In the wake of 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. Instead of making investors more confident and companies more efficient, the new laws and regulations may hamper 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 that follows this round of new legislation is what the real consequences of these rules will be once implemented. These fears are exacerbated today by two unique factors. First is the skeletal nature of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which left it up to the SEC and other regulatory agencies to develop how the law will be implemented in many cases. Second, there is the recent series of elections that have shifted 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 the expected and unexpected consequences of government action. So, in that spirit, it may be helpful to take a closer look 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 indicates, the The law addresses important reforms to consumer protection, trade restrictions for large banks and the regulation of financial products, it also contains significant new requirements for corporate governance that can directly affect family businesses.
Consequences, intended or not
As an example of how these decisions can affect family businesses under Dodd-Frank, by clarifying the reporting requirements of family offices, the SEC has drawn a clear line between a single-family office and those serving multiple families. As a result, family offices that have been opened up to other families to share their services and the costs of providing them can be considered investment advisers. If the SEC determines, based on its October 12, 2010 definition, that a family office is in fact providing investment advice to the public, it must register with the SEC under the provisions of the Advisers Act of 1940. In the past, advisers with fewer than 15 clients were exempt from the provisions of this law. However, the new legislation removed the exemption and one 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 family office that appears 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 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 of all of their customers, complicating the process of obtaining lines of credit and other loans for private businesses as well.
One of the most discussed and potentially far-reaching Dodd-Frank provisions deals with proxy access. Shortly after the law was passed, 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. While there are limits on how many candidates shareholders in power can place above those selected by the company’s nominating committee, this change is causing a stir in corporations. An investor or group of investors need only own 3 percent of a company’s voting shares to exercise this provision and place candidates for up to 25 percent of board seats in one representative. 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 be a disruptive force for family businesses that have sold even a small portion of their shares in a public offering.
This will undoubtedly discourage many family-owned businesses from turning to the public markets for funds to grow their businesses, and will effectively cut off an important source of investment capital. Any family business contemplating a public offering in the future should carefully consider the possibility that it could open up its board of directors to dissident groups with agendas set by minority owners outside the family. Proxy access will also provide new ammunition for those who want to challenge the stock classification in a way that allows families to retain control of the vote. 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 in shares sold in 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 rule’s application to larger companies to be studied. Therefore, it is critical that family businesses that fall under this small business definition start planning their strategy to control this new threat during the short time they have to prepare. Potential strategies may include share buyback plans and other ways to reduce exposure before the three years are up.
Clearing and Say-on-Pay
While not a direct threat to control, the payment opinion represents a potential intrusion and disruption of the governance of a publicly traded company, even if the majority stake is held by a family. This part of the regulation requires that at least every six years (may be more often with a shareholder vote) shareholders have a non-binding vote on executive compensation. While a non-binding vote would not directly affect an executive’s actual compensation, it has the potential to give more voice to dissident groups that do not understand or care about the competitive environment in which a company operates. This process will undoubtedly be another reason why family businesses will want to avoid raising capital through public offerings of their 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 the shutting down of an important source of growth capital for family businesses. Families have always had to carefully consider the pros and cons of selling part of their shares on public markets for privacy reasons. There is now a real threat to control, even if a minority of shares go public, and many may choose not to go down this path, even if it means slower growth and missed business opportunities.
Additionally, it is important to remember that even family businesses that do not sell shares on public exchanges will likely 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 SEC’s objectives in developing new regulations to meet Dodd-Frank’s intent are to promote effective communication and accountability among a company’s shareholders, owners, directors, and officers. These are also important goals for any family business owner to pursue. Trust and harmony between families are built and confirmed through transparency between owners and future 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 that family businesses depend on.