In the wake of the Great Recession-induced anger directed at Wall Street, the federal government has taken both legislative and regulatory action that many fear will miss the mark. Rather than making investors more confident and businesses more efficient, there looms the prospect that new laws and their attendant regulations will hamstring decision making and divert attention from core business activities. While most of the new regulation is aimed at large public companies, there are some implications for family businesses and family offices that are important to note.
As usual, the concern following this round of new legislation is what the actual consequences of these rules will be once implemented. These fears are exacerbated today by two somewhat unique factors. First is the skeletal nature of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which left it to the SEC and other regulatory agencies to flesh out how the law will be implemented in many cases. Second, is the recent set of elections that changed the balance of power in Washington and have effectively raised even more questions about what will ultimately be the law of the land.
Prudent business practice tells us to prepare for both the expected and unexpected consequences of government action. So, in that spirit, it may be helpful to look more closely at some of the implications of the Dodd-Frank Wall Street Reform and Consumer Protection Act that was signed into law on July 21, 2010. While, as its name implies, the law addresses major reforms to consumer protections, trading restrictions for big banks, and the regulation of financial products, it also contains significant new requirements for corporate governance which may directly impact family businesses.
Consequences, Intended or Not
As an example of how these decisions can affect family-owned enterprises under Dodd-Frank, in clarifying the reporting requirements of family offices, the SEC has drawn a clear line between a single-family office and those that serve multiple families. As a result, family offices that were opened to other families to share their services and the costs of providing them may be ruled to be holding themselves out to the public as investment advisors. If the SEC determines-based upon its October 12, 2010 definition-that a family office is in fact offering investment advice to the public, it will be required to register with the SEC under the provisions of the 1940 Advisers Act. In the past, advisers with fewer than 15 clients were exempt from the provisions of this act. However, the new legislation has removed the exemption, and a possible result is that only single-family offices will be able to avoid registration and reporting. Apparently, hedge funds, not family offices, were the intended targets of these changes, but the result has still caused the SEC to develop a definition of a family office that seems more restrictive.
An unintended consequences like this-and the results of attempts to clarify or repair laws and regulations-can often cause the most difficulties, precisely because no one saw the problem in advance. While some of these may have a direct impact on family businesses, as in the case of family offices, others may have a more systemic effect. For example, after the passage of Sarbanes-Oxley, public companies were required to disclose more information and significantly expand their filings with the SEC. Much of this paperwork has become so prevalent that it has influenced what banks and other financial institutions require from all of their clients, complicating the process of securing lines of credit and other borrowing for private companies as well.
One of the most widely discussed and potentially far-reaching provisions of Dodd-Frank deals with proxy access. Soon after passage of the law, the SEC approved new rules that allow shareholders access to a public company’s proxy to add their own candidates, at the company’s expense, for election to the board of directors. Although there are limits on how many candidates can be placed on the proxy by shareholders above those selected by the company’s nominating committee, this change is sending shock waves through corporations. An investor or group of investors need only own 3 percent of a company’s voting stock to exercise this provision and place candidates for up to 25 percent of the board seats on a proxy. This is a relatively low threshold for many pension funds, labor unions and other activist shareholder groups with their own agendas. Such a small percentage can represent a disruptive force for family businesses that have sold even a small portion of their stock in a public offering.
Certainly, this will discourage many family firms from turning to the public markets for funds to grow their businesses and effectively cut off an important source of investment capital. Any family business that contemplates a public offering in the future must carefully consider the possibility that they could open their board up to dissident groups with agendas set by minority owners outside the family. Proxy access will also give new ammunition to those who want to challenge the classification of stock in ways that enable families to retain voting control. The New York Times and Barnes and Noble have been the subject of these sorts of attacks in the recent past.
Even small companies, defined as those with less than $75 million of shares sold on the public markets, will be subject to this new proxy rule. However, the SEC has suspended implementation for small companies for three years to allow time for the application of the rule to larger companies to be studied. It is therefore critical for family businesses that fall within this small company definition to begin planning their strategy for this new threat to control during the short time they have to prepare. Potential strategies may include stock buy-back plans and other ways to reduce exposure before the three years are up.
Compensation and Say-on-Pay
While not a direct threat to control, say-on-pay represents a potential intrusion and disruption to the governance of a publicly traded company, even if controlling interest is held by a family. This part of the regulation requires that at least every six years (can be more often with shareholder vote) shareholders have a non-binding vote on executive compensation. Although a non-binding vote would not directly impact the actual compensation of an executive, it has the potential to give further voice to dissident groups that do not understand or care about the competitive environment in which a firm operates. This process will doubtless be another reason family businesses may wish to avoid raising capital through public offerings of their stock as many have in the past.
Impact on Family Businesses
Given the issues raised above, an unintended consequence of Dodd-Frank and the resulting SEC rules that implement it may be to shut off an important source of growth capital for family-owned businesses. Families have always had to carefully consider the pros and cons of selling some of their stock on the public markets for privacy reasons. Now there is a real threat to control, even if a minority of shares is floated, and many may choose to not go this route, even if it means slower growth and missed business opportunities.
Also, it is important to remember that even family businesses that do not sell any shares on the public exchanges will likely be impacted by the continuing development of new regulations as a result of the Dodd-Frank Act. As with Sarbanes-Oxley, banks and financial institutions will adjust their processes and practices to comply with new regulations for public companies. This will undoubtedly mean that family businesses will need to respond to issues designed for public companies simply because they have become a part of the way financial institutions do business. It is important that these businesses begin to anticipate these changes and work with their bankers, accountants, and attorneys to be ready.
Of course, not all the implications of these changes are bad. The SEC’s goals in developing new regulations to comply with the intent of Dodd-Frank are to promote effective communication and accountability among shareholders, owners, directors and executives of a company. These are also important goals for any business-owning family to pursue. Trust and harmony among family is built and confirmed through transparency among the owners and intended owners of a family business. Much of what Dodd-Frank seeks to impose on public companies regarding compensation practices and shareholder access can be used to preserve the patient capital family businesses rely on.