On December 18, 2019, the Securities and Exchange Commission (SEC) voted to propose amendments to the definition of “accredited investor” in Rule 501(a) of Regulation D (Reg D) under the Securities Act of 1933 (Securities Act) and the definition of “qualified institutional buyer” under Rule 144A (Rule 144A) under the Securities Act. The proposed amendments would expand the number of investors allowed to participate in private securities offerings, including hedge funds, venture capital funds, and private equity funds (hereinafter “private funds”), by modifying a number of the definition’s existing categories and by adding new categories to the accredited investor definition. In particular and as discussed in more detail below, if adopted as proposed, the amendments would:
- Add new categories to the definition that would permit natural persons to qualify as accredited investors based on certain professional certifications, designations or credentials from an accredited educational institution or, with respect to investments in private funds, based upon the person’s status as a “knowledgeable employee” of the fund.
- Add certain entity types to the current list of entities that may qualify as accredited investors, as well as a new “catch-all” category for any entity owning in excess of $5 million of “investments” 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.”
- Add the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purposes of qualifying as an accredited investor.
- Codify certain SEC staff interpretive positions that relate to the accredited investor definition.
The proposed amendments would also revise the definition of a “qualified institutional buyer” (QIB) in Rule 144A and expand the list of entities able to qualify as QIBs.
If adopted as proposed, the expanded accredited investor definition would likely have a substantial impact on private capital markets. Chairman Jay Clayton, who voted for the proposed amendments, has stated that many people who do not meet the income or net worth requirements of the current accredited investor definition nonetheless have the knowledge and financial sophistication to participate in private markets, and miss out on opportunities to invest in startups that turn into multibillion-dollar companies after an initial public offering. Among the criticisms of the proposal is that because private companies are not required to provide audited financial statements, the proposed amendments erode the basic disclosure framework underpinning the federal securities laws – to provide investors with enough information about companies to accurately assess companies’ value and allocate their capital accordingly.
The accredited investor definition is central to several exemptions from registration under the Securities Act, and plays an important role in other state and federal securities laws. For example, an individual or entity that falls within the definition of accredited investor may invest in private companies and certain private funds that offer their securities through unregistered offerings conducted under Reg D. According to the SEC, private securities offerings conducted pursuant to Reg D have a major role in capital formation in the United States. The proposing release states that in 2018 the estimated amount of capital raised in offerings conducted pursuant to Rule 506 of Reg D was $1.7 trillion, compared to $1.4 trillion raised in registered offerings. The opportunity to invest in Reg D private offerings is not available to investors that are not accredited investors.
Historically, the SEC has taken the position that the accredited investor definition is designed to encompass persons whose financial sophistication and ability to sustain the risk of loss of investment or fend for themselves render the protections of Securities Act registration unnecessary. The current definition uses wealth (e.g., the income and net worth tests for individuals) as a proxy for financial sophistication. The proposed amendments reflect the SEC staff’s belief that “wealth should [not] be the sole means of establishing financial sophistication for the purposes of the accredited investor definition.” Accordingly, the proposed amendments to the definition create new categories of individuals and entities that would qualify irrespective of wealth on the basis that such investors have the requisite ability to assess an investment opportunity and allocate investments so as to mitigate the risk of loss.
The current accredited investor definition provides that natural persons and entities that come within, or that the issuer reasonably believes come within, any of eight enumerated categories at the time of the sale of the securities is an accredited investor.
A person seeking to qualify as an accredited investor under the current definition must have (i) net assets of at least $1 million, excluding their primary residence, or (ii) income in each of the last two years in excess of $200,000 (or joint income with a spouse of $300,000), with a reasonable expectation they will reach that same income level in the current year. Directors, executive officers and general partners of an issuer or of the general partner of an issuer may also qualify. The proposed amendments would add to the accredited investor definition natural persons who:
- Hold certain professional certifications or designations or other credentials issued by an accredited educational institution that the SEC designates from time to time as meeting specified criteria1.
- Are “knowledgeable employees” of a private fund and are investing in the private fund.
An explanatory note would also be added to Rule 501(a) under Reg D clarifying that for the purposes of the accredited investor test, natural persons may include joint income from a “spousal equivalent” when calculating joint income and may include spousal equivalents when determining net worth. “Spousal equivalent” would be defined as a cohabitant occupying a relationship generally equivalent to that of a spouse.
The current definition of accredited investor also provides enumerated categories of entities that qualify. Some entities, such as banks, savings and loan associations and brokers or dealers registered under Section 15 of the Securities Exchange Act of 1934 (Exchange Act), qualify based on their status alone. Other entities may qualify as accredited investors based on a combination of their status and the amount of their total assets. Any entity not specifically covered in the enumerated categories is not an accredited investor. The proposed additional categories of accredited investors mirror the existing framework and include both entities that may qualify based on status alone and entities that may qualify based on status and total assets, as well as a new “catch-all” category based only on total assets. Set forth below are the new categories of entities that may qualify as accredited investors under the proposed rule.
The SEC is also proposing to add a note to Rule 501(a)(8)2 that would clarify that, in determining accredited investor status under Rule 501(a)(8), one may look through various forms of equity ownership to natural persons. If those natural persons are themselves accredited investors, and if all other equity owners of an entity are accredited investors, the entity would be an accredited investor under Rule 501(a)(8).
The proposed rule would also make conforming amendments to Rules 2153 and 163B under the Securities Act and Rule 15g-14 under the Exchange Act. Pursuant to recently adopted Rule 163B, an issuer may engage in test-the-waters communications with potential investors that are, or that the issuer reasonably believes are, QIBs or institutions that are accredited investors pursuant to Rule 501(a)(1), (a)(2), (a)(3), (a)(7) or (a)(8) (i.e., any one of the enumerated categories of entity accredited investors). The proposed amendments to Rule 163B would include a reference to proposed Rules 501(a)(9) and (a)(12), thereby allowing test-the-waters communications with institutions that would qualify as accredited investors pursuant to the proposed “catch-all” and family office definitions of accredited investor.
Comment Period and Requests for Public Comment
Comments on the proposed amendments to the accredited investor definition are due 60 days after the SEC publishes the proposal in the Federal Register. The rule proposal includes more than 60 questions on various aspects of the proposed amendments, including:
- Should we consider additional conditions, such as investment limits, for individuals with certifications, designations, or credentials who do not meet the income test or net worth test, in order to qualify as accredited investors?
- Should we consider professional experience in areas such as finance and investing, apart from professional certifications and designations, as another means for qualifying for accredited investor status?
- Should we consider developing an accredited investor examination as another means for determining investor sophistication?
- Would adding “knowledgeable employees” as a category in the accredited investor definition raise concerns that small private funds could qualify as accredited investors under Rule 501(a)(8) when all or most of its equity owners consist of knowledgeable employees?
- Instead of using the catch-all “any entity” in proposed Rule 501(a)(9), should we enumerate specific entity types? If so, which entity types should we enumerate?
- Should family offices and their family clients qualify as accredited investors?