Effects of Current US Regulatory Environment on Family BusinessReal Estate
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 companies more efficient, there is the prospect that new laws and accompanying regulations will paralyze decision-making and divert attention from core business activities. While most of the new regulation is directed at large public companies, there are some implications for family businesses and family offices that are important to consider.
As usual, the concern that follows this round of new legislation is what the real consequences of these rules will be once they are implemented. These fears are exacerbated today by two somewhat unique factors. First is the skeletal nature of the Dodd-Frank Wall Street Consumer Protection and Reform Act, which left the SEC and other regulatory agencies with the task of developing how the law will be implemented in many cases. Second, there is the recent series of elections that shifted the balance of power in Washington and, indeed, have raised even more questions about what will ultimately be the law of the land.
Prudent business practice tells us to prepare for the expected and unexpected consequences of government action. Therefore, in that spirit, it may be useful to take a closer look at some of the implications of the Dodd-Frank Wall Street Consumer Protection and Reform Act that was enacted into law on July 21, 2010. While, as its name indicates it, the law addresses important reforms to consumer protection, trade restrictions for large banks and regulation of financial products; it also contains important new requirements for corporate governance that may directly affect family businesses.
Consequences, foreseen or not
As an example of how these decisions can affect family businesses under the Dodd-Frank Act, by clarifying the reporting requirements of family offices, the SEC has drawn a clear line between a single-family family office and those that provide services to various families. As a result, family offices that have opened up to other families to share their services and the costs of providing them can be ruled out from presenting themselves to the public as investment advisers. If the SEC determines, based on its October 12, 2010 definition, that a family office is in fact offering investment advice to the public, it must register with the SEC under the provisions of the Advisors Act of 1940. In the past , advisers with less than 15 clients were exempt from the provisions of this law. However, new legislation has removed the exemption and one possible outcome 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 prompted the SEC to develop a definition of a family office that seems more restrictive.
Unintended consequences like this, and the results of attempts to clarify or fix laws and regulations, can often cause the most difficulties, precisely because no one saw the problem beforehand. 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 approval 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 of all their customers, complicating the process of obtaining lines of credit and other loans for private companies as well.
One of the most widely discussed and potentially far-reaching provisions of Dodd-Frank concerns proxy access. Shortly after the law’s passage, the SEC approved new rules that allow shareholders to access the power of a public company to add their own candidates, at the company’s expense, for election to the board of directors. Although there are limits on the number of candidates that shareholders can place in power over those selected by the company’s nominating committee, this change is causing shock waves in corporations. An investor or group of investors need only own 3 percent of the voting shares of a company to exercise this provision and place candidates for up to 25 percent of the board seats in a proxy. This is a relatively low threshold for many pension funds, 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 shares in a public offering.
Certainly this will deter many family businesses from turning to public markets for funds to grow their businesses and effectively cut off a significant source of investment capital. Any family business contemplating a public offering in the future should carefully consider the possibility that they may open their directory to dissident groups with agendas set by non-family minority owners. Proxy access will also give new ammunition to those who want to challenge stock rankings in ways that allow families to retain control of voting. The New York Times and Barnes and Noble have been the target of such attacks in the recent past.
Even small companies, defined as those with less than $ 75 million of shares sold in public markets, will be subject to this new proxy rule. However, the SEC has suspended implementation for small businesses for three years to allow time to study the rule’s application to larger businesses. Therefore, it is critical for family businesses that fall within this definition of a small business to begin planning their strategy to control this new threat during the little time they have to prepare. Potential strategies may include share buyback 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, the word about payment represents a potential intrusion and government disruption of a publicly traded company, even if the majority stake is in the hands of a family. This part of the regulation requires that at least every six years (may be more often with shareholders’ vote) shareholders have a non-binding vote on executive compensation. Although a non-binding vote would not directly affect an executive’s actual compensation, it has the potential to give more voice to dissident groups who do not understand or care about the competitive environment in which a company operates. This process will undoubtedly be another reason why family businesses want to avoid raising capital through public offerings of shares, as many have done 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 shutting down a significant source of growth capital for family businesses. Families have always had to carefully consider the pros and cons of selling some of their shares on public markets for privacy reasons. Now there is a real threat to control, even if a minority of stocks are listed, and many may choose not to go this route, even if it means slower growth and lost business opportunities.
Additionally, it is important to remember that even family businesses that do not sell shares on public exchanges are likely to be affected by the continued 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 the new regulations for public companies. This will undoubtedly mean that family businesses will have to respond to problems designed for public companies simply because they have become part of the way financial institutions do business. It is important that these companies begin to anticipate these changes and work with their bankers, accountants, and attorneys to be prepared.
Of course, not all the implications of these changes are bad. The objectives of the SEC in developing new regulations to meet the intent of Dodd-Frank are to promote effective communication and accountability among the shareholders, owners, directors, and officers of a company. These are also important goals for any business-owning family to pursue. Trust and harmony between the family is built and confirmed through transparency between the owners and future owners of a family business. Much of what Dodd-Frank seeks to impose on public companies with respect to compensation practices and shareholder access can be used to preserve the patient capital that family businesses depend on.