On December 18, 2019, the SEC, in a 3-2 vote, issued a release proposing amendments to the Rule 501(a) definition of “accredited investor,” which hasn’t been meaningfully updated since 1982[1]. The definition is an important piece of the securities law framework that determines how, and from whom, private companies can raise money to fund the launch, operation or growth of a business.
Why is this Important?
Rules 506(b) and 506(c) of Regulation D under the Securities Act exempt certain private securities offerings from registration with the SEC. However, these two rules require that such unregistered offerings only be sold to “accredited investors,” a group that includes specified institutions and individuals who are sufficiently sophisticated or in a position to bear a total loss of the investment. For an individual, with one exception for directors, officers and similar managers of the entity issuing the securities, this determination is based solely on his or her personal financial position. People with a net worth of over $1M (alone or with their spouse, not including any positive equity in their primary residence), or with annual income in the past two years, with a reasonable expectation of income in the current year, of $200,000 (or $300,000, if a spouse’s income also is considered), can take advantage of private investment opportunities under these exemptions.
Ultimately, the “accredited investor” definition is a boundary line between who can invest in certain opportunities outside of the public markets, such as angel investing in a start-up or investing in a private equity fund. By changing the definition, the SEC is deciding who gets to take advantage of these opportunities, and its objective is to strike the right balance between promoting capital formation and protecting investors.
What Does the Rule Propose?
The SEC’s release proposes the following important changes to the “accredited investor” definition:
- It would allow a limited liability company (LLC) with total assets in excess of $5M to qualify as an accredited investor, provided it wasn’t formed to acquire the offered securities. A similar qualification exists today but applies only to 501(c)(3) organizations, corporations, Massachusetts or similar business trusts and partnerships.
- It would expand parts of the definition that include spouses to include “spousal equivalents.” A spousal equivalent is defined in the rule as “a cohabitant occupying a relationship generally equivalent to that of a spouse.” So, in any joint annual income or joint net worth calculation (pursuant to the tests described above), the financials of a spousal equivalent would be included.
- It clarifies that assets need not be jointly held or purchased to be included in the net worth calculation.
- It confirms that any look-through of an entity purporting to be an accredited investor can examine its “various forms of equity ownership” to determine that each natural person owner is accredited.
- It would cover any entity (not otherwise covered by the rule) owning investments in excess of $5M, provided it wasn’t formed for the purpose of acquiring the offered securities. This is an addition to the existing categories of accredited investor types.
- It would allow individuals to qualify based on professional certifications. Commentators have long considered expanding the rule to include people who, despite not meeting the financial tests outlined above, have sufficient expertise with securities and investing to understand and bear the risks of investing in private offerings. This addition to the rule would allow this. It would require:
- The certification to result from an examination process administered by a self-regulatory organization or other industry body or is issued by an accredited educational institution;
- The examination to demonstrate comprehension or sophistication of securities and investing;
- People obtaining the certification to be reasonably expected to have sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of an investment;
- Availability of a public indication from the certifying body that the individual holds the certification; and
- The SEC to post the specific certifications recognized by it as satisfying the above criteria.
The release cites Series 7 (Licensed General Securities Representative), Series 65 (Licensed Investment Adviser Representative) or Series 82 (Licensed Private Securities Offerings Representative) licenses as potentially qualifying under this standard. Elad Roisman, one of the current SEC commissioners, also commented that “wealth is a crude measure of a person’s ability to make financial decisions” and lauded the addition of new methods for qualification of individuals in a statement made on the date of issuance of the proposed rule changes. He added, “someone entrusted to manage other people’s investments in the private markets should be considered financially sophisticated enough to invest his or her own money in the same types of offerings.”
- It adds a new category for “knowledgeable employees” of a Section 3(c)(1) or Section 3(c)(7) private investment fund. This is another new category for individuals based on the person’s professional experience with a fund, such as a hedge fund, venture capital or private equity fund. “Knowledgeable employee” means the fund’s officer, director, general partner or an employee who has regularly participated in the investment activities of such fund for at least 12 months.
- Adds any “family office” (as defined in the Investment Advisers Act of 1940) with over $5M AUM that was not formed to invest in the offered securities and whose investments are directed by a sufficiently knowledgeable or experienced person, along with any “family client” meeting the same criteria.
- Adds registered investment advisers (RIAs). RIAs were added because they “appear to have the requisite financial sophistication needed to conduct meaningful investment analysis.”
How Does this Affect Capital Markets?
The net effect of the proposed changes is to increase the overall accredited investor pool. By broadening out the opportunity to qualify to “spousal equivalents,” individuals with certain professional certifications and experience, and several additional types of entities, the pool of potential investors in private offerings would grow larger.
It’s also worth noting what the proposed rule does not do—which is to adjust the financial thresholds applicable to individuals under the current financial tests. Those thresholds have been at their current levels since 1982, notwithstanding an annual average inflation rate between 1982 and 2019 of 2.68%. By leaving the thresholds untouched, the SEC would enable a greater number of individuals to qualify over time. As the Wall Street Journal observed, “The number of households who meet the current definition rose to 16 million in 2019 from 1.31 million in 1983.” That said, Roisman noted in his recent comments that, even though he is 1 of 5 voting commissioners of the SEC, he himself is not an accredited investor under the current rule or the proposed rule, nor are many of the expert staff of the SEC. He added, “I wonder whether we have missed the mark [with this proposed rule].”
What Comes Next?
The SEC has 60 days to receive public comments, after which it is expected to promulgate and publish a final rule.
We will monitor all future developments related to this proposed release and issue client alerts in connection with any such developments. In the meantime, if you need assistance with any questions relating to the accredited investor definition, private offerings or securities law generally, please reach out to me at 216-736-7275 or caz@kjk.com.
[1] Except in 2011, when it amended the net worth standard to exclude the value of an investor’s primary residence.
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