On December 18, 2019, the Securities and Exchange Commission ("SEC") proposed amendments to the definition of "accredited investor" as set forth in Rule 501(a) of the Securities Act of 1933, as amended (the "Securities Act"). The proposed amendments would add new categories of natural persons that may qualify as accredited investors based on their professional knowledge, experience or certifications, and would also expand the list of entities that may qualify as accredited investors. At the same time, the SEC also proposed certain conforming changes to the definition of "qualified institutional buyer" for purposes of Rule 144A under the Securities Act.
As per the SEC's proposing release, the proposals "are intended to update and improve the [accredited investor] definition in order to identify more effectively institutional and individual investors that have the knowledge and expertise to participate in our private capital markets and therefore do not need the additional protections of registration under the Securities Act."
The accredited investor definition is a central component of several exemptions from registration under the Securities Act, such as Rules 506(b) and 506(c) of Regulation D (under which an estimated $1.7 trillion in capital was raised during 2018), and plays an important role in other federal and state securities law contexts.
The proposals, which are discussed more fully below, will remain open for public comment for a period of 60 days following their publication in the Federal Register.
Professional Certifications and Designations
The proposal would add new categories to the definition of "accredited investor" that would permit natural persons to qualify as accredited investors based on certain professional certifications and designations, such as a Series 7, Series 65 or Series 82 license, or other credentials issued by an accredited educational institution that the SEC designates from time to time as meeting specified criteria. In the proposing release, the SEC stated that it would consider the following non-exclusive list of attributes when determining which professional certifications and designations or other credentials qualify for accredited investor status:
- the certification, designation or credential arises out of an examination or series of examinations administered by a self-regulatory organization or other industry body or is issued by an accredited educational institution;
- the examination or series of examinations is designed to reliably and validly demonstrate an individual's comprehension and sophistication in the areas of securities and investing;
- persons obtaining such certification, designation or credential can reasonably be expected to have sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of a prospective investment; and
- an indication that an individual holds the certification or designation is made publicly available by the relevant self-regulatory organization or other industry body.
Currently natural persons may only qualify as accredited investors if they (either individually or together with their spouse) meet certain specified income or net worth standards, or if they serve as a director, executive officer or general partner of the issuer of the applicable securities (or a general partner of the issuer of such securities).
With respect to investments by a natural person in a private fund, the proposal would add a new category of accredited investor based on the person's status as a "knowledgeable employee" of the fund in which such person is making an investment. The SEC stated in the proposing release that it believes "that such employees, through their knowledge and active participation of the investment activities of the private fund, are likely to be financially sophisticated and capable of fending for themselves in evaluating investments in such private funds."
The term "knowledgeable employee" is defined in Rule 3c-5(a)(4) under the Investment Company Act of 1940 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 (as defined in Rule 3c-5(a)(1) of the Investment Company Act) of the private fund; and (ii) an employee of the private fund or an affiliated management person of the private fund (other than an employee performing solely clerical, secretarial or administrative functions with regard to such company or its investments) who, in connection with his or her regular functions or duties, participates 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, provided that such employee has been performing such functions and duties for or on behalf of the private fund or the affiliated management person of the private fund, or substantially similar functions or duties for or on behalf of another company for at least 12 months.
The SEC noted in the proposing release that an additional benefit of amending the accredited investor definition as described above would be to allow knowledgeable employees to invest in small private funds with assets of $5 million or less (which funds would not qualify as accredited investors unless all of their equity owners are accredited investors) without jeopardizing the qualification of such funds as accredited investors under Rule 501(a)(8).
LLCs / Registered Investment Advisers / RBICs
The proposal would add limited liability companies that have total assets in excess of $5 million and that were not formed for the specific purpose of acquiring the securities being offered to the list of entities that qualify as "accredited investors" pursuant to Rule 501(a) of the Securities Act. The proposal would also revise Rule 501(a)(1) of the Securities Act to add investment advisers that are registered under Section 203 of the Investment Advisers Act of 1940 and investment advisers registered under the laws of the various states, as well as rural business investment companies ("RBICs"), as accredited investors.
The proposal would add a new category of "accredited investor" for any entity, including but not limited to Indian tribes, labor unions and governmental bodies and funds, that are not specifically listed elsewhere in the definition of "accredited investor", that owns "investments" (rather than assets) in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered. In the proposing release, the SEC stated its belief that "an investments test may be more likely than an assets-based test to serve as a reliable method for ascertaining whether an entity is likely to require the protections of Securities Act registration." The term "investments" is as defined in Rule 2a51-1(b) under the Investment Company Act, and includes securities, real estate commodity interests, physical commodities, non-security financial contracts held for investment purposes and cash (or cash equivalents).
The proposal would add new Rules 501(a)(12) and 501(a)(13) to the Securities Act. These new rules would add "family offices" with at least $5 million in assets under management and their "family clients" (each as defined in the SEC's family office rule) within the categories of "accredited investors". The proposed definition would apply only to a family office whose purchase 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 family office must not be formed for the specific purpose of acquiring the securities offered, and the family client must be a family client of a family office that meets these requirements.
Under current Rule 501(a)(5), a natural person would qualify as an accredited investor if the net worth of such person (or the joint net worth of such person and such person's spouse) exceeds $1 million. A natural person would also qualify as an accredited investor under Rule 501(a)(6) if such person had individual income in excess of $200,000 in each of the two most recent years or joint income with such person's spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.
The proposal would add the term "spousal equivalent" to the accredited investor definition, so that spousal equivalents, rather than the more limiting term "spouses", may pool their finances for the purpose of qualifying as accredited investors. The SEC also clarified that the securities being purchased by an investor relying on the joint net worth test need not be purchased jointly.
A "spousal equivalent" would be defined as a cohabitant occupying a relationship generally equivalent to that of a spouse.
"Qualified Institutional Buyer"
The proposed amendments would modify the definition of "qualified institutional buyer" ("QIB") in Rule 144A to add limited liability companies and RBICs to the types of entities that are eligible for QIB status if they meet the $100 million in securities owned and invested threshold in the definition. In a further attempt to avoid inconsistencies between the types of entities that are eligible for accredited investor status and those that are eligible for QIB status, the proposal would also add a "catch-all" category that would permit institutional accredited investors under Rule 501(a), of an entity type not already included in the QIB definition, to qualify as QIBs when they satisfy the $100 million threshold.
No Change to Dollar Thresholds
Although the SEC acknowledged the substantial increase since the current thresholds were established in 1982 in the number of households (both on an absolute and a percentage basis) that qualify as accredited investors based on the income and net worth tests set forth in Rule 501(a), the SEC did not recommend that such financial thresholds be increased at this time. However, the SEC requested further comment on possible approaches to adjusting these financial thresholds, as it evaluates the need for potential rulemaking in this area down the road.
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