Proposed SEC Amendments Expand Pool of Accredited Investors

The concept of an accredited investor has existed in various forms under federal securities laws for nearly 50 years as a means by which people may invest in certain unregistered investments or private placements. The definition of accredited investor, which focuses on wealth criteria, is a significant part of several exemptions from registration, including Rules 506(b) and 506(c) of Regulation D.

Qualifying as an accredited investor is important because accredited investors may more easily participate in investment opportunities that are otherwise not available to the general public, such as opportunities to invest in private companies, equity funds, venture capital funds and certain hedge funds. In 2018, the estimated amount of capital reported as being raised in Rule 506 offerings was $1.7 trillion, compared to $1.4 trillion raised in registered offerings. Historically, the Securities and Exchange Commission (SEC) has stated that the accredited investor definition is intended to encompass those persons whose financial sophistication and ability to sustain the investment risks or fend for themselves render the protections of the Securities Act’s registration process unnecessary. But is wealth the best proxy for financial sophistication?

On January 15, 2020 the SEC proposed rule changes that amend the definition of accredited investor to add new categories of qualifying persons and entities, along with other modifications. SEC rulemaking generally aims to strike the appropriate balance between investor protection and capital formation. According to the proposal, these amendments are intended to update and improve the definition to more effectively identify institutional and individual investors that have the knowledge and expertise to participate in the U.S. private capital markets, without the additional protections provided by registration under the Securities Act of 1933. The SEC further believes the change would assist their efforts in assessing whether the exempt offering framework, as a whole, is consistent, accessible and effective for both issuers and investors.

The SEC has amended the accredited investor definition only three times since the adoption of Regulation D in 1982. In 1988, the definition expanded to include more entities, add a joint income test and eliminate qualification based on purchase size. In 1989, the definition expanded to include employee benefit plans established and maintained by certain state governments if plan assets exceed $5 million. In 2011, the definition changed to implement Dodd-Frank Act requirements and to exclude primary residence equity from an individual’s net worth calculation.

To summarize the current definition, accredited investors include:

• Individuals with net worth exceeding $1 million (excluding the equity value of their primary residence) either alone or with a spouse;
• Individuals with income over $200,000 in each of the two most recent years, or joint income with a spouse in excess of $300,000 in each of those years, with the reasonable expectation of reaching the same level in the current year;
• Directors, executive officers and general partners of the issuer; and
• Certain types of entities (e.g., financial institutions, insurance companies, registered investment companies, certain ERISA plans, corporations not formed for the specific purpose of acquiring the securities offered and with total assets in excess of $5 million).

Below is a brief summary of the key parts to the SEC’s proposed amendments:

• The amendments would add new categories allowing individuals to qualify as accredited investors based on certain professional certifications, designations or credentials, or a person’s status as a knowledgeable employee of a private fund.
  • While recognizing that the ability to mitigate or avoid unsustainable loss is important, the SEC is expanding the pool of investors to provide alternative means of assessing an investor’s need for protection. The amendments would allow holders of the following certifications to qualify regardless of income level:
    • Licensed General Securities Representative: Series 7
    • Licensed Investment Adviser Representative: Series 65
    • Licensed Private Securities Offerings Representative: Series 82
      
      The individuals would need to maintain their certification(s) but not necessarily actively practice in the related fields. This change potentially qualifies over 700,000 people.
  • Allowing knowledgeable employees would permit employees to qualify as accredited investors through their knowledge and participation in the investment activities of a private fund. This includes trustees, advisory board members and persons serving in a similar capacity, regardless of their income or net worth.
• The amendments would add certain types of entities that qualify as accredited investors, as well as a new category for any entity owning certain investments (as defined under the Investment Company Act) in excess of $5 million. Such entity types include:
  • investment advisers;
  • rural business investment companies;
  • limited liability companies (codifying the longstanding SEC staff position);
  • other entities meeting the investments-owned test; and
  • certain family offices and family clients
• The amendments would include the term spousal equivalent to the definition so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors. This change is to specifically include other legally recognized unions like domestic partnerships, civil unions and same-sex marriages.

In addition to expanding the pool of investors in Regulation D offerings, the change would have an impact in other areas. The change would benefit exempt offerings under Tier 2 of Regulation A. Such Tier 2 offerings include a limit on the amount any unaccredited investor may invest, while there is no limit for accredited investors. Accordingly, expect to see more investments under Tier 2 of Regulation A. Further, the change should ease diligence burdens for issuers conducting private offerings. Under Rule 506(c), issuers may utilize general solicitation to offer their securities if all purchasers are accredited investors. The issuer is responsible for taking reasonable steps to verify each purchaser’s accredited investor status under this rule. With accredited investors qualified by certain professional certifications, the verification process would become simplified. The expanded investor pool should also have a positive impact in the startup space, where companies have often been out of reach for certain investors, since the investment crowdfunding rules target smaller offerings and include a number of requirements.

The SEC is accepting comments on its proposed amendments until March 16, 2020. Once finalized and adopted, the SEC will confirm when the final amendments take effect. In the meantime, for more information on these proposed changes or to discuss how these rules may affect your company, contact your Varnum attorney.