On August 26, 2020, the Securities and Exchange Commission (the “SEC”) adopted amendments to the “accredited investor” definition under the U.S. securities laws. Status as an accredited investor is one of the principal tests for determining who is eligible to invest in private offerings. The amendments broaden the category of people who may participate in those investments, which are not registered with the SEC. The amendments also update the “qualified institutional buyer,” or “QIB,” definition applicable to Rule 144A offerings to include certain other institutional accredited investors not specifically enumerated in the existing definition.
The amendments are intended to update and improve the definitions to identify more effectively individual and institutional investors that have sufficient knowledge and expertise to participate in investment opportunities that do not have the rigorous disclosure and procedural requirements, and related investor protections, provided by registration under the Securities Act of 1933, as amended (the “Securities Act”). The amendments are part of the SEC’s broader effort to improve the exempt offering framework under the Securities Act to promote capital formation and expand investment opportunities while maintaining and enhancing appropriate investor protections.
Accredited Investor Definition
Under Section 5 of the Securities Act, absent an exemption, securities cannot be sold unless an effective registration statement with the SEC is in place (for example, an IPO is made pursuant to an effective registration statement). Section 4(a)(2) of the Securities Act provides an exemption from the registration requirements for private offerings. Regulation D under the Securities Act provides a set of safe harbors for limited offers and sales of securities without registration. Historically, most private offerings, including venture capital financings, have been made under Regulation D, which requires, among other things, that investors (some or all investors, depending on the rule applicable to the specific financing) purchasing securities in the offering are “accredited investors,” as defined in Rule 501(a) of the Securities Act.
Historically, the test for whether a proposed individual purchaser was an “accredited investor” under Rule 501(a) focused on specific income or net worth tests. To qualify as an accredited investor, an individual needed to have a net worth of at least $1 million excluding the value of their primary residence, or an annual income of at least $200,000 for the last two years (or a combined $300,000 for married couples). Individuals not meeting these tests were not considered accredited investors, limiting their ability to invest in private offerings.
The rules were intended to protect investors from risks that could result from the dearth of information about private companies and private funds and lack of regulatory oversight of private offerings. The SEC deemed accredited investors to be sophisticated enough to evaluate the higher risks of investing in a speculative, private company or private fund, and wealthy enough to bear potential losses, including a total loss of their investment. However, one of the consequences of using these wealth and income tests to determine who was “accredited” has been that many individual investors have been excluded from the opportunity to invest in private offerings, regardless of their financial sophistication. Many believe that, at a time when greater access to private markets for more investors is important to meet the growing needs for private businesses to raise capital, financial sophistication itself should be a significant factor in determining accredited investor status. SEC Chairman Jay Clayton acknowledged as much in his statement regarding the amendments:
The Commission’s use of income or wealth as the exclusive proxy for an individual’s financial sophistication and ability to assess and bear risk has long been unsatisfactory. Individual investors who do not meet the wealth tests, but who clearly are financially sophisticated enough to understand the risks of participating in unregistered offerings, are denied the opportunity to invest in our private markets.1
Mr. Clayton went further to describe the negative impact of the current accredited investor definition on businesses’ ability to raise needed capital, noting that an exclusive income, wealth or asset requirement for “accredited investor” status limits access to capital for businesses who are located in less affluent areas or do not have a wealthy network and disproportionally adversely affects underrepresented businesses, such as those owned by minorities and women:
Moreover, businesses – particularly smaller and early stage businesses, those in geographic areas with lower concentrations of accredited investors, or founders without a wealthy friends-and-family network – are unable to seek investments from otherwise financially sophisticated individuals to access much needed seed and growth capital. When small and medium-sized businesses often, and increasingly, rely on local sources of capital, particularly at the seed and initial growth stages, these restrictions are limiting and almost certainly stifle opportunity. It has been noted that these wealth-based limits on opportunity can have a disproportionate impact on minority- and women-owned businesses and other underrepresented founders.2
The amendments expand the definition of accredited investor to include an alternative to the wealth or income test for natural persons who qualify as accredited investors based on defined measures of professional knowledge, experience or certifications — specifically, persons who hold certain professional certifications and designations and other credentials from accredited educational institutions. Clayton explained the reasoning for adding financial sophistication to the accredited investor definition simply:
There is no doubt persons who have successfully obtained these certifications––and maintained them in good standing––are sufficiently financially sophisticated to participate in the private markets.3
The amendments also expand the list of entities that may qualify as accredited investors, including by allowing any entity that meets an investments test to qualify.
Highlights of the Amendments to the Accredited Investor Definition
The amendments to the accredited investor definition in Rule 501(a):
- add a new category that permits natural persons to qualify as accredited investors based on certain professional certifications, designations or credentials or other credentials issued by an accredited educational institution, which the SEC may designate from time to time by order. In adopting the amendments, the SEC designated holders in good standing of the Series 7, Series 65, and Series 82 licenses as qualifying natural persons. Importantly, the SEC noted its ability to reevaluate or add certifications, designations, or credentials in the future, and invited the public to propose for the SEC’s consideration additional certifications, designations or credentials that satisfy the attributes set out in the new rule;
- include as accredited investors, with respect to investments in a private fund, natural persons who are “knowledgeable employees” (e.g., an executive officer or certain investment personnel) of the fund;
- clarify that limited liability companies with $5 million in assets may be accredited investors and add SEC- and state-registered investment advisers, exempt reporting advisers, and rural business investment companies (“RBICs”) to the list of entities that may qualify;
- add a new category for any entity, including Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries, that own “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act of 1940, as amended, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered;
- add “family offices” with at least $5 million in assets under management and their “family clients,” as each term is defined under the Investment Advisers Act of 1940, as amended; and
- add the term “spousal equivalent” to the existing accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors under the net worth test.
The new catch-all category in the accredited investor definition for any entity with at least $5 million of investments will be beneficial to private funds and private companies seeking prospective investors that are sophisticated institutional investors (e.g., certain U.S. governmental bodies and funds, non-U.S. pension plans and sovereign wealth funds) but do not fall within any of the enumerated categories of accredited investors.
Qualified Institutional Buyer Definition
Additionally, the SEC updated the “qualified institutional buyer” definition applicable to Rule 144A offerings to include other institutional accredited investors not specifically enumerated in the existing definition that satisfy the threshold of owning and investing on a discretionary basis at least $100 million in securities of non-affiliated issuers. Rule 144A is an exemption from the registration requirements of Section 5 of the Securities Act for certain offers and sales of qualifying securities by certain persons other than the issuer of the securities. The exemption applies to resales of securities to qualified institutional buyers, who are commonly referred to as “QIBs.”
Rule 144A offerings include offerings of debt or preferred securities by public companies, offerings by foreign issuers that do not want to become subject to U.S. reporting requirements, and offerings of common securities by non-reporting issuers (also referred to as “backdoor IPOs”).
Summary of the Amendments to the QIB Definition
The amendments expand the definition of QIB in Rule 144A to include limited liability companies and RBICs if they meet the $100 million in securities owned and invested threshold in the definition. The amendments also add to the list any institutional investors included in the accredited investor definition that are not otherwise enumerated in the QIB definition, provided they satisfy the $100 million threshold. The amendments to the QIB definition remove longstanding uncertainty among certain large governmental investors that do not fit into any of the types of entities listed in the current “qualified institutional buyer” definition, despite meeting or far exceeding the $100 million threshold. As a result of these changes, governmental investors will now have expanded access to the Rule 144A commercial paper and bond markets, which will help diversify their investment portfolios and potentially enhance risk-adjusted returns.
Potential for Future Expansion of Access to Private Offerings and Private Capital
While the amendments received general support during the public comment period as a long overdue expansion, they are not seen as broadly growing the category of individuals who can participate in private markets. The SEC acknowledged as much in the adopting release:
(1) [W]e do not expect that number of newly eligible individual accredited investors to be significant compared to the number of individual investors that currently are eligible to participate in private offerings, and (2) we expect the amount of capital invested by such newly eligible individual investors to have minimal effects on the private offering market generally.4
For example, the amendments add individuals who are licensed to sell securities such as investment advisers (and who otherwise did not previously qualify as accredited investors) but continue to exclude their clients. In addition, other individuals who have sophisticated knowledge, experience or qualifications such as chartered financial analysts, chartered alternative investment analysts and certified public accountants are not yet included in the list.
Even if the list of those deemed by the SEC to be sufficiently sophisticated is currently small, the expansion of the accredited investor definition to add individual investors who do not meet the accredited investor income or asset tests, but who the SEC has deemed to have the financial sophistication to understand the risks of participating in unregistered offerings is significant. That is because potentially the most important part of these amendments is the SEC’s ability to reevaluate or add certifications, designations, or credentials in the future, and their invitation to the public to propose for the SEC’s consideration additional certifications, designations or credentials that satisfy the attributes set out in the new rule.
This flexibility and willingness of the SEC to consider proposals for further expansion of the category of sophisticated individuals based on the framework of professional knowledge, experience or certifications — and specifically, persons who hold certain professional certifications and designations and other credentials from accredited educational institutions – provides a basis for further expansion of the accredited investor pool. Expansion of the accredited investor pool in this way would help level the playing field for individual investors and help more investors access the private markets and help private funds and private company issuers find more sources of capital.
The amendments and order become effective 60 days after publication in the Federal Register. The SEC has invited the public to propose for the SEC’s consideration additional certifications, designations or credentials that satisfy the attributes set out in the new rule.
1SEC Chairman Jay Clayton, Statement on Modernization of the Accredited Investor Definition, August 26, 2020. https://www.sec.gov/news/public-statement/clayton-accredited-investor-2020-08-26
2Clayton, Statement on Modernization of the Accredited Investor Definition.
3Clayton, Statement on Modernization of the Accredited Investor Definition.
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