In June 2019, the Securities and Exchange Commission (the SEC) published a concept release (the Concept Release) that sought public comment on how to improve the framework for private securities offerings under the Securities Act of 1933 (the 1933 Act), with the goal of encouraging capital formation as well as opening up investment opportunities to a broader group of investors. After receipt and consideration of comments on the Concept Release, on December 18, 2019, the SEC issued a release in which it proposed expansion of the definition of an “accredited investor” in Rule 501(a) of Regulation D of the 1933 Act in an effort to further the goals discussed in the Concept Release. The SEC’s proposed rule changes are designed to modernize and broaden the criteria by which both individual and institutional investors can participate in private securities offerings.
An individual or institutional investor is required to be an accredited investor in order to participate in certain private unregistered securities offerings under federal securities laws. In particular, the accredited investor definition is a key component of exemptions from registration under Rules 506(b) and 506(c) of Regulation D and, therefore, qualifying as an accredited investor is important because it allows such investors to invest in private companies and investment funds that are not accessible to those who do not qualify as an accredited investor. The rationale behind creating the accredited investor concept was that those “persons whose financial sophistication and ability to sustain the risk of loss of investment or fend for themselves render the protections of the Securities Act’s registration process unnecessary.”
Currently, an individual meets the accredited investor definition if such individual (i) has income in excess of $200,000 individually, or $300,000 with a spouse, in the two most recent years preceding the transaction and must have a reasonable expectation of maintaining that income level in the current year; (ii) has net worth in excess of $1 million, either individually or with a spouse, without regard to the value of such individual’s primary home; or (iii) is a director, executive officer or general partner of an issuer or of a general partner of an issuer. An institutional investor meets the accredited investor definition if (i) such entity has more than $5 million in assets; or (ii) all of its owners are accredited investors. The wealth and income criteria were established in 1982, and while there have been amendments to the definition over the years, there have been limited changes to these particular aspects of the test. However, there has been significant debate for the past several years as to how to expand the category of eligible investors.
The proposed changes expand the historical income and net worth tests to add other means of qualifying as an accredited investor. The highlights are as follows:
- adding a new category allowing professionals with specific certifications, such as a Series 7, 65 or 82 license and other credentials issued by an accredited educational institution, to qualify as an accredited investor;
- with respect to investments in private funds, adding a new category of “knowledgeable employee” of a private fund who is investing in such fund as an individual who can qualify as an accredited investor;[1]
- adding other entities (e.g., registered investment advisers) that can qualify as an accredited investor, clarifying that limited liability companies (LLCs) qualify for accredited investor status if their total assets exceed $5 million and were not specifically created to invest in the offering, and permitting any entity with investments greater than $5 million and were not specifically created to invest in the offering to qualify for accredited investor status;
- including family offices with $5 million or more in assets and their “family clients” in determining qualification for accredited investor status; and
- including the term “spousal equivalent” so that couples who are not married can combine their income and/or assets to qualify as an accredited investor.
SEC Chairman Jay Clayton commented that “[t]he current test for individual accredited investor status takes a binary approach to who does and does not qualify based only a person’s income or net worth…[m]odernization of this approach is long overdue. The proposal would add additional means for individuals to qualify to participate in our private capital markets based on established, clear measures of financial sophistication.”
The accredited investor concept is intended to ensure that investors in private offerings are sophisticated and able to bear the loss of their investment. The proposed amendments acknowledge that unregistered offerings pursuant to Regulation D are a very important part of small business capital formation and that the current definition of accredited investor is too limiting. Further, the rules address various changes necessary to harmonize the 1933 Act exemptions with exemptions under other securities laws as well as to modernize certain provisions to reflect changes in entity structure and investment vehicles (e.g. LLCs and family offices).
The public has 60 days to provide comments on these proposed rule changes. Many groups such as the National Venture Capital Association and the Angel Capital Association have been advocating for years for expansion of the definition, as well as advocating against any changes to the wealth and income criteria that would shrink the class of qualified accredited investors. On the other hand, others have argued that loosening the criteria will add risk to the private markets. We expect that the SEC will receive many comments on the proposed changes, including those seeking further clarification around what categories of professionals will qualify as accredited beyond investment professionals who hold a Series 7, 65 or 82 license. The SEC proposal for now simply sets forth a “non-exclusive list of attributes that the Commission would consider in determining which professional certifications and designations or other credentials qualify for accredited investor status.”
We will continue to monitor the comments submitted and any further developments as to the proposed rule change. If you have questions or would like further information, please contact Lori Smith (smithl@whiteandwilliams.com; 212.714.3075) or Jeremy Miller (millerj@whiteandwilliams.com; 212.631.4414).
[1] This change is intended to harmonize the rules with the Investment Company Act which provides that “‘knowledgeable employees’ of a private fund may acquire securities issued by the fund without being counted for purposes of Section 3(c)(1)’s 100-investor limit.” This allows those that take part in management of a fund to invest in such fund as a benefit of their employment.