Introduction
On August 26th, 2020, the U.S. Securities and Exchange Commission (“SEC”) amended its definition of “accredited investor” to include additional categories of individuals and entities that would qualify to invest in certain private offerings exempted from registration under the Securities Act of 1933 (the “Securities Act”).
According to the SEC, this amendment (along with others, including amendment to the definition of “qualified institutional buyer” not discussed in this article) is part of a broader effort to simplify and improve private offering regulations under the Securities Act to promote capital raising and expand investment opportunities, all while maintaining appropriate investor protections.
Significance
Certain securities offerings are exempt from the rigorous disclosure, procedural and filing requirements provided under the Securities Act. These so-called “exempt offerings” (which includes but is sometime synonymous with “private offerings”) are the primary means through which most companies raise money.
As estimated by the SEC, in 2019, registered offerings (which includes IPOs) accounted for $1.2 trillion (30.8%) of new capital raised. This is compared to approximately $2.7 trillion (69.2%) of new capital raised through exempt offerings in 2019. Of the exempt offerings, the two primary methods of raising capital was through Rule 506(b) and Rule 506(c) of Regulation D (collectively, “Rule 506”), which accounted for $1.56 trillion (~57.78%) of all exempt offerings in 2019.
As the SEC points out, the definition of “accredited investor” is a “central component” of the Rule 506 exemptions from registration and also plays an important role in other federal exemptions (like Regulation A offerings) and state securities exemptions.
Qualifying as an “accredited investor” would permit an individual, institution or entity to participate in investment opportunities (often conducted through Rule 506 exempted offerings) not otherwise available to non-accredited investors, including investments in private companies, hedge funds, real estate investment funds, token offerings, private equity funds and venture capital funds.
Thus, the expanded definition of “accredited investor” could create new opportunities for both companies seeking to raise capital and investors. For companies, an expanded accredited investor definition creates new capital sources and could likely reduce the cost of finding new investors and verifying accredited investor status, as well as reduce reliance on intermediaries. For many investors, an expanded definition will open new investment opportunities not previously available. Additionally, qualifying as an accredited investor will permit an investor to participate at a higher amount in Regulation A offerings since accredited investors are not subject to investment limits under Regulation A.
Amendment
At its heart, the recent amendment to the definition of “accredited investor” aims to better identify investors who have sufficient knowledge and expertise to participate in private investment opportunities—based on factors apart from their wealth and income.
Additional Categories of Individuals Qualifying as “Accredited Investors”
The SEC has recognized that individuals’ wealth should no longer be the sole means of establishing their ability to participate in exempt offerings. Rather, financial sophistication should be determined by their ability to assess an investment opportunity and bear the risk of a loss. Accordingly, the SEC has added a new category to the accredited investor definition in Rule 501(a)—those natural persons “holding in good standing one or more professional certifications or designations or other credentials from an accredited educational institution that the SEC has designated as qualifying an individual for accredited investor status.” The amendment included a non-exclusive list of factors the SEC would consider in determining which certifications, designations, and credentials qualify:
- 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.
In a concurrent order, the SEC designated FINRA’s Series 7, Series 65 and Series 82 licenses as the initial certifications, designations, or credentials under the new definition. Although the public will retain the right to receive notice and comment on any future qualifications, leaving this to SEC order gives the agency flexibility to change this class as necessary.
Additionally, “knowledgeable employees” of private funds, as defined in Rule 3c-5(a)(4) under the Investment Company Act, now qualify as accredited investors in that fund. Similar to the existing category of directors, executive officers, and general partners of an issuer, this new class includes, among others, “trustees and advisory board members, or persons serving in a similar capacity, of a Section 3(c)(1) or 3(c)(7) fund or an affiliated person of the fund that oversees the fund’s investments, as well as employees of the private fund or the affiliated person of the fund (other than employees performing solely clerical, secretarial, or administrative functions) who, in connection with the employees’ regular functions or duties, have participated in the investment activities of such private fund for at least 12 months.”
However, the SEC did leave the existing wealth and income thresholds for individuals in unchanged, although individuals are now allowed to pool joint income from a “spousal equivalent” when calculating joint income or net worth. A spousal equivalent is a cohabitant occupying a relationship generally equivalent to that of a spouse—a definition that mirrors Regulation Crowdfunding and the Advisers Act to promote consistency with existing rules. The SEC noted that these assets do not need to be acquired jointly.
Additional Categories of Entities Qualifying as “Accredited Investors”
To accommodate certain entities that either did not exist or were not popular when Regulation D was adopted, the SEC expanded the accredited investor definition by including SEC- and state-registered investment advisers, rural business investment companies (RBICs), and LLCs holding over $5 million in assets. The SEC also created a catch-all group of entities, including Indian tribes, labor unions, governmental bodies and funds, and entities organized under the laws of a foreign country, owning “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million and not formed simply to obtain the offered securities.
The SEC further added a new category of accredited investors—certain “family offices” and “family clients of family offices.” Family offices are those entities “established by families to manage their assets, plan for their families’ financial future, and provide other services to family members.” To qualify as an accredited investor, the family office must:
- Have at least $5 million in assets under management;
- Not be formed for the specific purpose of acquiring the securities offered; and
- Have its prospective investment 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
Implications for Companies and Next Steps
As an attempt to expand market access to exempt offerings, the SEC’s move away from wealth and income-based thresholds for individual investors, expansion of the number of entities that qualify as accredited investors, and goal of consistency in the regulations may all be steps in the right direction. But at the same time, the SEC repeatedly notes the real possibility that many individual and entity investors that will meet the new categories may already be considered accredited investors under the existing definition. Ultimately, it remains to be seen whether these amendments have the effects the SEC intends.
In the meantime, however, these amendments will likely have real implications for the way many companies raise capital. Assuming that the revised definition would capture many individual and entity investors who previously did not qualify as accredited investors, then issuers—particularly emerging companies without a robust network of high income or net-worth investors—may now find Rule 506 Regulation D offerings even more attractive than other exempt offerings like Regulation CF, Regulation A and Rule 504 offerings. The changes in the definition may also make it easier for issuers to verify accredited investor status as required under Rule 506(c) offerings since now in addition to reviewing tax returns and financial statements, issuers could also for some individuals rely on proof of certifications, licenses and credentials that would satisfy the new accredited investor definition.
In any case, companies can begin to prepare for the upcoming changes, which come into effect 60 days after they are published in the federal registrar, in a couple of ways. First, companies should review and amend any offering document forms, such as investor questionnaires or recordkeeping efforts, to adjust to the new definitions. Second, companies can start thinking about potential investors in their networks that would now qualify as accredited investors. In all, clients should carefully consider whether the amendments provide better opportunities to raise capital and consult with their legal counsel if they have questions about updating their documents or strategy.
DISCLAIMER: The subject matter discussed above is constantly evolving and may change on a frequent basis. The information contained in this post is for general education and informational purposes only. It should not be construed as legal advice or as creating an attorney-client relationship between the reader and TKN Law.
