On December 18, 2019, the Securities and the Exchange Commission (the “SEC” or the “Commission”) published its proposal to amend the accredited investor definition set forth in Rule 501(a) of Regulation D under the Securities Act of 1933, as amended (the “Securities Act”). The proposal (the “Proposed Rules”) would modify several of the current definition’s existing categories and also add new categories.1 The Proposed Rules were released six months after the June 18, 2019 “Concept Release on Harmonization of Securities Offering Exemptions”2 seeking public comments to assess the currently available exemptions from registration.
The Proposed Rules would change the definition of accredited investor in the following key ways:
- Financially sophisticated natural persons with either professional certification or experience managing and investing in private funds would qualify as accredited investors without having to meet any income or net worth thresholds.
- The definition of accredited investor would include new types of entities such as limited liability companies,3 Rural Business Investment Companies (RBICs), tribal governments, and other entities owning investments of more than USD$5 million.
By expanding the definition of accredited investor, the Proposed Rules seek to facilitate capital formation, harmonize existing rules and regulations, and reduce compliance burdens for issuers.
Comments on the proposed rules are due on or before 60 days after publication in the Federal Register.
“Accredited Investor” - the Cornerstone Definition of Regulation D
The definition of “accredited investor” plays a central role in federal securities law and also state securities (or “blue sky”) laws, for which exemptions are often based on the federal securities law definition of accredited investor. Qualifying as an accredited investor allows a person to more freely invest in private companies as well as certain hedge funds, private equity funds and venture capital funds – opportunities that are generally not available to non-accredited investors. While the concept was originally developed to protect investors by limiting access to unregistered offerings, which have less rigorous disclosure requirements, it also prevented millions of Americans from participating in the potential growth of private companies. As noted by Commissioner Elad L. Roisman at the open meeting for the Proposed Rules on December 18, 2019, instead of protecting investors by prohibiting them from investing at all, the Proposed Rules make “headway toward a more rational approach for protecting investors than the one we have now.”4
Proposed Amendments to Rule 501(a)
Proposed Amendments Concerning Natural Persons
The current definition of accredited investor allows individuals to qualify only by meeting one of two minimum financial requirements: (a) net worth exceeding USD$1 million (excluding the value of primary residence), either alone or with a spouse; or (b) income in excess of, USD$200,000 alone, or USD$300,000 with that individual’s spouse, in each of the two most recent years, along with a reasonable expectation of reaching the same income level in the current year. The Proposed Rules expand the definition by adding categories of natural persons who qualify without regard to net worth or income level because their professional knowledge and experience demonstrate that they possess the necessary financial sophistication to qualify as an accredited investor.
Natural Persons with Certain Professional Certifications
The strict financial threshold in the current standard restricts investment opportunities for individuals who are less wealthy in income or net worth but, as the Commission states in the Release, have “… not only an ability to analyze the risks and rewards of an investment but also the capacity to allocate investments in a way to mitigate or avoid risks of unsustainable loss.” Under the Proposed Rules, the Commission will identify certain professional certifications and designations through a Commission order, and investors holding such certifications or designations will be deemed to possess an appropriate level of financial sophistication that renders these investors less in need of protections under the Securities Act. The Release provided the following non-exhaustive list of attributes that the Commission would consider when determining which certifications or designations it would identify in a separate Commission order:
- The relevant certification arises out of an examination or series of examinations administered by a self-regulatory organization or industry body or is issued by an accredited educational institution.
- The examination(s) are designed to reliably and validly demonstrate an individual’s comprehension and sophistication in the areas of securities and investing.
- Persons obtaining the certification can reasonably be expected to have sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of a prospective investment.
- There is a publicly available indication that the individual holds the certification or designation.
Professional certifications and designations suggested by the proposal include Licensed General Securities Representative (Series 7), Licensed Investment Advisor Representative (Series 65), and Licensed Private Securities Offerings Representative (Series 82). The SEC indicates that there are approximately 700,000 individuals holding relevant certifications (although some may already be accredited investors and there may be double counting among individuals holding more than one certification).5 Besides expanding the pool of natural persons eligible to become accredited investors, the Proposed Rules are also expected to reduce compliance burdens for issuers given that information on certifications and designations are often publicly available and more easily verifiable than data on net worth and income.
“Knowledgeable Employees” of Private Funds
Private funds generally rely on Section 4(a)(2) of the Securities Act and Rule 506 of Regulation D to offer and sell their interests without registration under the Securities Act and are excluded from the definition of an “investment company” pursuant to Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940 (the “ICA”). To qualify for one of these exclusions, private funds, among other requirements, have to either (i) maintain fewer than 100 beneficial owners of their outstanding securities pursuant to Section 3(c)(1) of the ICA; or (ii) limit the holders of its securities to persons or entities that are “qualified purchasers” pursuant to Section 3(c)(7) of the ICA. Rule 3c-5(a)(4) of the ICA allows certain “knowledgeable employees” of private funds to invest in such funds without being counted as a beneficial owner for the 100-person rule and allows such employees to invest in a Section 3(c)(7) fund even though they do not meet the typical requirements of a “qualified purchaser.” The Proposed Rules borrow the definition of “knowledgeable employees” from ICA Rule 3c-5(a)(4) and aim to capture individual investors with sufficient financial sophistication based on their professional experience managing and investing in private funds. In addition, this proposed change should also benefit smaller private funds. Under Rule 501(a)(8) of Regulation D, private funds with assets of USD$5 million or less may qualify as accredited investors if all of the fund’s equity owners are accredited investors. By expanding the category of accredited investors to include “knowledgeable employees,” this proposed amendment could enable smaller private funds to participate in Rule 506 offerings that are limited to accredited investors. The SEC indicated that there are approximately 32,200 private funds, although it was unable to quantify the number of knowledgeable employees at these funds.
Proposed Rules Concerning Entities
Besides natural persons, the Proposed Rules would also expand the definition of accredited investor for entities, adding new categories such as Registered Investment Advisers, RBICs, limited liability companies, other entities meeting an investments-owned test, and certain “family offices” and their “family clients.”
- Registered Investment Advisers
Under the Proposed Rules, investors registered as an investment advisor under Section 203 of the Investment Advisers Act of 1940 (the “Advisors Act”) or pursuant to the laws of a state will be considered to be accredited investors under Rule 501(a)(1). The Commission reasons that because these registered investment advisers are treated like other institutional investors under various state laws, there is no compelling reason to further distinguish them from those institutional investors already treated as accredited investors under 501(a)(1).
An RBIC, as defined in Section 384A of the Consolidated Farm and Rural Development Act, is an entity that focuses on promoting economic development and creating job opportunities in rural areas. Under the Advisers Act, RBICs are treated similarly to Small Business Investment Companies (SBICs) because both entity types share the goal of promoting capital formation. Given that SBICs could be recognized as an accredited investor under Rule 501(a)(1), the proposal would lead to equal treatment and add RBICs to the entity types recognized as accredited investors under Rule 501(a)(1).
- Limited Liability Companies
Limited liability companies have become a widely adopted corporate form since the Commission last updated the accredited investor rule in 1989. The current proposal will therefore add limited liability companies to the list of entity types that would qualify as accredited investors under Rule 501(a)(3). The proposed amendment would codify a longstanding staff position that limited liability companies that satisfy the other requirements of the definition are eligible to qualify as accredited investors under Rule 501(a)(3).6
- Other Entities meeting an investments-owned test (catch-all category)
The Proposed Rules will add a new category for any entity owning investments in excess of USD$5 million that is not formed for the specific purpose of acquiring the securities being offered. This is intended to be a catch-all provision to capture entity forms not already included within Rule 501(a), such as Indian tribes and governmental bodies, and even entity types that may be created in the future. In the Release the Commission stated that requiring USD$5 million in investments instead of assets “may better demonstrate that the investor has experience in investing and is therefore more likely to have a level of financial sophistication similar to that of other institutional accredited investors.” The Proposed Rules incorporate the definition of “investment” from Rule 2a51-1(b) under the ICA, to alleviate confusion and facilitate compliance.
- Certain Family Offices under and Family Clients
Under Proposed Rules 501(a)(12) and 501(a)(13), a “family office” and “family client,” which are defined in Rule 202(a)(11)(G)-1 of the Advisors Act, may also qualify as accredited investors, provided the family office has at least USD$5 million in assets under management. These family offices and family clients would satisfy the Commission’s requirement on financial sophistication because they are likely to possess sufficient assets to sustain the risk of loss, and their assets would be managed by someone with sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of a prospective investment.
Proposed Amendments that Simplify and Harmonize the Current Regulatory Framework
The Proposed Rules also include amendments that would clarify, simplify and improve the current exempt offering framework. For instance, the Proposed Rules would add the definition of “spousal equivalent” to Rule 501(a), defined as “a cohabitant occupying a relationship generally equivalent to that of a spouse,” and allow individuals, for purposes of qualifying as an accredited investor through joint income, to pool finances with persons to whom they are not legally married. Given that the Commission has adopted this kind of definition in other regulations, such as Regulation Crowdfunding and the Advisers Act, the addition of the definition would further harmonize and promote consistency among existing rules.
Rule 163B currently allows an issuer in a registered offering to engage in test-the-waters communications with potential investors that are, or are reasonably believed to be, qualified institutional buyers, as defined in Rule 144A, or institutions that are accredited investors, as defined in Rule 501(a)(1), (a)(2), (a)(3), (a)(7), or (a)(8). The Proposed Rules would amend Rule 163B to include a reference to proposed Rules 501(a)(9) (other entities meeting an investments owned test) and (a)(12) (family offices). By expanding the types of entities with whom an issuer may engage in test-the-waters communications, the Commission aims to encourage the use of Rule 163B and allow issuers to better gauge market interest when contemplating a registered offering.
The Proposed Rules would also expand the definition of “qualified institutional buyer” in Rule 144A to reflect the expanded scope of the definition of accredited investor and bring the two definitions into closer alignment. This would include adding RBICs and limited liability companies to the list of entities that may qualify as a qualified institutional buyer and to add a catch all provision for institutional accredited investors that satisfy the USD$100 million threshold for securities owned and invested.
Considerations for Issuers
By expanding the pool of accredited investors, the Proposed Rules aim to improve the ability of issuers to raise capital in exempt markets. Among all types of issuers, the effect on smaller and growth-stage businesses will likely be the most significant. With a median offering size of USD$1.7 million, the Regulation D market typically involves relatively small offerings undertaken by smaller and growth-stage issuers.7 The SEC estimates that during the period of 2009 to 2018, there were on average approximately 293,700 accredited investors participating annually in Regulation D offerings.8 This number will likely increase if the Proposed Rules are adopted. The Commission believes that besides boosting an issuer’s ability to raise capital, the Proposed Rules will increase the liquidity of securities issued in unregistered offerings by expanding the pool of potential purchasers in resale transactions. Additionally, from a practical point of view, issuers could benefit from reduced compliance cost as the proposed amendments allow for additional ways of verifying an investor’s status as an accredited investor. Under Rule 506(c), issuers are required to take reasonable steps to verify the accredited investor status of all purchasers in an offering, and the Proposed Rules thus relieve this compliance burden and remove a potential impediment to using Rule 506(c) for raising capital.
Considerations for Investors
In 2018, the estimated amount of capital raised in Rule 506 offerings was USD$1.7 trillion, larger than the USD$1.4 trillion raised in registered offerings.9 More and more businesses are staying private longer, while growing quickly and generating high returns for investors. Under the Proposed Rules, newly eligible accredited investors would be able to participate in the high-growth stage of these issuers and gain broader access to investment opportunities.