Today's family offices handle an increasingly large volume of wealth. Too often, the management structures and procedures for overseeing a family's assets fail to keep pace with the growth and complexity of their portfolio. This is especially true in the area of risk management, where even families with wealth of institutional dimensions sometimes limit their definition of risk to the loss or impairment of key assets due to market fluctuation. These families and the offices that manage their affairs might be well advised to adopt a more comprehensive view of risk, one that looks beyond traditional investment diversification and property insurance coverage.
In today's world, wealth management must include a sophisticated approach to risk management. Of course, private wealth is subject to a unique dynamic because protection of the family members themselves is at least as important as protection of their assets. It is important, therefore, to focus on some of the risks that can be of particular concern to members of high-net-worth families with active businesses or family offices.
Perhaps the most significant area where risk is overlooked is in the context of how a family enterprise relates to family members and other insiders who act in an official capacity within family organizations. There are very good reasons for family members to assume positions of trust and responsibility within the family's operations. Whether it is as a trustee of a family trust, as a director of a family company, or as an officer of a family foundation, there often is no substitute for placing a trusted family member on the "front lines" of a family venture. Serving in these capacities can benefit family members while also helping the younger generation mature into more seasoned, knowledgeable and mature stewards of the family wealth.
However, with that responsibility comes risk, and it is in the best interests of the family--in particular the family member who will be assuming the selected role--to understand these risks. More importantly, it is vital to take reasonable steps to limit these risks to an acceptable degree. The particular risks faced will vary depending on a number of factors, including the type of position. From a legal perspective, the greatest exposure is probably that of a family member acting as trustee of a trust. As a fiduciary, a trustee is held to a particularly high standard of behavior under the law (which often cannot be waived) and must perform a number of specific duties to the trust beneficiaries. For example, a trustee has a duty of loyalty and a duty to avoid conflicts of interest. Thus, a trustee generally may not use trust property in any manner that appears to put the trustee's personal interests ahead of those of the trust beneficiaries. In fact, a trustee generally may not use trust property in any manner that benefits the officers of family charities.
Because the IRS or a state attorney general can be a formidable opponent--with the ability to damage reputations--roles associated with charities should be assumed only with the utmost care, professional advice and proper limitations on liability.
As with private corporations, the best practice will include good counsel and the maintenance of robust insurance coverage for family and non-family directors and officers alike, as well as a periodic review of coverage levels and potential exposure to ensure that coverage remains adequate.
Families should also be aware of the fact that risk exposure is not necessarily additive. In other words, risk exposure for a particular family member can increase exponentially when more than one role is filled. The saga of the Hunt family of Dallas illustrates this point well: One of the accusations made against the trustee of many of the family's trusts was that he had a conflict of interest because of his role as chairman of the board of a company owned by the family trusts. Thus, a family should be careful to avoid, wherever possible, assigning an individual to a position that is the "check" or "balance" of another position.
A classic example might be an individual acting as trustee of a trust that owns a family company while acting as an officer or director of the same company. These problems can be exacerbated when the same individual is a beneficiary of the trust. A family or family member considering such a dual role would be well advised to discuss the matter with their own advisors or counsel to decide whether one role or the other should be reconsidered.
Family Information
The foregoing discussion highlights only a few of the risks associated with a family's operations, and some of these risks are not particularly unique to family offices. Record keeping, for example, is critical to an efficient and well-organized family office. As with any other organization, centralized information goes hand-in-hand with an increased risk for breach of confidentiality. Indeed, the centralized information that family offices work so hard to develop can be the Achilles' heel for families who wish to keep their details, assets, operations and aspirations confidential.
A variety of threats to the confidentiality of family information exist. Probably the most common is simple carelessness--leaving physical documentation in unlocked cabinets or failing to encrypt electronic files containing sensitive information. These types of risks can be minimized only through good staff training and the maintenance of good operating procedures. Adequate training of staff can only go so far in helping to reduce more sinister threats, such as those posed by a disgruntled, unreliable or ambitious employee who uses their iPod to steal secrets.
To address these kinds of risks, families need to explore the data protection tools employed by private industry, such as active prevention technologies and preventive controls like encryption and rights management.
Families should also make use ofstate-of-the-art background checks and evaluations when hiring new employees--including household staff. These services are widely available in the commercial marketplace and in the long run, can prove to be well worth the investment. Employing every precaution--from secure, hack-proof servers to firewalls to electronic access control--families can ensure that sensitive or proprietary family information is as secure as possible.
A family member acting as a director or officer of a family company is also exposed to a certain degree of risk. Generally speaking, however, the law accords a greater degree of protection to a company director than to a trustee. Thus, officers, directors, managers and other agents of a corporation generally are immune from liability to the corporation for losses incurred in corporate transactions that are within their authority and power to make when sufficient evidence demonstrates that the transactions were made in good faith and with reasonable skill and prudence. It would be a mistake, however, to view the business judgment rule as a nearly blanket protection from liability. In certain cases, a corporation's agents--especially its directors--can be held to an affirmative duty to protect the shareholders by obtaining and reviewing information necessary to help the directors make sound business decisions. If directors fail to adequately inform themselves of the issues involved in a major business decision, they can be held liable to the shareholders for their bad business judgment.
As with so many areas of risk management, the key to limiting potential liability to the company's shareholders--typically other family members--is to prepare copious documentation of the reasons for particular decisions. For a good object lesson, see the case of Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985), where the Supreme Court of Delaware held that the directors of a corporation failed to exercise informed business judgment and instead, acted in a grossly negligent manner by agreeing to sell the company for only $55 a share. In that case, the court focused on evidence indicating that the directors reached their decision to sell at that price after hearing only a 20-minute oral presentation concerning the sale. The court also noted that the directors had received no documentation indicating that the sale price was adequate and had not requested a study to help them determine whether the price was fair.
Close family ties might lead some families to believe that director or officer liability is less pronounced in the case of a closely-held family business. Families should keep in mind, however, that directors and officers can also be exposed to claims from counterparties in a reorganization, purchasers of the company's goods and services, and even the company's employees. It is best practice, therefore--no matter what the circumstances--for a family business to maintain robust errors and omissions insurance coverage for family and non-family directors and officers alike, and to periodically review coverage levels and potential exposure to ensure that coverage remains adequate.
The risks associated with a position of corporate responsibility are even greater when the entity serves a charitable purpose. Because a charity does not have private beneficiaries or shareholders, the attorney general or a similar state officer generally will monitor and enforce the rights and entitlements of the intended beneficiaries. In addition, most state attorneys general require charities to make periodic regulatory or informational filings with the state, and they can hold directors and officers of the charities responsible for any failure to make such filings in a timely and accurate manner.
Finally, because most family charities will qualify as private foundations for federal tax purposes, they must meet extensive IRS compliance reporting requirements. These regulatory requirements can create exposure to excise taxes, civil penalties and even criminal sanctions for family members acting as directors or officers of family charities.
Families and family offices should make every effort to ensure that their risk management practices are on a par with those of businesses of similar size, while keeping in mind that potential liability is a factor which should be considered any time a family member considers assuming an official role within the family's operations.
Joseph A. Field (joe.field@withers.us.com) a partner in the New York office of Withers Worldwide, represents substantial international families on estate planning and structuring their affairs. Ed Vergara (edward.vergara@withers.us.com) is an associate at Withers Bergman LLP.
