On August 26, 2020, the U.S. Securities and Exchange Commission (SEC) amended the definition of “accredited investor” in Rule 501(a) under the Securities Act of 1933 (Securities Act). The amendments add specified categories of institutional and individual investors who have sufficient knowledge and expertise to participate in the private capital markets. The SEC also updated the definition of “qualified institutional buyer” in Rule 144A under the Securities Act to conform to the expanded accredited investor definition.
The amendments are part of the SEC’s effort to simplify, harmonize, and improve the exempt offering landscape while maintaining and enhancing appropriate investor protections.
Under federal securities laws, any offer or sale of a security must either be registered with the SEC or qualify for an exemption from registration. Since its adoption in 1982, Regulation D has become one of the most prevalent means by which private issuers can raise capital without having to register with the SEC. However, the regulatory framework for exempt offerings and the significance of exempt securities markets have evolved considerably since Regulation D was first adopted. In 2019, for example, registered offerings accounted for $1.2 trillion, or 30.8% of new capital, while the SEC estimates that $2.7 trillion, or 69.2%, was raised through exempt offerings. Of the $2.7 trillion raised in private offerings, the capital raised under Rule 506(b) and 506(c) was approximately $1.56 trillion.
Qualification as an “accredited investor” is one of the principal tests for determining who is eligible to participate in private issuances under Rule 501 of Regulation D. Historically, the criteria for individuals to qualify as accredited investors was based on specific income or net worth tests, without consideration of an investor’s overall financial sophistication apart from these limited metrics. While these criteria were put in place as a means to safeguard uninformed or unsophisticated investors from taking on risks they may not fully appreciate, the SEC recognized that the old test did not accurately reflect an investor’s overall financial sophistication and limited the ability of knowledgeable and savvy investors who do not meet the income or net worth criteria to participate in the private capital markets.
Amendments to Accredited Investor Definition
The additions to the definition attempt to maintain the core purpose of investor protection while correcting the outdated misconception that wealth is a proxy for financial sophistication. They add greater flexibility to who may invest in unregistered securities as “accredited investors.” The amendments to the definition of “accredited investor” in Rule 501 under the Securities Act add:
- Natural persons holding in good standing a professional certification or designation or credentials from an accredited educational institution that the SEC has designated as qualifying an individual for accredited investor status. The SEC has initially designated Series 7, 65, and 82 licenses as qualifying an individual for accredited investor status.
- With respect to an investment in a private fund (e.g. hedge fund, venture capital fund, and private equity fund), natural persons who are “knowledgeable employees” of the fund, as defined in Rule 3c5(a)(4) under the Investment Company Act of 1940. “Knowledgeable employees” include, among other persons, trustees and advisory board members of the private fund, or persons serving in a similar capacity, and employees of the fund or the affiliated person of the fund who, in connection with the employees’ regular duties, have participated in the investment activities of such private fund for at least 12 months, excluding employees performing solely clerical, secretarial, or administrative functions.
- SEC and state-registered investment advisers.
- Exempt reporting advisers under Section 203(m) or Section 203(l) of the Investment Advisers Act of 1940.
- Rural business investment companies, as defined in Section 384A of the Consolidated Farm and Rural Development Act.
- Any entity owning “investments,” as that term is defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million that is not formed for the specific purpose of acquiring the securities being offered.
- A “family office” (as that term is defined in the SEC’s family office rule under the Investment Advisers Act of 1940) with at least $5 million in assets under management, as long as the family office was not formed for the specific purpose of acquiring the securities offered and its investments are directed by a person who has such knowledge and experience in financial and business matters that such family office is capable of evaluating the merits and risks of the prospective investment.
- A “family client” (as that term is defined in the SEC’s family office rule under the Investment Advisers Act of 1940) of a family office that is an accredited investor whose investment is guided by that family office.
The amendments also expanded the universe of accredited investors by permitting an investor to include the net worth and income of a “spousal equivalent” when calculating joint income and joint net worth for the purpose of qualifying as an accredited investor. A “spousal equivalent” is a cohabitant occupying a relationship generally equivalent to that of a spouse. Prior to the amendments, only the net worth or income of a spouse could be included.
Finally, the amendments to the accredited investor definition incorporate the following long-standing staff positions:
- A limited liability company with at least $5 million in assets may qualify as an accredited investor.
- An investor that qualifies as an accredited investor based upon the joint income or net worth together with his or her spouse or spousal equivalent can make the investment separately.
- In determining whether an entity is an accredited investor under Rule 501(a)(8) because all of the equity owners of that entity are accredited investors, an entity can 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 the entity seeking accredited investor status are accredited investors, then Rule 501 (a)(8) may be available.
Amendments to Definition of Qualified Institutional Buyer
The SEC also amended the “qualified institutional buyer” definition in Rule 144A under the Securities Act to expand the list of entities that are eligible to qualify as qualified institutional buyers.
An institutional accredited investor, as defined in Rule 501(a) under the Securities Act of a type not listed in paragraphs (a)(1)(i)(A) through (I) or paragraphs (a)(1)(ii) through (vi) of Rule 144A under the Securities Act can be a qualified institutional buyer if it owns and invests on a discretionary basis at least $100 million in securities of issuers that are not affiliated with the entity.
To correspond to certain of the amendments to the definition of accredited investor, the SEC also added limited liability companies and Rural Business Investment Companies as eligible for qualified institutional buyer status if they satisfy the $100 million threshold.
The amendments to the definitions of accredited investor and qualified institutional buyer will become effective 60 days after publication in the Federal Register.