Four years after issuing its report on the definition of “accredited investors” in December 2015, the SEC has published a proposed rule amendment to the definition. See HERE for my blog on the SEC’s report. The amendments were anticipated following an in-depth discussion on the definition contained in the SEC’s Concept Release on Private Offerings published in July 2019 (see HERE)
As a whole industry insiders, including myself, are pleased with the proposal and believe it will open up private investment opportunities to a wider class of sophisticated investors, while still maintaining investor protections. In the rule amendment release the SEC cites numerous comment letters suggesting and supporting many of the proposed amendments including one from the Crowdfunding Professionals Association (CfPA), Legislative & Regulatory Affairs Division, a committee I sit on and for which I participated in the preparation of the comment letter.
The current test for individual accredited investors is a bright line income or net worth test. The amended definition will add additional methods for a person to qualify as accredited based on professional knowledge, experience and certifications. The amended definition will also add categories of businesses, entities, and organizations that can qualify including a catch-all category for any entity owning in excess of $5 million in investments. The expansion of qualified entities is long overdue as the current definition only covers charitable entities, corporations, business trusts and partnerships, and entities in which all equity owners are individually accredited.
The SEC is also proposing to amend the definition of a “qualified institutional buyer” under Rule 144a of the Securities Act of 1933 (“Securities Act”) to expand the list of eligible entities. The amendments would also make some conforming changes including updating the definition of accredited investor in Section 2(a)(15) to match the definition in Rule 501 of Regulation D and cross-referencing the entity accredited investor categories in Rule 15g-1(b) – the broker-dealer penny stock rules (see HERE).
All offers and sales of securities must either be registered with the SEC under the Securities Act or be subject to an available exemption from registration. The ultimate purpose of registration is to provide investors and potential investors with full and fair disclosure to make an informed investment decision. The SEC does not pass on the merits of a particular deal or business model, only its disclosure. In setting up the registration and exemption requirements, Congress and the SEC recognize that not all investors need public registration protection and not all situations have a practical need for registration.
The definition of an accredited investor has become a central component of exempt offerings, including rule 506(b) and 506(c) of Regulation D. Qualifying as an accredited investor allows such investor to participate in exempt offerings including offerings by private and public companies, certain hedge funds, private equity funds and venture capital funds. Exempted offerings carry additional risks in that the level of required investor disclosure is much less than in a registered offering, the SEC does not review the offering documents, and there are no federal ongoing disclosure or reporting requirements.
Exempt offerings play a significant role in the U.S. capital markets and are the foundation for start-up, development-stage and growing businesses. In 2018 the estimated capital raised in rule 506 offerings was $1.7 trillion compared to $1.4 trillion in registered offerings. Of the $1.7 trillion, $1.5 trillion was raised by pooled investment funds and the balance directly by other businesses. The SEC has been talking about increasing access to this large and growing market sector for some time.
In November 2019 the topic was front and center at the Investor Advisory Committee meeting (see HERE). In my blog on the meeting, I suggested that access to private markets and private funds could be expanded by amending the definition of an “accredited investor” to add individuals with professional licenses, investment and/or financial experience (including through employment) and education such as through an accredited investor exam. The proposed amendments would do just that.
The Current Definition of “Accredited Investor”
An “accredited investor” is defined as any person who comes within any of the following categories:
Any bank as defined in section 3(a)(2) of the Act, or any savings and loan association or other institution as defined in section 3(a)(5)(A) of the Act, whether acting in its individual or fiduciary capacity; any broker or dealer registered pursuant to section 15 of the Securities Exchange Act of 1934; any insurance company as defined in section 2(a)(13) of the Act; any investment company registered under the Investment Company Act of 1940 or a business development company as defined in section 2(a)(48) of that Act; any Small Business Investment Company licensed by the U.S. Small Business Administration under section 301(c) or (d) of the Small Business Investment Act of 1958; any plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5,000,000; any employee benefit plan within the meaning of the Employee Retirement Income Security Act of 1974 if the investment decision is made by a plan fiduciary, as defined in section 3(21) of such act, which is either a bank, savings and loan association, insurance company, or registered investment adviser, or if the employee benefit plan has total assets in excess of $5,000,000 or, if a self-directed plan, with investment decisions made solely by persons that are accredited investors;
Any private business development company as defined in section 202(a)(22) of the Investment Advisers Act of 1940;
Any organization described in section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;
Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer;
Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his or her purchase exceeds $1,000,000, not including their principal residence;
Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;
Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person as described in Rule 506(b)(2)(ii); and
Any entity in which all of the equity owners are accredited investors.
The proposed amendments to the accredited investor definition would add new categories of natural persons based on professional knowledge, experience, or certifications. The proposed amendments would also add new categories of entities, including a catch-all category for any entity owning in excess of $5 million in investments. In particular, the proposed amendments would: (i) add new categories to the definition that would permit natural persons to qualify as accredited investors based on certain professional certifications and designations, such as a Series 7, 65 or 82 license, or other credentials issued by an accredited educational institution; (ii) with respect to investments in a private fund, add a new category based on the person’s status as a “knowledgeable employee” of the fund; (iii) add limited liability companies that meet certain conditions, registered investment advisers and rural business investment companies (RBICs) to the current list of entities that may qualify; (iv) add a new category for any entity, including Indian tribes, owning “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered; (v) add “family offices” with at least $5 million in assets under management and their “family clients,” as each term is defined under the Investment Advisers Act; and (vi) add the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors.
The proposed amendments do not adjust the net worth or asset test which was first enacted in 1988 and amended in 2011 to exclude primary residence from the net worth test.
The proposed amendments to the qualified institutional buyer definition in Rule 144A would add limited liability companies and RBICs to the types of entities that are eligible for qualified institutional buyer status if they meet the $100 million in securities owned and investment threshold in the definition. The proposed amendments would also add a catch-all category that would permit institutional accredited investors under Rule 501(a), of an entity type not already included in the qualified institutional buyer definition, to qualify as qualified institutional buyers when they satisfy the $100 million threshold.
Professional Certifications, Designations and Credentials
The proposed amendment would add new categories to the definition that would permit natural persons to qualify as accredited investors based on certain professional certifications and designations, such as a Series 7, 65 or 82 license, or other credentials issued by an accredited educational institution. The added categories are intended to demonstrate an individual’s background and understanding in the areas of securities and investing and thus a reduced need for regulatory protection. The SEC believes that individuals with financial sophistication have the ability to balance risky investments, make risk assessments and avoid unsustainable losses.
The SEC proposes to include professional certifications or designations or other credentials issued by an accredited educational institution that the SEC designates from time to time as meeting specified criteria. The amendment would include a non-exclusive list of attributes the SEC would consider in determining which professional certifications and designations or other credentials qualify for accredited investor status including: (i) the certification, designation, or credential arises out of an examination or series of examinations administered by a self-regulatory organization or other industry body or is issued by an accredited educational institution; (ii) the examination or series of examinations is designed to reliably and validly demonstrate an individual’s comprehension and sophistication in the areas of securities and investing; (iii) persons obtaining such certification, designation, or credential can reasonably be expected to have sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of a prospective investment; and (iv) an indication that an individual holds the certification or designation is made publicly available by the relevant self-regulatory organization or other industry body.
The SEC would issue an order designating professional certifications and designations or other credentials as qualifying for accredited investor status. The list of professional certifications and designations or other credentials recognized by the SEC as qualifying individuals for accredited status would be posted on the SEC’s website.
The SEC also preliminarily anticipates including those that hold a Series 7, 65 or 82 license as qualifying for accredited status. Although the SEC considered adding other professional licenses up front, such as an MBA or other finance degree or individuals that work in the securities industry as lawyers and accountants, they ultimately thought it would be too broad and leave too much discretion to the marketplace. Rather, the SEC believes that passing an exam and maintaining an active certification serves the purpose of adequately expanding the definition.
Also requiring that a list of individuals that hold the certifications be publicly available would reduce the costs of verifying accredited status for companies relying on Rule 506(c). Current procedures would still need to be used for verification where an investor is claiming accredited status based on the traditional income or net worth tests.
Knowledgeable Employees of Private Funds
With respect to investments in a private fund, the SEC proposes to add a new category based on the person’s status as a “knowledgeable employee” of the fund. The private fund category is meant to encompass funds that rely on the exemptions found in Sections 3(c)(1) and 3(c)(7) from registration as an investment company under the Investment Company Act of 1940. These funds generally rely on the private offering exemptions in Section 4(a)(2) and Rule 506 to raise funds.
Section 3(c)(1) exempts funds with 100 or fewer investors from the definition of an Investment Company and Section 3(c)(7) exempts funds where all investors are “qualified purchasers.” A qualified purchaser is one that owns $5 million or more in investments. The Investment Company Act already allows for some accommodations for knowledgeable employees of these funds. In particular, a knowledgeable employee is not counted towards the 100 investors and may invest even if not a qualified purchaser. However, if the knowledgeable employee does not qualified as accredited and the fund is relying on Rule 506 for its offering, the knowledgeable employee would be excluded. Accordingly, the SEC proposes to fill this gap and include knowledgeable employees of private funds in the amended definition of an accredited investor.
The SEC proposes to add a note to Rule 501 to clarify that the calculation of “joint net worth” can be the aggregated net worth of an investor and his or her spouse or spousal equivalent. A spousal equivalent will be defined as a cohabitant in a relationship generally equivalent to a spouse. The rule will not require joint ownership of assets in making the determination whether a relationship is a spousal equivalent.
Additional Entity Categories
The amended rules would (i) add limited liability companies that were not formed for the specific purpose of making the investment, registered investment advisers and rural business investment companies (RBICs); (ii) any entity, including Indian tribes, owning “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered; and (iii) “family offices” with at least $5 million in assets under management and their “family clients,” as each term is defined under the Investment Advisers Act, to the current list of entities that may qualify as accredited.
As mentioned above, these additions are long overdue as the current definition only includes charitable entities, corporations, business trusts and partnerships, and entities in which all equity owners are individually accredited.