfolio companies to fall even further. The debacle ultimately resulted in a $20 billion dollar loss to Archegos, its lenders, and shock waves throughout the markets. The Securities and Exchange Commission (SEC) is now investigating the matter, which has drawn attention to the regulations that affect Family Offices and other types of Private Foundations.
Impact of Archegos’s Collapse
No doubt that regulators will soon be scrutinizing the lack of transparency that can occur when family offices or other less regulated investment organizations engage in investment activities. The Commissioner of the Commodity Futures Trading Commission (CFTC) said “the collapse of Archegos Capital Management and the billions of dollars in losses to investors and other market participants is a vivid demonstration of the havoc that errant large investment vehicles called ‘family offices’ can wreak on our financial markets.”
In the meantime, family offices and private foundations should understand the rules governing their investment practices. The following outlines common scenarios where family offices and foundations are susceptible to regulation and best practices to avoid regulatory missteps.
Best Practices for Family Offices
A family office is an investment organization that manages a family’s or multiple families’ wealth. Unlike traditional hedge funds, family offices can generally avoid state and federal securities regulations. These exemptions allow owners to have a substantial amount of control of their investments and avoid large amounts of reporting. However, a family office must be careful to not to violate its exemption status. Once a family office loses its exemption, state and federal agencies have much more regulatory oversight. The following are common areas where family offices are susceptible to losing their exempt status:
Third-Party Investments. Family offices need to be careful when investing with third parties. CFTC regulations may be triggered when family offices invest or enter into a joint venture with hedge funds, private equity funds, or real estate funds. Family offices should structure the partnerships strategically so that they can retain security exemptions.
Size. The size of family offices can affect exemptions because securities regulations exempt certain investment vehicles from regulations based on the number of members or the number of assets it manages. For example, the Securities Exchange Act exemption caps the number of assets under control and the Investment Company Act exemption caps the number of family members within the office.
Marketing. Family offices must be careful how they market themselves. They are not permitted to hold themselves out to the public as investment advisers. This is particularly important when co-investing with third parties where the content of the marketing materials could be perceived as holding themselves out to be investment advisers.
Best Practices for Private Foundations
Private foundations are generally established to continue a family’s charitable legacy. They are created, funded, and operated by a donor or the donor’s family members. Unlike family offices, which are solely focused on growing wealth, private foundations may engage in similar investment strategies as a family office, but with a focus on increasing their wealth for philanthropic purposes. Family offices with philanthropic ambitions may choose to set up a foundation that is bankrolled by assets generated by the family office.
Private foundations typically make donations via monetary grants to charitable organizations. Unlike public charities, private foundations have a greater degree of control and flexibility over their activities. However, there are basic principles that every private foundation must abide by when investing its assets.
Two main laws govern a foundation manager’s investment conduct: State Prudent Investor Laws and the Federal Internal Revenue Code (IRC). Below are the key rules and restrictions that apply to private foundations.
State Prudent Investor Laws
Applicable state law requirements will depend on whether the foundation is structured as a trust or corporation. Investment standards for trusts are typically found in the applicable state’s version of the Uniform Prudent Investor Act (UPIA) whereas not-for-profit corporations are found in the state’s version of the Uniform Prudent Management of Institutional Funds Act (UPMIFA). Generally, foundation managers have a fiduciary duty to invest foundation assets prudently. This potentially could include diversifying the foundation’s assets, but not necessarily.
IRS Regulations on Private Foundation Investments
Jeopardizing Investments: A private foundation can be penalized if the foundation’s assets are invested in a way that creates an unreasonable amount of risk or that isn’t prudent to the foundation when evaluated as a whole. Currently, the Internal Revenue Code does not define what it considers “jeopardizing investment.” However, practices such as trading on margin, trading in commodity futures, investments in oil and gas, purchase of put calls and straddles, and purchase of warrants have been scrutinized in the past. Foundation managers should make decisions at the time of investment that don’t jeopardize the foundation’s exempt purpose as a whole. If a foundation is found to engage in “jeopardizing” behavior, it will be subject to a tax equal to 10% of the amounts invested for each year. Foundation managers can also be penalized personally in certain circumstances.
Self-Dealing: Private foundations must not engage in “self-dealing” transactions. This means a direct or indirect transaction that is between the foundation and an insider of the organization, or his/her family members. These are referred to as “disqualified persons.” While exceptions do exist, the scenarios in which this is an acceptable practice can be convoluted. Having an attorney who specializes in this area of law can help private foundations avoid penalties. Private organizations that engage in self-dealing are charged 10% of the amount involved in the self-dealing.
Excess Business Holdings: Private foundations are not permitted to hold more than a 20% interest in a business enterprise. If a foundation owns more than 20% interest, it is required to sell the excess. Excess business holdings are subject to a 10% tax.
5% Payout Requirement: Private foundations are required to pay out 5% of the average value of the foundation’s investment assets from the prior year in charitable grants. As such, payout requirements can affect investment decisions and could significantly impact the value of a foundation’s assets over time.
Special Income Taxes: Although private foundations do not have to pay regular federal income tax, they are subject to an excise tax on net investment income and an unrelated business income tax (UBIT). Foundations must pay an annual 2% excise tax of net investment income. The UBIT is placed on income that is generated from a regularly carried-on trade or business not related to the foundation’s charitable purposes.
Annual IRS Tax Return: All private foundations are required to file taxes with the IRS each year via Form 990-PF. This includes a detailed report of investments, expenditures, and the foundation’s current board members.
Private Foundations Going Forward…
The regulations that pertain to family offices and private foundations are inherently nuanced. As events like the collapse of the Archegos fund occur, more attention will be drawn to how these investment vehicles are regulated. Managers of these organizations should be very familiar with the regulations they are subject to and seek counsel to ensure their compliance with them.
Ellis Carter is a nonprofit lawyer with Caritas Law Group, P.C. licensed to practice in Washington and Arizona. Ellis advises nonprofit and socially responsible businesses on corporate, tax, and fundraising regulations nationwide. Ellis also advises donors with regard to major gifts. To schedule a consultation with Ellis, call 602-456-0071 or email us through our contact form.