Effects of the current US regulatory environment on family businesses
In the wake of Great Recession-induced anger directed at Wall Street, the federal government has taken both legislative and regulatory actions that many fear will miss the mark. Instead of making investors more confident and companies more efficient, there is a chance that new laws and related regulations will hamper decision-making and divert attention from core business activities. While most of the new regulation is targeted at large public companies, there are some implications for family businesses and family offices that are important to keep in mind.
As usual, the concern that follows this round of new legislation is what the actual 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 useful 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 The law addresses important consumer protection reforms, 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 that serve multiple 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 considered 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 will be required to register with the SEC under the provisions of the Advisers Act of 1940. In the In the past, advisors 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. Hedge funds, not family offices, were apparently the intended targets of these changes, but the result has still caused the SEC to develop a definition of 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 ahead of time. While some of these may have a direct impact on family businesses, such as 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 their customers, complicating the process of obtaining lines of credit and other loans for private businesses as well.
proxy access
One of the most discussed and potentially far-reaching Dodd-Frank provisions deals with proxy access. Shortly after the bill 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 incumbent shareholders 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 represent 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 businesses from turning to the public markets for funds to grow their businesses and will effectively cut off a major 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 to splinter 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 ranking in a way that allows families to retain voting control. The New York Times and Barnes and Noble have been the targets of such attacks in the recent past.
Even small companies, defined as those with less than $75 million in shares sold on the public markets, will be subject to this new proxy rule. However, the SEC has suspended the implementation for small companies for three years to allow time to study the application of the rule to larger companies. Therefore, it is critical that family businesses that fall under this definition of a small business start planning their strategy to control this new threat in 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 payout view represents potential government intrusion and disruption 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 (maybe more often with 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 who do not understand or care about the competitive environment in which a company operates. This process will no doubt 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, one unintended consequence of Dodd-Frank and the resulting SEC rules implementing it may be the closure of a significant 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 the 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 lost business opportunities.
Additionally, it is important to remember that even family-owned 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 no doubt 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 lawyers to be prepared.
Of course, not all the implications of these changes are bad. The SEC’s objectives in developing new regulations to meet the intent of Dodd-Frank are to promote effective communication and responsibility 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 the owners and future owners of a family business. Much of what Dodd-Frank seeks to impose on public companies with regard to compensation practices and shareholder access can be used to preserve the patient capital on which family businesses depend.