The U.S. Securities and Exchange Commission (the SEC) has proposed amendments to Rule 501 of Regulation D¹ that would revise the definition of “accredited investor” by expanding the list of entities that may qualify as accredited investors and including new categories to permit natural persons to qualify based on certain professional certifications, designations and credentials. The proposed changes reflect an evolution of the current approach to satisfying the criteria of accreditation, which for individuals has been premised on a person’s income or net worth, and acknowledges that certain entities, such as tribal governments, have historically been precluded from fully accessing the benefits of Regulation D.
SEC Chairman Jay Clayton noted that, “The 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, [and 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. I also am pleased that the proposal specifically recognizes that certain organizations, such as tribal governments, should not be restricted from participating in our private capital markets.”
As one of the most prolific safe harbor exemptions from registration used by private issuers of securities, Regulation D was originally adopted by the SEC in 1982 for the core purpose of making needed capital access less burdensome for businesses. While Regulation D has continued to evolve as the SEC has adopted various changes and amendments over time, this fundamental purpose has remained the same.
Regulation D offers multiple ways by which an issuer can avail itself of the safe harbor exemption from registration, but each of them involves, to differing degrees, the idea that investors qualify as accredited under Rule 501. The rationale behind this is simple: in a securities offering that is not registered, and thus lacks the rigorous disclosure requirements overseen by the SEC, there is obvious concern that an uninformed (or worse, misinformed), unsophisticated investor lacking proper understanding or appreciation for the risks of a proposed investment, might be disadvantaged. By limiting the scope of potential investors in these offerings to those who demonstrate a certain level of financial sophistication (or at the very least have the financial wherewithal to withstand losing the entirety of their investment), Regulation D endeavors to curb this potential for investor abuse.
It is important to note that certain rules under Regulation D do allow for sales to investors who do not qualify as accredited under certain circumstances, but additional safeguards (e.g. additional information requirements, caps on investment amounts) exist in these circumstances in furtherance of the same core rationale of investor protection. As Chairman Clayton noted however, there has long been a disconnect in the accredited investor definition as it relates to natural persons, as a person’s income or net worth may not be directly reflective of their financial sophistication or ability to identify or appreciate the risk of a particular investment. The SEC’s proposed amendments attempt to bridge this disconnect by adding additional categories that deal directly with a natural person’s overall financial literacy, familiarity with the issuer and ability to evaluate the merits and risks of a particular investment in a sophisticated manner.
The proposed amendments also make a number of practical changes to address how Regulation D is used by issuers in today’s investing climate that perhaps weren’t contemplated in the original formulation of the definition. The proposed amendments to the accredited investor definition would:
- add new categories to the definition that would permit natural persons to qualify as accredited investors based on certain professional certifications and designations, such as a Series 7, 65 or 82 license, or other credentials issued by an accredited educational institution;
- with respect to investments in private funds (e.g. hedge funds, venture capital funds and private equity funds), add a new category based on a person’s status as a “knowledgeable employee” of the fund;
- add limited liability companies that meet certain conditions, registered investment advisers and rural business investment companies to the current list of entities that may qualify as accredited investors;
- add a new category for any entity, including Native American tribes, labor unions, governmental bodies and funds, and entities organized under the laws of a foreign country, owning “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million 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,” as each term is defined under the Investment Advisers Act; and
- add the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors.
In addition to the direct impact of the proposed amendments on private offerings under Regulation D, there would also be a trickle-down effect on other securities regulations if the proposed amendments were adopted, as the accredited investor definition in Rule 501 plays an important role across a number of additional federal and state securities laws, including Regulation A and Rule 144A. The proposal is now subject to a 60-day public comment period.
¹17 C.F.R. §230.501