The amendments to the “accredited investor” definition provide new opportunities for natural persons and entities to qualify as accredited investors and to participate in private capital markets.
On August 26, 2020, the U.S. Securities and Exchange Commission (SEC) adopted final rules amending the definitions of “accredited investor” and “qualified institutional buyer” (QIB). The purpose of the amendments is to identify more effectively institutional and individual investors that have sufficient knowledge and expertise to participate in investment opportunities without investor protections provided by registration under the Securities Act of 1933.
The final amendments will be published in the Federal Register soon and become effective 60 days after publication.
Definition of “Accredited Investor”
The definition of “accredited investor” is one of the principal tests used to determine if an investor is eligible to invest in private capital markets, including securities offerings conducted pursuant to Regulation D under the Securities Act and other federal and state securities law exemptions. Accredited investors may participate in investment opportunities that are generally not available to nonaccredited investors, such as investments in private companies, hedge funds, private equity funds and venture capital funds.
The amendments expand the definition of “accredited investor” beyond the traditional financial requirements by adding the following categories for investors that have certain knowledge.
1. Professional certifications, designations and credentials. The amendments allow natural persons to qualify as “accredited investors” if they are holders in good standing of certain professional certifications, designations and credentials specifically designated by the SEC, irrespective of their personal wealth or income. The initial list of qualifying professional certifications, designations and credentials includes:
- The General Securities Representative license (Series 7);
- The Investment Adviser Representative license (Series 65); and
- The Private Securities Offerings Representative license (Series 82).
The SEC may reevaluate this list of certifications, designations and credentials and designate additional ones from time to time by means of SEC orders.
2. Knowledgeable employees of private funds. The amendments allow “knowledgeable employees” of a private fund (such as a hedge fund, a venture capital fund or a private equity fund) to qualify as accredited investors for investments in that fund. “Knowledgeable employees” include, among other persons, trustees and advisory board members (or persons serving in a similar capacity) of a private fund that oversees the fund’s investments, as well as employees of the fund (except those performing solely clerical, secretarial or administrative functions) who, in connection with their regular duties, have participated in the investment activities of the fund for at least 12 months.
3. Spousal equivalent. Under the current definition, a natural person, together with a spouse, may qualify as an accredited investor by having at least $300,000 in joint income in the two most recent years or at least $1 million in joint net worth. This remains unchanged, but to address uncertainties regarding whether persons in legally recognized unions (such as domestic partnerships, civil unions and same-sex marriages) were considered spouses for purposes of the “accredited investor” definition, the amendments add the term “spousal equivalent” (defined as a cohabitant occupying a relationship generally equivalent to that of a spouse) so that spousal equivalents can pool finances to meet the joint income and joint net worth tests.
4. Entities by type. The amendments also add the following entities in the definition of “accredited investor”:
- Limited liability companies (LLCs) that have total assets in excess of $5 million and were not formed for the specific purpose of acquiring the securities being offered;
- SEC- and state-registered investment advisers and exempt reporting advisers;
- Rural business investment companies (RBICs), which are companies approved by the Secretary of Agriculture and have entered into participation agreements with the secretary;
- “Family offices” (i.e., entities established by wealthy families to manage their wealth, plan for their families’ financial future and provide other services to family members) that meet following requirements: (i) having at least $5 million in assets under management, (ii) not being formed for the specific purpose of acquiring the securities being offered and (iii) having prospective investment be directed by persons with knowledge and experience in financial and business matters;
- “Family clients” of family offices meeting the requirements above and whose prospective investment is directed by such family offices (family clients generally are family members, former family members and certain key employees of the family office, as well as certain of their charitable organizations, trusts and other types of entities); and
- Any entities (including Indian tribes, labor unions, governmental bodies and funds, and entities organized under the laws of a foreign country or entity types that may be created in the future) owning investments in excess of $5 million that were not formed for the specific purpose of investing in the securities offered.
Definition of “Qualified Institutional Buyer”
Rule 144A under the Securities Act provides a safe harbor exemption from the registration requirements for resales of certain restricted securities to QIBs. The QIB definition, thus, determines who is eligible to purchase unregistered securities in transactions that comply with Rule 144A. Under the current QIB definition, with some exceptions, to qualify for the QIB status, an entity must:
- In the aggregate own and invest on a discretionary basis at least $100 million in securities of unaffiliated issuers; and
- Be one of the following types of entities: insurance companies, registered investment companies, small business investment companies, certain employee benefit plans, certain trust funds, business development companies, Section 501(c)(3) organizations, corporations, partnerships, Massachusetts or similar business trusts and registered investment advisers.
The amendments expand the QIB definition to include LLCs and RBICs that meet the $100 million threshold. In addition, the amendments add a “catch-all” category to include in the QIB definition any institutional accredited investor of an entity type not already included in the QIB definition, so long as it satisfies the $100 million threshold. To address potential confusion, the amendments include a clarifying note that an entity seeking QIB status under the new catch-all provision may be formed for the purpose of acquiring restricted securities being offered.
Potential Effects of the Amendments
More Accredited Investors
The amendments to the “accredited investor” definition provide new opportunities for natural persons and entities to qualify as accredited investors and to participate in private capital markets. It is likely that many individuals who qualify as accredited investors under the new definition would also qualify under the old definition, so the increase in size of the new individual accredited investor pool could be limited. For entities, however, the impact of the amendments is likely more significant, due to a broad range of entities that were not covered in the old definition.
Lower Cost of Private Capital
The larger pool of accredited investors is expected to improve the ability of issuers to raise capital in the exempt market, reduce competition for capital and thus may reduce the cost of capital. Similarly, the expansion of the QIB definition would increase the liquidity in the resales market.
Verification in Rule 506(c) Offerings
Rule 506(c) exemption of Regulation D requires issuers to take reasonable steps to verify the “accredited investor” status of purchasers in unregistered offerings. Compliance with this requirement has been cited as a potential impediment to the use of Rule 506(c) offerings despite the ability to use general solicitation when conducting those offerings. For categories of accredited investors where the verification requirement is easier to satisfy (for example, the registration and licensing information of Series 7, 65 and 82 licensees can be verified online through FINRA’s BrokerCheck or the SEC’s Investment Adviser Public Disclosure database), issuers may be more willing to advertise or sell private securities to those investors.
Efficiency Gains for Rule 504 Offerings
Under the rarely used Rule 504 of Regulation D, issuers are permitted to use general solicitation or general advertising to accredited investors. Because the pool of accredited investors likely would increase under the amendments and the costs of advertising and solicitation is mostly fixed, the cost effectiveness of advertising and solicitation under Rule 504 may improve, which may increase reliance by issuers on Rule 504.
Under Section 5(d) of the Securities Act and Securities Act Rule 163B (the test-the-waters provisions), issuers are allowed to communicate with institutional accredited investors and QIBs to gauge interest in contemplated registered offerings. With the larger pool of institutional accredited investors and QIBs, issuers can now engage in test-the-waters communications with a larger set of investors, resulting in a more efficient and potentially lower-cost and lower-risk capital raising process.
The ability of knowledgeable employees of private funds to invest in those funds would enable private funds to offer such employees additional types of performance incentives, aligning incentives between such employees and fund investors.
For More Information
If you have any questions about this Alert, please contact Nanette C. Heide, Darrick M. Mix, Phuong (Michelle) Ngo, any of the attorneys in our Capital Markets Group or the attorney in the firm with whom you are in regular contact.
Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.