On December 18, the U.S. Securities and Exchange Commission (“SEC”) issued a proposal to update the definition of “accredited investor” pursuant to Rule 506 of Regulation D under the Securities Act of 1933 (“Securities Act”) and the definition of “qualified institutional buyer” in Rule 144A under the Securities Act. If approved, this would mark the first update to the definition of “accredited investor” since the SEC’s adoption of Regulation D in 1983.
“Accredited Investors” and Why They Matter
The expanded definition of “accredited investor” could have significant impacts on those issuers who wish to privately place securities under Rule 506 of Regulation D under the Securities Act, which is the most commonly used exemption from the registration requirements of the Securities Act. In order to qualify for the Rule 506 safe harbor, among other things, an issuer must sell securities only to accredited investors and, in very limited circumstances, up to 35 non-accredited investors.
As currently defined, an “accredited investor” includes:
- Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his or her purchase exceeds $1,000,000 (excluding for this purpose the value of such person’s primary residence, calculated by subtracting from the estimated fair market value of the property the amount of debt secured by the property, up to the estimated fair market value of the property).
- 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, in each case, has a reasonable expectation of reaching the same income level in the current year.
- Any organization described in section 501(c)(3) of the Internal Revenue Code, corporation, business trust or partnership, in each case not formed for the specific purpose of acquiring the Interests, with total assets in excess of $5,000,000.
- Regulated banks, savings and loan associations, brokers, dealers, insurance companies, registered investment companies, small business development companies (SBICs), business development companies (BDCs) and private business development companies.
- State pension plans with total assets in excess of $5,000,000 solely for the benefit of its employees and certain ERISA benefit plans with total assets in excess of $5,000,000.
- Any director, general partner or executive officer of an issuer (or its general partner).
- Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person as described in Rule 506(b)(2)(ii) under the Securities Act.
- Any entity in which all of the equity owners are accredited investors. This may include entities with less than $5,000,000 in assets or entities created specifically for the purpose of acquiring the securities, so long as all of the equity owners of that entity are accredited investors.
The SEC Chairperson, Jay Clayton, notes in a released statement that the current definition of “accredited investor” applies a “binary approach” to determine which individuals qualify for accredited status: they either have a net worth high enough or they make enough money to qualify.
Expanding the Definition of “Accredited Investors”
As proposed, the revised definition of “accredited investor” would close a number of existing gaps and expand the definition to permit additional individuals and entities to invest based on professional knowledge, experience or certifications. These proposed expansions are intended to allow greater access to and higher participation in our private capital markets, lowering the barriers to entry and decreasing requirements for registration and filing which may deter private investments. The new definition would include the following as “accredited investors”:
- Any natural person with a general securities representative (Series 7), investment adviser representative (Series 65) or private securities offerings representative (Series 82) license or certain other accreditation as may be determined by the SEC in the future.
- Any person who is a “knowledgeable employee” of a private fund, so long as that person is investing in said fund. As proposed, this definition is the same as a “knowledgeable employee” that would be a “qualified purchaser” for purposes of Section 3(c)(7) under the Investment Company Act of 1940. This would not, however, make such a knowledgeable employee of a fund an accredited investor with respect to a portfolio company in which the fund invests.
- Any limited liability company, which codifies a long-standing position of the SEC staff.
- Any registered investment advisers; this would not include “exempt reporting advisers” relying on the venture capital adviser exemption or the private funds adviser exemption.
- Any rural business investment companies (“RBICs”).
- Any “family offices” with at least $5 million in assets under management, as well as their “family clients.” This terminology matches up with the definitions used in the single family office exception from the Investment Advisers Act of 1940.
- Any entity owning “investments” in excess of $5 million, so long as the “investments” fit the definition supplied in Rule 2a51-1(b) of the Investment Company Act and so long as the entity was not formed for the specific purpose of investing in the securities offered. This would have the potential to close up a number of current gaps in the definition of “accredited investor,” such as Native American tribes, foreign sovereign wealth funds, foreign entities without a U.S. corporate analogue and state plans that are not solely for the benefit of employees.
Additionally, the proposed expansion would add spousal equivalents along with legal spouses, making it possible for domestic partners or any other individuals in a relationship which parallels a spousal relationship to pool their finances in order to meet the net worth or income to qualify as accredited investors. Notably, the proposal would not increase any thresholds for accredited investor status to account for inflation.
The New Qualified Institutional Buyers
The expanded definitions also contain adjustments to the meaning of “qualified institutional buyer” as it relates to Rule 144A of the Securities Act. Rule 144A excludes non-issuer sellers of securities from being deemed underwriters under the Securities Act so long as the purchasers are qualified institutional buyers and other informational and disclosure requirements are met.
If the proposed amendment were to be put into place, the definition of qualified institutional buyer would be expanded to include limited liability companies and RBICs, so long as they own at least $100 million in securities and meet the investment threshold set forth in the original definition and would add a catch-all provision covering institutional accredited investors of any other entity type owning at least $100 million in securities.
If approved as proposed, this would eliminate significant uncertainty for certain classes of institutional investors. For example, certain states consider their plans and wealth funds to not be accredited investors or qualified institutional buyers unless those plans or funds are solely for the benefit of employees. This has precluded many ultra-sophisticated investors from making investments into asset classes in which major institutions typically would participate.