The much anticipated amendments to the accredited investor definition and definition of qualified institutional buyer under Rule 144A were adopted by the SEC on August 26, 2020. The amendments come almost five years after the SEC published a report on the definition of “accredited investors” ( see HERE) and nine months after it published the proposed amendments (see HERE). The rule changes also took into account the input and comment letters received in response to the SEC’s concept release and request for public comment on ways to simplify, harmonize and improve the exempt offering framework (see HERE).
As a whole industry insiders, including myself, are pleased with the rule changes and believe it will open up private investment opportunities to a wider class of sophisticated investors, while still maintaining investor protections. As the SEC pointed out historically, individual investors who do not meet specific income or net worth tests, regardless of their financial sophistication, have been denied the opportunity to invest in our multifaceted and vast private markets. The amendments are meant to improve the definition to include institutional and individual investors with knowledge and expertise in the marketplace.
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 with $5 million in assets and 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 has also amended 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 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).
The amendments become effective 60 days after publication in the Federal Register.
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 Rules 506(b) and 506(c) of Regulation D. Qualifying as an accredited investor allows an 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 2019 the estimated capital raised in exempt offerings was $2.7 trillion compared to $1.2 trillion in registered offerings. The amended definition of accredited investor is part of the SEC’s larger effort to simplify, harmonize, and improve the exempt offering framework. Earlier this year the SEC published broader proposed rule changes to the exempt offering structure, which I broke down into a 5-part blog series. The first centered on the offering integration concept (see HERE); the second on offering communications, testing the waters and a new demo day exemption (see HERE); the third on Regulation D, Rule 504 and bad actor rules (see HERE); the fourth on Regulation A (see HERE); and the fifth on Regulation Crowdfunding (see HERE).
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.
Summary of Amendments
The amendment to the accredited investor definition adds new categories of natural persons based on certain professional certifications, designations or credentials or other credentials issued by an accredited educational institution, which the SEC may designate from time to time by order. In particular, to start the amendment provides that a holder in good standing of a Series 7, 65 or 82 license qualifies as an accredited investor. The SEC further provides that it may add additional certifications, designations, or credentials in the future. In addition, a knowledgeable employee of a private fund will now be considered accredited. The 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 for natural persons.
The amendments also: (i) clarify that limited liability companies with $5 million in assets qualify as accredited and add SEC- and state-registered investment advisers, exempt reporting advisers, and rural business investment companies (RBICs) to the list of entities that may qualify; (ii) add a new catch-all category for any entity, including Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries, that own “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; (iii) 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 (iv) 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 amendments to the qualified institutional buyer definition in Rule 144A 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 amendments also add a catch-all category that permits 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
Noting that relying solely on financial thresholds as an indication of financial sophistication is suboptimal, including because it may unduly restrict access to investment opportunities for individuals whose knowledge and experience render them capable of evaluating the merits and risks of a prospective investment—and therefore fending for themselves—in a private offering, irrespective of their personal wealth, the final amendment adds new categories to the definition that would permit natural persons to qualify as accredited investors based on certain professional certifications and designations. The final amendments track the proposed amendments in this area except that the final amendments require that any certification, license or designation be in good standing in order to qualify for accreditation.
The final amendment provides that the SEC may designate qualifying professional certifications, designations, and other credentials by order, with such designation to be based upon consideration of all the facts pertaining to a particular certification, designation, or credential. The final amendment includes a non-exclusive list of attributes the SEC will 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 list of professional certifications and designations or other credentials recognized by the SEC as qualifying individuals for accredited status will be posted on the SEC’s website.
Concurrent with adopting the final amendments, the SEC issued an order designating good standing holders of 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 would 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.
Requiring that a list of individuals that hold the certifications be publicly available will 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 has added a new category based on the person’s status as a “knowledgeable employee” of the fund. A knowledgeable employee is defined as (i) an executive officer, director, trustee, general partner, advisory board member, or person serving in a similar capacity, of the private fund or an affiliated management person; and (ii) an employee of the private fund or an affiliated management person of the private fund who in connection with his or her regular functions or duties, participates in the investment activities of the fund and has been doing so for at least 12 months.
The private fund category is meant to encompass funds that rely on the investment company registration exemptions found in Sections 3(c)(1) and 3(c)(7) of 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, prior to this amendment, if the knowledgeable employee does not qualify as accredited and the fund is relying on Rule 506 for its offering, the knowledgeable employee would be excluded.
The SEC has added 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 is defined as a cohabitant in a relationship generally equivalent to a spouse. The rule does not require joint ownership of assets in making the determination whether a relationship is a spousal equivalent.
Additional Entity Categories
The amended rules add the following entities to the accredited investor definition: (i) limited liability companies with total assets in excess of $5 million that were not formed for the specific purpose of making the investment; (ii) SEC and state registered investment advisers and exempt reporting advisors; (iii) rural business investment companies (RBICs); (iv) 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 (v) “family offices” with at least $5 million in assets under management, that were not formed for the purpose of making the investment, and their “family clients,” as each term is defined under the Investment Advisers Act as long as the prospective investment is directed by a person who has such knowledge and experience in financial and business matters that such family office is capable of evaluating the merits and risks of the prospective investment.
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.
Qualified Institutional Buyer – Rule 144A
The SEC has amended 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. Rule 144A(a)(1)(i) specifies the types of institutions that are eligible for qualified institutional buyer status if they meet the $100 million in securities owned and invested threshold. The amendments expand the definition of qualified institutional buyer by adding RBICs, limited liability companies, and all entities, including Indian tribes that meet the $100 million threshold.
The amendments 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).