On December 18, 2019, the Securities and Exchange Commission (SEC) issued a proposed rule – “Amending the ‘Accredited Investor’ Definition” (the Proposed Rule) – that would expand access to private funds for certain individuals and entities. Specifically, the Proposed Rule would extend the definition of an “accredited investor” to include several new categories of investors, which would allow those investors greater access to invest in private funds. The Proposed Rule also would expand the definition of a “qualified institutional buyer” to include additional entities, which would allow private funds to access a greater number of investors. The Proposed Rule is a continuation of SEC’s multi-year effort to modernize the framework for exempt offerings and responds to comments the SEC solicited in June when it released the “Concept Release on Harmonization of Securities Offering Exemptions” (the Concept Release).1 The SEC has indicated that the goal of these modernizations is to promote capital formation while maintaining adequate investor protections.
Accredited Investor Definition
Most private funds offer unregistered securities to investors pursuant to an exemption provided under Regulation D of the Securities Act of 1933, as amended (the Securities Act). Regulation D generally exempts non-public securities offerings from registration under the Securities Act, provided that the securities are offered only to certain financially sophisticated investors, including “accredited investors.” An investor currently qualifies as an accredited investor if, among other things, the investor:
- Relationship to the Fund – Is a director, executive officer, or general partner of either the issuer of the securities or the general partner of the issuer of the securities;
- Net Worth – Has, individually or jointly with such investor’s spouse, a net worth that exceeds $1 million (with certain exclusions);2
- Income – Had income in excess of $200,000, or joint income with that person’s spouse in excess of $300,000, in each of the two most recent years, and has a reasonable expectation of reaching the same income level in the current year; and
- Financial Institution or Fund – Is a sophisticated financial institution or investment company, including a bank, savings and loans association, registered broker or dealer, insurance company, registered investment company, business development company (BDC), small business investment company (SBIC), certain other entities (501(c)(3) organizations, trusts, and certain employee benefit plans) with total assets in excess of $5 million, certain other employee benefits plans, and any entity in which all of the equity owners are accredited investors.
The Proposed Rule would add several new categories of individuals and entities that would qualify as “accredited investors.”
Professional Certifications and Designations
Upon releasing the proposed rule, the SEC Chairman Jay Clayton stated that “[t]he current test for individual accredited investor status takes a binary approach to who does and does not qualify based only on a person’s income or net worth.” To address this binary approach, the Proposed Rule, would allow certain individuals to qualify as accredited investors on the basis of professional certifications, designations, or other credentials that generally indicate financial sophistication. The SEC expects that individuals with the following active certifications or designations would qualify as accredited investors under the Proposed Rule:
- A Series 7 license;
- A Series 65 license; and
- A Series 82 license.
Notably, the Proposed Rule would allow the SEC to periodically designate by order additional certifications and designations that qualify for accredited investor status. Although the Proposed Rule anticipates that any such orders would provide for a notice and comment period, the ability to add new categories to the Proposed Rule by order would give the SEC the additional flexibility to further expand the Proposed Rule in the future.
Knowledgeable Employees of Private Funds
The Proposed Rule would allow certain “knowledgeable” employees of private funds, such as hedge funds, venture capital funds, private equity funds, and certain other funds, to qualify as accredited investors. The definition of a knowledgeable employee would have the same scope as that term under Rule 3c-5(a)(4) of the Investment Company Act of 1940, as amended (the Investment Company Act), and generally would include executive officers, directors, general partners, advisory board members, and employees (other than those performing solely clerical, secretarial, or administrative tasks) that have participated in the investment functions of the fund for at least 12 months.This proposed change also would be beneficial to funds with assets of $5 million or less. Rule 501(a)(8) of Regulation D provides that a fund with assets $5 million or less may be considered an accredited investor if all of the equity owners of such fund qualify as accredited investors. Thus, the Proposed Rule would allow employees of funds with assets $5 million or less to invest in such fund without the fund losing its status as an accredited investor.
Clarification of “Joint Net Worth” and Addition of Spousal Equivalents
The Proposed Rule would add a note to Rule 501(a)(5) of Regulation D to clarify that the joint net worth ownership requirement does not require spouses (or spousal equivalents) to jointly own the assets used for purposes of the calculation. The Proposed Rule also would allow spousal equivalents – cohabitants occupying a relationship generally equivalent to that of a spouse – to be included in the calculation for joint net worth and joint income.
No Proposed Change to Net Worth and Income Thresholds
Although the Concept Release requested comments regarding whether the net worth and annual income thresholds should be adjusted for inflation or geographic regions, the Proposed Rule retains the current net worth and income thresholds. Since the SEC adopted the original thresholds in 1982, the number of households that can meet those thresholds has increased from about 1.3 million to approximately 16.0 million.3 By retaining the current thresholds without adjustment, the Proposed Rule would not reduce the number of investors that meet those thresholds.
LLCs, RBICs, and RIAs
The Proposed Rule would add limited liability companies (LLCs), rural business investment companies (RBICs), and registered investment advisers (RIAs) to the list of entities that qualify as accredited investors. While the Proposed Rule would include RBICs and RIAs under Rule 501(a)(1), which allow those entities to be accredited investors by nature of their status as RBICs and RIAs, LLCs would be included in Rule 501(a)(3), and would be considered accredited investors only if such entities have total assets exceeding $5 million.
Other Entities Meeting an Investments-Owned Test
The Proposed Rule would create a new category of accredited investors for all entities, including Native American tribes, labor unions, governmental bodies and funds, and foreign entities, that own investments in excess of $5 million, and that were not formed for the specific purpose of acquiring the securities to be offered. The Proposed Rule indicated that this category is intended to be a “catch-all” provision that is designed to cover new and existing entity types. Additionally, the definition of “investments” for the purpose of this category would incorporate Rule 2a51-1(b) of the Investment Company Act, and would include securities, real estate, commodity interests, physical commodities, and non-security financial contracts held for investment purposes.
Clarification of the Ownership Look-Through
As discussed above, Rule 501(a)(8) of Regulation D provides that an entity may qualify as an accredited investor if all of the equity owners qualify as accredited investors. Since entities may be owned by other entities, the Proposed Rule clarified that one may “look through” the various forms of equity ownership to the ultimate individual that owns those entities.
The Proposed Rule would add family offices and family clients as a new category of accredited investors. Family offices generally are entities that are established by wealthy families to manage their wealth. The Proposed Rule would allow family offices with assets under management in excess of $5 million, and its family clients, to qualify as accredited investors.
The Proposed Rule would make conforming amendments to the definition of accredited investor under Rule 215 of the Securities Act to make that definition the same as the definition under Rule 501(a) of Regulation D. The Proposed Rule also would amend under Rule 163B to include the new categories of accredited investors for purposes of applying the test-the-waters provision. See Legal Alert: SEC proposes to expand “testing-the-waters” provisions to all issuers (February 25, 2019). Certain other confirming amendments would be made to Rule 15g-2 through 15g-6 of the Securities Exchange Act of 1934, as amended.
Qualified Institutional Buyer
Rule 144A of the Securities Act provides a safe harbor from registration for the resale of unregistered securities if both the seller and buyer meet certain requirements. Specifically, a seller that qualifies under the rule may resell securities to a “qualified institutional buyer” (QIB) without registering the unregistered securities. A QIB currently is defined as any of the following entities, acting for its own account or the account of other QIBs, that owns and invests on a discretionary basis an aggregate of at least $100 million:
- A registered investment company;
- An SBIC;
- Governmental employee benefits plan;
- Certain trusts;
- A BDC;
- A 501(c)(3) organization;
- A corporation (other than certain banks and savings and loan institutions), partnership, or business trust; and
The definition of a QIB also includes certain registered dealers.
Although private funds are unable to qualify to the Rule 144A safe harbor, the safe harbor is important to private funds because it allows financial intermediaries to buy their unregistered securities and resell those securities to an unlimited amount of QIBs in qualifying transactions.
The Proposed Rule would modify the definition of a QIB by allowing LLCs and RBICs to qualify as QIBs if they meet the $100 million threshold discussed above. Additionally, the Proposed Rule would include a “catch-all” provision that would allow any entity that qualifies as an accredited investor to also qualify as a QIB, provided that the accredited investor meet the $100 million threshold discussed above.
The SEC’s Proposed Rule to expand the definition of accredited investor would allow more investors to participate in private offerings by expanding the categories of individuals and entities that qualify as accredited investors. The Proposed Rule also would expand the definition of a QIB, thereby expanding the potential market for shares of private funds. The Proposed Rule has a 60-day comment period following its publication in the Federal Register.