On August 26, 2020, the U.S. Securities and Exchange Commission, or the SEC, approved long-awaited amendments to the definition of “accredited investor” that may both increase the avenues through which companies can raise funds and afford many more persons access to the private markets. These amendments only create new categories of accredited investor and do not eliminate from the definition anyone currently qualifying as an accredited investor.
The vast majority of U.S. private placements are effected through Rule 506 under the Securities Act of 1933, as amended, or the Securities Act. The traditional private placement exemption, Rule 506(b), at a high level prohibits general advertising or general solicitation of the offering, imposes restrictions on subsequent transfer of the securities, disqualifies certain issuers associated with bad actors and limits the sale of the securities only to “accredited investors” and, if extensive disclosure requirements are met, up to 35 non-accredited investors. More recently, the SEC adopted Rule 506(c), which permits advertising and solicitation, but requires that all investors be accredited investors and that the issuer use reasonable means to verify that accredited investor status.
An increase in the number of accredited investors, among other things: provides greater options for startups and emerging companies to get financing; increases the number of investors, including retail investors, who can invest in private markets; gives fund managers more options for compensating junior professionals; and gives issuers, brokers and crowdfunding platforms using Rule 506(c) additional, and potentially easier, ways to verify accredited investor status. The new types of accredited investor, and the potential impact of these new types on future capital raising, are described in further detail below.
Accredited Investor – The Current Definition
While there are many categories of accredited investor under the present definition, the vast majority of accredited investors fall into one of the following five categories:
- any 501(c)(3), corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;
- any natural person whose individual net worth, or joint net worth with that person's spouse, exceeds $1,000,000 (excluding primary residence and mortgage thereon, except to the extent the mortgage is underwater or a hold equity line was taken out in the prior 60 days);
- any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that 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;
- any director, executive officer or general partner of the issuer of the securities being offered or sold, or any director, executive officer or general partner of a general partner of that issuer; and
- any entity in which all of the equity owners are accredited investors.
In addition, the current definition of accredited investor includes trusts with assets of greater than $5,000,000 that were nor formed for the purpose of acquiring securities that are directed by sophisticated persons, a number of different types of regulated entities and certain employee benefit plans. Per the release, the definition is “intended to encompass those persons whose financial sophistication and ability to sustain the risk of loss of investment or fend for themselves render the protections of the Securities Act’s registration process unnecessary.”
The accredited investor definition also tracks through a number of other laws and regulations. For example, one of the most common commodity pool operator exemptions for fund managers requires that all investors be accredited investors. In addition, Section 4(a)(7) of the Securities Act requires that the purchaser be an accredited investor in resale transactions relying on that exemption. Conforming changes were also made to the definition of “qualified institutional buyer” – the type of investor, typically investing at least $100 million in securities, that may purchase securities in institutional resales under Rule 144A of the Securities Act.
Below we outline the new exemptions as well as some of the classes of investor that may benefit most from these amendments.
New Categories of Accredited Investor and Potential Impacts
Knowledgeable Employees of Funds
What it is – Two of the primary exceptions used by funds so that they do not need to register under the Investment Company Act of 1940, as amended – the ‘100 and fewer beneficial owners’ exception and the ‘all qualified purchasers’ exception – have long permitted additional investments by “knowledgeable employees” of the manager of the fund. A knowledgeable employee includes (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; 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. While an extensive facts and circumstances analysis in consultation with counsel should be performed, this is much broader than the definition of “executive officer” of an issuer.
Major effect – Private fund managers will be able to permit more junior investment professionals to purchase interests in funds that they are helping to manage. It might also give venture capital operating partners the opportunity to invest, as well as those whose income has recently increased but might not meet the net worth standard due to market fluctuations or other extenuating circumstances. This might also give these persons the ability to purchase secondary shares under Section 4(a)(7) of the Securities Act. In some instances, persons affiliated with a venture capital or private equity sponsor may qualify for this categorization even if they couldn’t qualify for status as a director, executive officer or general partner.
Professionals With Certifications or Credentials
What it is – Individuals who hold certain professional certifications and designations or other credentials that indicate financial sophistication, which certifications and designations are in good standing, will be accredited investors. The rule permits the SEC to designate credentials that would qualify the holder for accredited investor status. The first three licenses with this status are the Series 7 (general securities representative), Series 82 (securities offerings representative) and Series 65 (licensed investment adviser) FINRA licenses. The SEC will also continue to re-evaluate the subject certifications based on a non-exclusive list of attributes, including who issues the license, whether examinations are required, whether they require financial sophistication to obtain and that holding the license is independently verifiable.
Major effect – Individuals with the professional knowledge base to make investments will be able to make those investments through Rule 506 offerings. A little over 700,000 individuals hold these licenses, although it is impossible to know how many of them already were accredited investors. It will be easier, however, to have their accredited investor status verified for purposes of Rule 506(c) since each of those licenses are easily searchable on FINRA BrokerCheck. This may help streamline the process for issuers that are utilizing general advertising and general solicitation without registration under the Securities Act, as verification of net income and net worth limits can be both burdensome for the issuer and an intrusion on an individual’s finances.
Registered Investment Advisers
What it is – Similar to professionals with credentials, the SEC believes that registered investment advisers, at either the federal or state level, have enough investment acumen to conduct a meaningful analysis about purchasing a security. Federal exempt reporting advisers – private fund advisers and venture capital fund advisers, also would qualify under this prong of the definition.
Major effect – In total, it is estimated that there are about 35,000 firms that would qualify under this prong of the definition. Some registered investment advisers might not have $5 million of assets even if they have far greater than $5 million of assets under management. In addition, for purposes of Rule 506(c), status as a registered investment adviser or exempt reporting adviser is easily verifiable at the Investment Adviser Public Disclosure website.
Family Offices and Family Clients
What it is – Certain “family offices” with assets under management of at least $5 million, along with the family clients of those family offices, would be added to the definition of accredited investor. Its investments must also be directed by a person with such knowledge and experience in financial and business matters that such family office would be capable of evaluating the merits and risks of the prospective investment. “Family office” is defined in the same manner as it is under the Investment Advisers Act and the pending new amendments to the Volcker Rule. Thus, as a general matter it needs to be a single-family office that raises no outside capital where all but a few individuals with longstanding relationships must be lineal descendants of the same person from no more than 10 generations ago.
Major effect – This gives single-family offices and family clients a lot more certainty in investing. Oftentimes members of a single-family office will include minors and other more remote beneficiaries who do not necessarily meet the definition of accredited investor, yet the family office is still investing on their behalves. The amendments give the flexibility for a family office manager to invest funds in a particular investment on a pro rata basis, all the way across the board, without needing to carve out the family clients that don’t themselves meet the net asset or net worth thresholds.
Rural Business Investment Companies
What it is – The Rural Business Development Program works with for-profit developmental capital funds to help meet the equity capital investment needs of rural communities through granting Rural Business Investment Company (RBIC) licenses by the Department of Agriculture.
Major effect – RBICs clearly become accredited investors. The Small Business Administration (SBA) analogue, the Small Business Investment Companies (SBICs), have always been included within the definition of accredited investor. This makes the law internally consistent.
Limited Liability Companies
What it is – The last time the definition of accredited investor was amended, limited liability companies (LLCs) were not a widely-adopted form of entity. Now they are one of the most common forms of entity.
Major effect – Not much. For many years the SEC’s position has been that LLCs are intended to be included in the portion of the definition that includes corporations and partnerships and the like. This codifies their position and eliminates any potential confusion.
Entity Investment Catch-All
What it is – All entities that own greater than $5 million of investments that were not formed for the specific purpose of investing in the offering will be considered accredited investors. While the definition of “investments” is nuanced, it generally includes, among other things, securities, real estate, commodity interests, physical commodities and investment contracts, in each case that is held for investment purposes.
Major effect – Some more esoteric forms of entity never technically fit into the definition of accredited investor. For example, for a state investment fund to clearly be within the definition of accredited investor it would need to be solely for the benefit of employees (i.e., a pension). Most states now have complex investment vehicles that are not solely for the benefit of employees. The California Debt and Investment Advisory Commission even issued advice to state municipal entities that they should not make qualified institutional buyer investments because the risk was too high that they might not be deemed such. Other examples include certain intergovernmental agencies, labor unions, Native American tribes and esoteric non-U.S. forms of entity. It is also intended to capture any new forms of entity that develop in the future. This amendment eliminates all ambiguity that this type of institutional investor is an accredited investor and a qualified institutional buyer if it meets the applicable thresholds and could expand the amount of capital that is available in the private markets. This could also increase the presence of these entities in the 144A resale markets. It is unclear whether this might cover enterprises that technically are not entities, such as contractual joint ventures or decentralized autonomous organizations (DAOs).
These amendments go effective 60 days after publication on the Federal Register, meaning they will be effective at the end of October or in early November.