SEC Amends “Accredited Investor” Definition
On August 26, 2020, the U.S. Securities and Exchange Commission (SEC) adopted amendments expanding the definition of “accredited investor” to allow additional categories of investors to invest in unregistered private offerings. The new definition moves beyond the long-standing reference to wealth and income to determine whether individuals may be deemed accredited investors, adding established, objective measures of financial sophistication as a qualifying factor to determine if the investor has demonstrated the requisite ability to assess an investment opportunity. The amendments will become effective 60 days after the SEC’s rule release is published in the Federal Register, which is expected to be in November 2020.
Amendment of “Accredited Investor” Definition
The SEC made the following amendments to the accredited investor definition in Rule 501(a) of Regulation D:
- Natural Persons Holding Professional Certifications: Added a new Rule 501(a)(10) for individuals holding and being in good standing with 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 (the final rule does not permit individuals to self-certify that they have the requisite financial sophistication to be an accredited investor). In conjunction with the adoption of the amendments, the SEC designated by order holders in good standing of the General Securities Representative license (Series 7), the Private Securities Offerings Representative license (Series 82), and the Licensed Investment Adviser Representative (Series 65), each as issued by the Financial Industry Regulatory Authority (FINRA), as qualifying natural persons. The SEC noted the addition of this new category provides the SEC with flexibility to further expand and add certifications or credentials in the future. This is likely to prompt other “knowledgeable” groups to push the SEC to expand the category even further. Among those referenced by commenters were individuals qualifying as a CPA, CFA, CMA and MBA. It is yet to be seen how the SEC will draw the line and will distinguish one qualification from another
- “Knowledgeable Employees” of Private Funds: Added a new Rule 501(a)(11), with respect to investments in a private fund, natural persons who are “knowledgeable employees” of the fund1
- Limited Liability Companies: Added in Rule 501(a)(3) limited liability companies not formed for the specific purpose of investing in the securities offered, with total assets in excess of $5 million2
- Investment Advisers: Added SEC- and state-registered investment advisers as well as federally exempt reporting advisers to Rule 501(a)(1)
- Rural Business Investment Companies (RBICs): Added RBICs to Rule 501(a)(1)
- Catch-All for Other Entities: Added a new Rule 501(a)(9) to capture any entity that owns “investments,”3 in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered4
- Family Clients: Added a new Rule 501(a)(13) for “family clients” of “family offices” with at least $5 million in assets under management and their “family clients”, as each term is defined in the Investment Advisers Act5
- Spousal Equivalent6: Added to the net worth standard in Rule 501(a)(5) (individual or joint net worth of $1 million) and the income standard in Rule 501(a)(6) (individual income in excess of $200,000 or joint income in excess of $300,000) and an associated definition in new Rule 501(j), allowing spousal equivalents to pool their finances for the purpose of qualifying as accredited investors
- Clarification Regarding Joint Net Worth: Added a note to codify an existing SEC staff position that the calculation of “joint net worth” for purposes of Rule 501(a)(5) can be the aggregate net worth of an investor and his/her spouse or spousal equivalent (regardless of whether property is owned jointly), and that the securities being purchased by an investor relying on the joint net worth test of Rule 501(a)(5) need not be purchased jointly
- Clarification Regarding an Entity if All Equity Owners are Accredited Investors: Added a note to codify an existing SEC staff position that, in determining accredited investor status under Rule 501(a)(8), one may look through various forms of equity ownership to natural persons. This prong of the definition is useful where an entity does not qualify as an accredited investor on its own merits, such as if it does not have more than $5 million in assets or if it was formed for the purpose of making the investment (if it is the type of entity where these factors are preconditions to institutional accredited investor status), and if those natural persons are themselves accredited investors, and if all other equity owners of the entity are accredited investors, the entity would be an accredited investor.
In addition, the SEC amended Securities Act Rule 215 by replacing the existing definition with a cross reference to the definition in Securities Act Rule 501(a), and made conforming amendments to Rule 163B under the Securities Act (the newly established categories of institutional accredited investors are now included among the types of potential investors that an issuer contemplating a registered public offering may contact with oral or written “test-the-waters” communications before the filing of a registration statement with the SEC) and to Exchange Act Rule 15g-1 (exempting certain “penny stock” transactions from broker-dealer disclosure requirement).
Amendment of “Qualified Institutional Buyer” Definition
In addition, the SEC made similar amendments to expand the definition of “qualified institutional buyer” (QIB) in Securities Act Rule 144A to include RBICs (Rule 144A(a)(1)(i)(C)), limited liability companies (Rule 144A(a)(1)(i)(H)) and any institutional investors included in the accredited investor definition in Securities Act Rule 501(a) that are not otherwise enumerated in the definition of qualified institutional buyer (Rule 144A(a)(1)(i)(J)), in each case, provided they satisfy the $100 million threshold. In addition, the SEC added a note to clarify that an entity seeking qualified intuitional buyer status under Rule 144A(a)(1)(i)(J) may be formed for the purpose of acquiring the 144A securities being offered.
- Issuers of securities in private offerings will need to update their accredited investor and QIB questionnaires for future offerings and/or accepting new accredited investor subscribers into an existing open-end structured fund. This includes privately held companies, private equity, venture capital and hedge funds. The existing financial thresholds are not changed, thus investors that meet the current accredited investor standards will be unaffected.
- Both issuers and fund managers may want to update their requirements for investments by knowledgeable employees to reflect the changes and clarifications provided by the new amendments.
- Representations and warranties as to accredited investor status in subscription agreements, stock purchase agreements, and some M&A transactions will need to be updated to address the new amendments.
- Since more financially sophisticated investors who do not otherwise meet the income or net worth tests will now be considered accredited investors, there may be a greater risk that some newly accredited investors may invest in private investments where they are less able to financially bear the risk of loss posed by such investments. Issuers and private fund managers may want to consider whether to continue to assess the financial stability of all of their prospective investors, particularly given the typical limitations on transferability and illiquid nature of unregistered securities.
- Since general solicitation in private placements (a Rule 506 (c) offering) is only permitted if, among other requirements, all purchasers are “accredited,” the expanded definition may increase the benefits of engaging in such offerings. However, the addition of “spousal equivalents” to joint net worth and income determinations may create uncertainty for issuers subject to the independent verification requirements of Rule 506 (c) if an investor proposes to treat an individual in an other-than-legally-recognized union as a spousal equivalent.
- If an offering straddles the effective date, issuers should consult with legal counsel to determine the appropriate way to handle the expansion of the universe of eligible investors.
The SEC may have additional guidance on the changes to the definitions of accredited investor and qualified institutional buyer as effectiveness grows closer and the questions and implications surrounding these amendments come into focus. Under the Dodd-Frank Act, the SEC is required to review the definition of accredited investor every four years; the next review will take place in 2023. For more information, please contact Mitchell Littman, Esq. or any member of our Corporate and Securities Team.
1 A “knowledgeable employee” is generally defined in Rule 3c-5(a)(4) under the Investment Company Act of 1940 to include 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” (an affiliated person that manages the investment activities of a private fund ) of the private fund, and certain other employees of the private fund or an affiliated management person of the private fund who routinely participate in the investment activities of such private fund, other private funds, or investment companies the investment activities of which are managed by such affiliated management person of the private fund.
2 Limited liability companies have been permitted to be considered accredited investors since 1996 by virtue of SEC interpretive advice. The new rules formalize the long-standing position in the official definition of “accredited investor.”
3 Generally defined by Rule 2a51-1(b) under the Investment Company Act of 1940 as investments in independently controlled companies meeting certain minimum requirements and held for investment purposes.
4 The amendments list, as non-exclusive examples of additional entities covered by this clause, Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries.
5 “Family offices” are generally defined under 275.202(a)(11)(G)-1 as private advisory entities established by families to manage their assets, plan for their families’ financial future, provide other services to family members, and do not hold themselves out to the public as investment advisers. The SEC has previously observed that single family offices generally serve families with at least $100 million or more of investable assets.
6 The term “spousal equivalent” means “cohabitant occupying a relationship generally equivalent to that of a spouse,” based on existing definitions found in the Investment Advisers Act and Regulation CF.
This memorandum is for informational purposes only and not for the purpose of providing legal advice. Further, the above memorandum is not intended to be a substitute for consultation with counsel. The opinions expressed in this memorandum are the opinions of the individual author and may not reflect the opinions of Littman Krooks LLP or any other attorneys at Littman Krooks LLP. Please contact the professional listed above, or your regular Littman Krooks LLP contact.