Scarcely Regulated Family Investment Funds: Lessons from the Archegos Capital Wipe-Out

[By Sanchit Singh

The author is a student at Vivekananda School of Law and Legal Studies, GGSIPU, Delhi. 

The Dodd-Frank Wall Street Reforms and Consumer Protection Act, which came in response to the 2008 financial crisis, removed a historic exemption enabling the Securities and Exchange Commission (SEC) to regulate hedge funds and private fund, advisors. However, this included a new provision that required the SEC to define family offices in order to exclude them under Section 202(a)(11)(G) of the Investment Advisers Act, 1940. Among other aspects, family offices were not required to disclose their size or leverage as a result of this exemption. The family office, Archegos Capital Management’s extreme leverage led to a reported $10 Billion loss to some of the biggest banks globally in March 2021. This has attracted a great deal of discourse regarding the lack of transparency of family offices, especially the ability of these invisible whales to hurt the U.S. economy.

The March 2021 Meltdown

The losses resulted from the family office’s inability to meet margin calls relating to total return swap agreements and such positions that were financed by prime brokers. The U.S. Federal Reserve had raised attention to such practices in its May 2020 Financial Stability Report, noting that the concentration for hedge fund leverage had “increased markedly”where the top 25 hedge funds accounted for 50 per cent of industry borrowing. The reason for this concentration the report mentions “dealers have reportedly given preferential terms to their most-favoured hedge fund clients” and that “hedge funds with disproportionately high leverage can have outsized effects”. Despite this, the price decline in Archegos’ concentrated positions led to margin calls which prompted the sale of positions which further led to the decline of affected stocks, finally leading to the losses for the banks to bear.

Japan’s largest investment bank, Nomura and Credit Suisse have been hit the hardest with them collectively facing losses close to $6 Billion alone. Other banks like JP Morgan, Goldman Sachs and Deutsche Bank were prompt to avert significant financial impact by de-risking their exposure to Archegos Capital.

Were Disclosure Standards the Real Problem?

As previously discussed, family offices are exempted from any registration with the SEC due to its exclusion under the Investment Advisors Act. Consequently, hedge funds like Archegos Capital do not need to file quarterly financial reports on their performance or the size of equity holdings including the types of assets. This hampers the ability for prime brokers of banks to evaluate risk and oversight by market regulators including the Federal Reserve and SEC. Despite this, many believe that adequate disclosure standards were not the main problem resulting to collapse.

There has indeed been an evolution in the relationship between family offices and these banks. Deutsche Bank v. Sebastian Holdings Inc. (2013) was consequential for banks to realise that family offices were not significant institutional players, where the Deutsche was sued for $8 Billion in 2008 over margin calls arising from trades with the prime brokerage division. The court dismissed the entire claim and ordered the payment of $240 Million in dues. Thereafter, family offices were treated more like private clients which meant less leverage and higher trading costs. The preferential relationship with Archegos depicts a major change in attitude ever since. Clearly, banks with prime brokerages had loosened up restrictions in search of lucrative clients by providing high leverage, especially considering the staggering increase in the number of family offices where assets under management stood at $5.9 Trillion as of 2019, significantly larger than all U.S. private equity firms put together.

In an independent review conducted by a law firm at the behest of Credit Suisse, there was enough evidence to suggest that the bank slept on multiple warning signals that could have prevented their burden of losses. Archegos Capital had begun frequently breaching its PE limit and by April 2020 it was ten times more than its $200 million limits. This evidently indicates highly volatile and under-margined swap positions of significant risk to the Bank. There does not seem to be any sign of fraudulent activities or corruption but rather rises questions on the Bank’s competence to identify and appreciate the scale and urgency of Archegos’ risk. While typically most family offices are risk-averse and their main objective is to preserve wealth but a different breed of such offices have come out that demonstrate speculative aggression much similar to some of the most competitive hedge funds. It becomes difficult to truly categorise Archegos Capital as a family office or a hedge fund outrightly, considering the scale of leveraging. The industry has come to refer to them as “invisible whales” equipped with great capabilities to move and influence the markets.

With Credit Suisse’s specific example, one can imagine the systemic problem in the manner in which these large banks conduct business and manage risk.

Potential Legislative Correction and the Exclusive Grandfather Clause

HR 4620, the Family Office Regulation Act of 2021 was introduced in the House Financial Services Committee on 22 July 2021. The Bill has sought to reflect on the Archegos Capital meltdown and address the exemptive and exclusive clauses. As amended, HR 4620 would limit family office exclusion from “investment adviser” to a more comprehensively defined “covered family office” which includes family offices with less than $750 Million in assets under management. Offices with more than $750 Million under management would be exempted from registration with the SEC under the new legislation but will be required to submit reports in accordance with the Commission as exempted reporting advisors (ERA). Further, Section 409 of the Dodd-Frank Wall Street Reform and Consumer Protection Act that allowed clients who were not members of the family to be eligible for the family office exclusion would be repealed. Lastly, the Bill would authorize the Commission to exclude a family office from the “covered family office” definition when the family office is highly leveraged and/or engages in high-risk activities in the interest to protect investors.

While the legislative expectation for HR 4620 is not certain considering the Republican Party opposition to the Bill and the slim chances for it to pass before the Senate due to Republican Party disinterest, much contrarian to the situation when the Bill is presented before the House. Despite this, Denton observes “That said, even if HR 4620 never becomes law, the positions taken in the Financial Services Committee by the bill’s supporters could significantly impact the way regulators in the SEC and CFTC choose to address the regulation of family office issues.”

Interestingly, on the Executive side of things, the U.S. Department of Justice’s Anti-Trust Division has launched a probe into the Archegos Capital fall. A similar investigation is being conducted by the U.K. Prudential Regulation Authority, considering the Credit Suisse leverage-based from London. It is not particularly clear whether Archegos Capital or its dealing banks will be accused of regulatory violations and breaking the law. The authorities investigating the collapse seem to be piecing the puzzle that impacted banks and investors by collecting information on lending to Archegos along with coordinative efforts in solving the puzzle with counterpart regulators in Japan and Switzerland.

Conclusion

The May 2021 Financial Stability Report acknowledges that Archegos Capital’s collapse had an impact on markets but with limited spillovers. The Federal Reserves does, however, mention the impact that material distress of the NBFCs might have on the broader financial system. The incident has been seen to be a more isolated case that did not have destabilising damage to these banks, but which very much could have. The collapse calls attention to inadequate regulatory vigilance and poor risk management by the banks.

Family offices pose a significant systemic risk considering their size and concentration of investments. For example, Bezos Expeditions has close to $200 Billion under management – ten times bigger than Archegos Capital’s leverage. Further, family offices have made their entry into cryptocurrency with half of all hedge funds dealing in them being family offices.  The times beg for greater scrutiny and transparency in the relationship with and manner in which family offices manage assets. The manner in which legislators and regulators intend to address the exemptions is yet to have more clarity but attention and dialogue on the catastrophic risk that family offices can pose to the U.S. economy have become more evident than ever.

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