The Securities and Exchange Commission recently proposed amendments to the definition of “accredited investor” under Regulation D of the Securities Act of 1933, which, if adopted, would expand the categories of individual and entity investors in private securities offerings, including offerings under Rules 506(b) and 506(c) of Regulation D and other federal and state securities law exemptions. Broadly speaking, the proposal would expand the number of natural person investors who qualify by adding categories of eligibility based on professional knowledge, experience or certifications. For entities, the proposal also would expand the types of entities that qualify as “accredited investors.” This is significant, because when an issuer is able to offer and sell securities to accredited investors, it is able to avail itself of one or more of these exemptions from the registration or qualification requirements of the Securities Act and state laws. These proposed rules would expand the pool of potential investors for startups and emerging growth companies.
SEC’s Authority to Amend the “Accredited Investor” Definition
The requirements to be considered an accredited investor were established by the SEC to provide investor protection in private offerings, and those requirements have not been changed significantly since 1985. The SEC has authority under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 to periodically review, analyze and gather data related to accredited investor protection and under the Securities Act to expand the definition of “accredited investor” based on several factors, including financial sophistication, knowledge and experience in financial matters. The current proposal comes after the SEC published its analysis and review of the current definition in December 2015. This report examined the history and framework for the “accredited investor” definition and, as is custom, sought public comment on ways to harmonize greater access for investors to invest in private offerings. Ultimately, the report concluded that revisions were needed to the definition of “accredited investor” based on other indications of sophistication outside of financial requirements.
Expanded Definition for Individual Investors
It is reasonably understood that an individual who is financially sophisticated has enough assets and has the capacity to protect her own interests in connection with an investment transaction, can fend for herself, and thus does not need the same level of protection as a person who is unsophisticated or below a certain level of wealth. Based on this notion, the SEC has proposed the following changes for natural person investors:
Professional Certifications, Designation or Credentials
The SEC considered several factors to determine what modification would best provide access for potential investors to invest in private offerings, including (1) the ability to evaluate an investment opportunity, (2) the capacity to allocate investments in such a way as to mitigate or avoid risks of unsustainable loss, (3) the ability to scrutinize the risks and rewards, and (4) the ability to gain access to information about an issuer or about an investment opportunity.
As proposed, the amendment expands the “accredited investor” definition to individuals who possess, in good standing, professional credentials, certifications or designations which demonstrate a knowledge and understanding of securities and investments. These individuals may include licensed securities representatives and financial advisors who are licensed under the Financial Industry Regulatory Authority.
- The proposed amendment adds “knowledgeable employees” of private funds, including hedge funds and venture capital funds, who invest in private funds as accredited investors.
- “Knowledgeable employees” of private funds include the general partners, trustees, advisory board members, directors and officers or other persons serving in similar capacity who have participated in the investment activities of such private fund for at least 12 months.
Additionally, the SEC has asked for comments to determine if managers of limited liability company issuers should specifically be listed as qualifying individuals because of their relationship with, and access to information about, the issuer. The SEC’s current opinion is to not amend the definition of “executive officer” under Rule 501(a)(4) or 501(f) to specifically list managers of issuing limited liability companies, as the current definition has been interpreted to include individuals who perform similar policy-making functions for the issuer.
Rule 501(a) of the Securities Act enumerates the types of entities which can currently qualify as accredited investors. However, the enumerated list is not reflective of the evolving federal and state law developments in terms of the types of entities since the adoption of Regulation D. As a result, the SEC has proposed adding several types of entities to the list of entities that qualify as accredited investors.
- The SEC proposes including investment advisors who are registered under state law or under Section 203 of the Investment Advisors Act of 1940 to the list of accredited entities under Rule 501(a).
- The proposed amendment also adds RBICs as defined in Section 384A of the Consolidated Farm and Rural Development Act as an accredited entity.
The SEC has proposed adding “family offices and their family clients” with at least $5,000,000 in assets under management within the definition of “accredited investor.” Family offices are typically private entities established for wealth and investment management for families. This type of entity would be added to the definition so long as the person directing the investment has knowledge and experience in financial and business matters.
Entities which manage assets in excess of $5,000,000 and which were not established solely for the purpose of investing in securities, including governmental organizations, Indian tribes and foreign entities, would be added to the list entities qualifying as accredited investors under the new amendments.
The SEC provides compliance and disclosure interpretation of the Securities Act and its rules, and issues FAQs and no-action letters which reflect the views of the staff. Although they are not actual rules or regulations, this interpretive guidance is useful to many practitioners who look to them for guidance. The SEC has proposed to codify some of the established staff interpretations relating to the “accredited investor” definition, including:
- Adding limited liability companies that are not formed for the specific purpose of acquiring the securities offered and with total assets in excess of $5,000,000;
- Adding comments to Rule 501(a)(8) which would allow issuers to look through the various forms of equity ownership to natural persons in determining accreditation;
- Specifying that securities being purchased by investors who qualify under the joint net worth test do not need to be purchased jointly; and
- Allowing spousal equivalents to pool finances together for purposes of qualifying as accredited investors. The proposed amendments would define “spousal equivalent” as cohabitants occupying a relationship generally equivalent to that of a spouse.
The SEC has also proposed expanding the list of entities to which a security holder can resell securities without registering under Rule 144A. The current regulations allow resale without registration to “qualified institutional buyers” or “QIBS.” These amendments would include the resale of unregistered securities to limited liability companies and Rural Business Investment Companies.
The SEC is currently soliciting comments on the proposed amendments for a 60-day period from the date of publication in the Federal Register, which will expire on February 16, 2020. More information about comments can be found on the SEC website. The definition of “accredited investor” is the lynchpin for most private offerings of securities, and these proposed rules will have practical and broad-reaching impacts on companies.