The Commissioners of the Securities and Exchange Commission (“SEC”) voted to amend and expand the definition of an “accredited investor” used in the Securities Act Rules. The Final Rule issued on August 26, 2020, adopts and incorporates a broader understanding of financial sophistication that would allow a greater number of entities and natural persons to participate in private securities offerings under Regulation D. This marks a significant shift away from the Commission’s historical reliance on wealth as the sole indicator of financial sophistication, with the Final Rule noting that the new rules would focus on granting accredited investor status to individuals and entities that “have demonstrated the requisite ability to assess an investment opportunity… irrespective of their wealth.”
Why accredited investors?
The Securities Act of 1933 (“Securities Act”) requires companies to disclose comprehensive and accurate information about themselves and the securities being issued so that investors can make educated investment decisions. The Securities Act ensured that these disclosures were being made by requiring the sale of securities to be registered with the SEC unless the sale met the requirements for an exempt private offering. A key component of exempt, uncapped private offerings made under Rule 506(b) or 506(c) of Regulation D is that most (if not all) of the participants in such sales of securities have the necessary financial sophistication to assess the risks inherent to non-registered offerings—in other words, the participants have to be “accredited investors.”
Amendments to the accredited investor definition for natural persons
Perhaps the most noteworthy change ushered in by this amendment is the addition of two new categories of “accredited investors”: (1) natural persons with professional certifications, and (2) knowledgeable employees of private funds. Additionally, the Commission made a minor adjustment to the natural persons categories by allowing joint income from spousal equivalents to be included in determinations of net worth.
- Natural Persons with certain professional certifications.
The first of these two new natural-person categories is the designation of natural persons with certain “qualifying professional certifications, designations, and other credentials” to qualify as accredited investors.
The Commission has stipulated that it would designate the specific certifications, designations, and other credentials “based upon consideration of all the facts pertaining to a particular certification, designation, or credential,” an approach that would allow the Commission to have a certain degree of flexibility in designating the credentials that would qualify for this category and later re-evaluating those designations in light of the “evolving nature of market and industry practices.” The Commission has also stipulated that such individuals will also have to meet a good-standing requirement in order to maintain their accredited investor status.
Although the Commission has not finalized the certifications, designations, or credentials required for natural persons to qualify as accredited investors, the Final Rule has indicated that holders of a General Securities Representative license (Series 7), the Private Securities Offerings Representative license (Series 82), and the Licensed Investment Adviser Representative license (Series 65) will be the first credentials recognized under the amended rule. It remains to be seen what other certifications the Commission will designate next.
- Natural Persons that are knowledgeable employees of a private fund.
The second new natural-person category grants “knowledgeable employees” of a private fund accredited investor status for investments in that fund.
This category draws on Rule 3c-5(a)(4) of the Investment Company Act, which defines a “knowledgeable employee” with respect to a private fund 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 of the private fund; 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 such private fund… for at least 12 months.”
The Commission noted that these “knowledgeable employees”, by virtue of their positions within the private fund and familiarity with its investments, would have “sufficient knowledge and expertise to participate in investment opportunities that do not have the additional protections provided by registration under the Securities Act.”
- Spousal equivalent.
The third and final amendment to the natural person categories would allow the joint income from spousal equivalents—that is, a “cohabitant occupying a relationship generally equivalent to that of a spouse”—to be included in a natural person’s calculation of his or her net worth for purposes for Rules 501(a)(5) and (6). This minor adjustment simply brings the definition of “accredited investor” in line with the rest of the Commission rules where spousal equivalent is already in use, thereby promoting consistency throughout the regulations.
Amendments to the accredited investor definition for entities
In addition to expanding the scope of accredited investor status for natural persons, the amendment to the Securities Act Rules also expanded and clarified definitions for certain entities, such as investment advisors, limited liability companies, Indian tribes, and family offices.
- Investment advisers, exempt reporting advisers, RBICs, and LLCs.
With regards to entities, the Commission has determined that (i) rural business investment companies (RBICs) and limited liability companies (LLCs) that meet the $5 million assets minimum, (ii) entities that are state- or federal-registered investment advisers, and (iii) exempt reporting advisers will be considered accredited investors.
The Final Rule notes that registered investment advisers and exempt reporting advisers generally “have the requisite financial sophistication needed to conduct meaningful investment analysis.” Furthermore, the Commission observed that registered investment advisers are already “generally considered to be institutional investors under state law,” and that exempt reporting advisers are “professionals managing either venture capital funds or small investment funds,” which, as institutional investors, are presumed to be financially sophisticated.
Additionally, the amendment would include RBICs and LLCs that meet the $5 million asset minimum in the definition of accredited investors. RBICs are companies formed for the purpose of promoting “economic development and [creating] wealth and job opportunities in rural areas” and among those living there—goals similar to those of small business investment companies (SBICs). Since SBICs are already accredited investors under Rule 501(a)(1), the Commission felt it logical to treat RBICs similarly. Likewise, the inclusion of limited liability companies that meet the requirements of Rule 501(a)(3) is simply bringing the Rules in line with the times, seeing as LLCs have grown significantly in prevalence since the Rules were last updated to add entity types in 1989.
- Entities owning investments catch-all.
The amendment also adds another entity category to the “accredited investor” definition: “any entity owning ‘investments’… in excess of $5 million that is not formed for the specific purpose of acquiring the securities being offered.”
This category was specifically meant as a “catch-all” provision, and thus the Commission felt that “enumerating a list of entities in the rule” was necessary. As such, this category would allow Indian tribes, labor unions, governmental bodies and funds, entities formed under the laws of foreign countries, and other entities to be considered accredited investors so long as they already hold “investments” in excess of $5 million. Reference is made to the definition of investments in Rule 2a51-1(b) of the Investment Company Act, which includes “securities; real estate, commodity interests, physical commodities, and non-security financial contracts held for investment purposes; and cash and cash equivalents,” among others.
- Family offices.
Finally, the amendment also added a category to the “accredited investor” definition that would allow a “family office” to be an accredited investor so long as it meets certain requirements. A “family office” is an entity organized by a family to manage the assets and financial planning of the family and other family members. Family offices generally only serve “family clients,” who are generally “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.” Although the SEC has recognized single family offices generally meet the definition of “investment adviser” under the Advisers Act, in 2011 the Commission opted to exclude family offices from regulation under the Advisers Act. Despite this, the SEC’s final rule would recognize a family office as accredited investors so long as the family office has over $5 million in assets under management, is not formed for the purpose of purchasing the securities offered, and 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.”
The New Accredited Investors
Out of the approximately $2.7 trillion of new capital raised through exempt offerings in 2019, around $1.56 trillion was raised in Rule 506(b) or 506(c) offerings alone. That number is certain to increase in light of these revisions and additions to the definition of accredited investor. While it remains to be seen just how inclusive the Commission will be in the designation of professional certifications category, the general expansion of access ushered in by these revisions is sure to increase the number of participation and result in more numerous and robust private placements.