In a December 18, 2019 release, the U.S. Securities and Exchange Commission proposed to amend the definition of “accredited investor” in Rule 501 of Regulation D and the definition of “qualified institutional buyer” in Rule 144A (both are rules under the Securities Act of 1933, as amended). The current definition of accredited investor for individuals utilizes wealth and income standards originally established in 1982 as the sole proxy for establishing investor sophistication for natural persons. The proposed amendments would add new categories of individuals and entities that would qualify as accredited investors and expand the list of eligible entities under the qualified institutional buyer (QIB) definition. The Commission vote was divided, with three Commissioners in favor of the proposal and two dissenting.
Broader Accredited Investor Definition
Regulation D permits the sale of securities by issuers of those securities without registration under the Securities Act, establishing safe harbor provisions for the private placement of securities. Rule 506 of Regulation D generally requires investors to be “accredited investors.” The current definition of accredited investor for natural persons includes those with a net worth of over $1 million or income exceeding $200,000 in each of the prior two years (or joint income with a spouse exceeding $300,000) and an expectation of the same level of income for the current year. Entities that qualify as accredited investors include organizations with assets exceeding $5 million not formed for the purpose of acquiring the securities being offered or entities in which all of the equity owners are accredited investors.
Proposed amendments to the definition include:
Permitting Natural Persons to Qualify Based on Certain Professional Certifications and Designations, Such as a FINRA Series 7, 65 or 82 License, or Other Credentials Issued by an Accredited Educational Institution
The Commission suggests it is thinking broadly about various indicia of sophistication or means to participate in private offerings not captured by the existing definition’s focus on net worth or income. This might include, for example, licensed securities professionals, attorneys or accountants, or others with relevant employment or advanced degrees.
At this time, however, the Commission proposes only to expand the accredited definition to include those with specified licenses administered by the Financial Industry Regulatory Authority, Inc. (FINRA). This addition would be by an order of the Commission published concurrently with the final rules under this rulemaking. The Commission indicates it would be prepared to issue future orders identifying additional qualifications based on “professional certifications or designations or credentials from an accredited educational institution.” For now, this does not appear to refer to, for example, college or advanced degrees, in part because the Commission says such degrees may not provide a consistent measure of financial sophistication. Instead, the rulemaking suggests this refers to credentials that require specific examinations or licensing directly bearing on knowledge of securities and investing.
We note, however, that the proposal would not include the Series 79 (Investment Banking Representative) license or the Securities Industry Essentials (SIE) examination in the initial list of certifications, or designations that would qualify an individual as an accredited investor. In addition, the Commission expressly noted in the proposal that the SIE and other examinations (e.g., the Series 65 and Series 66) do not require that the individual be sponsored by a FINRA-member firm to sit for the examination, and requested comment as to whether a waiting period should be imposed before individuals with these credentials can invest in offerings as accredited investors.1
The Commission also indicates that the initial expansion of the rule to cover FINRA-licensed personnel is attractive in part because registration and licensing information is easily available online through FINRA’s BrokerCheck, which simplifies the accredited investor verification process for issuers in a Rule 506(c) offering. (Rule 506(c), which allows general solicitation and advertising in the context of a Regulation D offering, requires the issuer to take reasonable steps to verify that purchasers are accredited investors; in other instances, the requirement is that the issuer “reasonably believes” the investor to be accredited.)
The proposed definition would not change the current financial thresholds for individuals to qualify as accredited investors—net worth of $1 million or annual income of $200,000 ($300,000 with spouse). These thresholds have not, however, been adjusted for inflation since their adoption in 1982. The Commission noted its position that a significant reduction in the accredited investor pool could disrupt the Regulation D market (in which more capital was raised in 2018 than in registered offerings).
With Respect to Investments in a Private Fund, Permitting Qualification by the Fund’s “Knowledgeable Employees”
This proposal would address issues related to private funds that rely on the exclusion from the definition of an “investment company” in Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940 (the “Investment Company Act”). By way of background, Section 3(c)(1) excludes from the definition of “investment company” an issuer whose outstanding securities (other than short-term paper) are beneficially owned by not more than 100 persons and which does not make a public offering of its securities. Section 3(c)(7) of the Investment Company Act excludes from the definition of “investment company” an issuer whose outstanding securities are owned exclusively by persons who, at the time of acquisition of such securities, are “qualified purchasers,” and which does not make a public offering of its securities. These are commonly relied upon exclusions for many types of private investment funds.
Under Investment Company Act Rule 3c-5, a “knowledgeable employee” of a fund includes certain executives or others close to the investment process at the fund or its investment adviser. Such a knowledgeable employee is permitted to invest in the fund without being counted toward the Section 3(c)(1) 100-person count or meeting the Section 3(c)(7) qualified purchaser standard. Rather awkwardly, however, if the knowledgeable employee does not separately meet the financial thresholds required of accredited investors as defined under Regulation D, he or she can be prohibited from participating in the fund’s private offering of its securities. The proposed addition of knowledgeable employees as accredited investors would address this problem and be consistent with the current definition of accredited investor, which includes any director, executive officer or general partner of the issuer of the securities being offered or sold, regardless of net worth or income. The change would allow a person to invest in any fund for which he or she qualifies as a Rule 3c-5 knowledgeable employee without also having to meet the traditional accredited investor financial thresholds.
Adding Limited Liability Companies (LLCs) That Meet Certain Conditions
Because they were not widespread when the accredited investor definition was adopted, LLCs are not expressly included in the list of entity types that qualify for accredited investor status under the entity investor prong of the definition (Rule 501(a)(3)). This has left some technical doubt as to whether an LLC qualifies as an accredited investor, notwithstanding that the LLC is an entity with the requisite $5 million in total assets. The proposal would codify a longstanding Commission position that LLCs meeting the requirements under Rule 501(a)(3) are eligible to qualify as accredited investors.
Adding Registered Investment Advisers and Rural Business Investment Companies (RBICs) to the Current List of Entities That Automatically Qualify as Accredited Investors
Certain entities, such as banks, insurance companies and registered investment companies, qualify as accredited investors by virtue of their status and without having to meet financial criteria. Under the proposal, SEC- and state-registered investment advisers and RBICs would be added to this list.
RBICs promote economic development and job opportunities in rural areas and are described in the rule proposal as similar to small business investment companies (SBICs). SBICs are already on the list of entities treated as accredited investors by virtue of status. Adding RBICs would rationalize their treatment with SBICs.
Adding a new “Catch-All” Category for Entity Investors
As with LLCs, other types of entities, such as tribal governments and labor unions, are not listed among the entities treated as accredited investors under Rule 501(a)(3). The Commission proposes to add a “catch-all” qualification for any entity with total investments (as defined in the Investment Company Act) in excess of $5 million that was not formed for the specific purpose of investing in the securities offered. The Commission discussed whether the $5 million threshold for this category should be based on total assets as for the other entities under the rule and specifically determined to use investments, reasoning that investments are a better indicator of financial sophistication.
Adding Certain “Family Offices” and Their “Family Clients,” as Each Term is Defined Under the Investment Advisers Act Of 1940 (the “Investment Advisers Act”)
The “family office rule” under the Investment Advisers Act (Rule 202(a)(11)(G)-1) generally defines a family office as a company that has no clients other than “family clients” (subject to the other provisions of the family office rule). “Family clients” are generally defined as 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. The proposal would treat any family office meeting this definition as an accredited investor so long as (i) it has at least $5 million in assets under management, (ii) it was not formed for the specific purpose of investing in the securities offered and (iii) the purchase of securities is directed by a person who has knowledge and experience in financial and business matters so that the family office is able to evaluate the prospective investment.
The proposal also would treat each “family client” of such a qualifying family office as an accredited investor. At present, investments made in Regulation D private offerings by individual family members or their trusts or other family entities generally require that each such investor separately qualifies as an accredited investor under the applicable financial thresholds. The proposal would allow these individual family members and family entities to, in effect, “piggy back” on the accredited investor status of the qualifying family office.
Adding the Term “Spousal Equivalent” to the Accredited Investor Definition
Under the current definition, an individual, together with a spouse (previously undefined), may qualify for accredited investor status either by meeting the $300,000 joint income threshold or having over $1 million joint net worth. The proposal would allow natural persons to include joint income and assets from spousal equivalents when calculating joint income under either test. The proposal would define spousal equivalent as a cohabitant occupying a relationship generally equivalent to that of a spouse. The Commission has used this definition elsewhere, such as in the Investment Advisers Act. The proposal would also clarify that an accredited investor relying on joint income or net worth to establish accredited investor status need not actually purchase the investment jointly.
Conforming Qualified Institutional Buyer Definition Changes
Rule 144A provides a non-exclusive safe harbor exemption from the registration requirements of the Securities Act for resales to QIBs of certain restricted securities. Entities that own and invest on a discretionary basis at least $100 million in securities of issuers not affiliated with the entity may qualify as QIBs.
To avoid inconsistencies with the proposed amendments to the accredited investor definition, the proposal similarly would update the definition of QIB to include:
- LLCs and RBICs that satisfy the $100 million threshold; and
- “Catch-all” category of entities not otherwise included in the QIB definition that meet the $100 million threshold.
These changes to the accredited investor and QIB definitions would be consistent with the spirit of the “private offering concept release” issued by the Commission over the summer. Both releases focus on continued growth of the private securities markets, which are now larger than the public markets. Both releases also focus on the balance between protecting individual investors and ensuring access to a diverse set of investment opportunities. Here, a majority of the Commissioners clearly believes there is room to be more expansive. The dissenters, however, suggest the agency is moving too quickly and without sufficient study of the risks involved.
Comments on the proposal are due within 60 days after its publication in the December 26, 2019 Federal Register.
1 Release Nos. 33-10734; 34-87784; File No. S7-25-19 at 36.
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