United States: Recent Developments Relating To The Definition Of "Accredited Investor"

Article by Tracy Crum and Chase Mechanick (Law Clerk)

When is an individual an "accredited investor" under the Securities Act of 1933? H.R. 2187, the Fair Investment Opportunities for Professional Experts Act, which recently passed in the House of Representatives, may broaden the answer by expanding the definition of "accredited investor" in Section 2(a)(15) of the Act to include licensed brokers and investment advisors and individuals with educational or professional expertise.

Background. An issuance of securities to accredited investors is exempt from the Act's registration requirements under Regulation D if the issuer complies with certain restrictions. Regulation D — and, in particular, Rule 506 thereunder — is by far the most relied-upon exemption for private placements, with an estimated $4.7 trillion raised in Regulation D offerings between 2009 and 2014 according to an SEC study.

An issuance of securities to accredited investors may also be exempt under Section 4(a)(5) of the Act. However, most issuers rely on Regulation D rather than  Section 4(a)(5), because Section 4(a)(5) prohibits issuers from engaging in "general solicitation or advertising" of the offering, which is permitted in certain Rule 506 offerings, and Section 4(a)(5) offerings are capped at $5 million, whereas Rule 506 has no size limit.

The definition of accredited investor is identical under both exemptions with respect to individuals, but is defined in Rule 501 for Regulation D offerings and in  Section 2(a)(15) and Rule 215 for Section 4(a)(5) offerings. An individual may qualify as an accredited investor under either exemption if it satisfies certain financial thresholds based on a person's net worth or income.

Recent Developments. Whether these financial thresholds — which have not changed since the 1980s — remain reliable proxies for investor sophistication has been called into question. On December 18, 2015, the Securities and Exchange Commission (SEC) released a report  setting forth a number of alternative reforms to the definition, such as indexing all financial thresholds to inflation on a going-forward basis and treating individuals with sufficient investing experience or professional credentials as accredited investors.

Consistent with the SEC's report, H.R. 2187 modifies the definition in Section 2(a)(15) to include the net worth and income tests at their current thresholds, but requires that the relevant financial thresholds be adjusted for inflation by the SEC every five years. We have discussed the pros and cons of this approach in a previous post on AG Deal Diary. While this change would only affect a person's status as an accredited investor under Section 4(a)(5), the bill could, however, prompt the SEC to adopt a similar inflation-adjustment rule under Regulation D.

H.R. 2187 also defines an accredited investor to include natural persons who are brokers or investment advisors. While brokers are already considered accredited investors under Regulation D, investment advisers are not. Thus, the bill could provide investment opportunities for investment advisors under Section 4(a)(5) that are not otherwise available under Regulation D. Note that this provision relates to only natural persons, so it would not include investment advisors organized as limited liability companies or corporations. 

Finally, and most significantly, H.R 2187 would direct the SEC to adopt regulations affording accredited investor status under Section 4(a)(5) to natural persons who "have demonstrable education or job experience to qualify such person as having professional knowledge of a subject related to a particular investment," and whose education or experience is verified by Financial Industry Regulatory Authority or another self-regulatory organization. Regulation D contains no such provision. Thus, the bill could make the largely overshadowed Section 4(a)(5) relevant again in offerings to financially experienced investors — such as analysts, economists, industry specialists or even professors — whose net worth or individual income does not otherwise satisfy the bright-line test for accredited investors pursuant to Regulation D.

It is not clear how the SEC would determine who is and is not sufficiently "educated" or "experienced."  In its December report, the SEC proposed several means of assessing financial sophistication without relying on financial thresholds, including (i) the amount of money an individual has already invested, (ii) an individual's professional credentials, (iii) the number of prior offerings in which the individual has participated and (iv) an "accredited investor examination" that tests one's understanding of the risks involved in a private offering. The SEC has also proposed that employees of a private fund be deemed accredited investors for the purpose of investing in the fund for which they work. If the bill becomes law, the SEC will likely incorporate one or more of these designs in its implementing regulations.

Although H.R. 2187 purports to expand the definition of an accredited investor for only natural persons, it could result in a large number of corporations and other entities also qualifying as accredited investors. Under Rule 215, an entity is an accredited investor if its "equity owners" are all accredited investors. This provision is particularly likely to open up Section 4(a)(5) opportunities to management-owned companies as long as each owner is an accredited investor.

That said, while H.R. 2187 has the potential to breathe some life into Section 4(a)(5), the impact of this bill should not be overstated. As discussed, this bill would not affect Regulation D, unless the SEC chooses to harmonize the rules. Furthermore, offerings under Section 4(a)(5) would still be subject to the $5 million limitation, and the  prohibition on general solicitation and advertising.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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