On August 26, 2020, after over a year’s worth of work examining how it may better simplify, harmonize and improve the framework and rules around exempt offerings under the Securities Act of 1933, as amended (the “Securities Act”) and heighten protections for investors participating in such offerings, the Securities and Exchange Commission (the “SEC”) adopted certain amendments (the “Adopting Amendment”) to the definition of “accredited investor” under Rule 501(a) of Regulation D promulgated under the Securities Act. The Adopting Amendment, which largely mirrored an initial set of proposed rules issued for comment by the SEC in December 2019, was approved to encourage greater capital formation in U.S. markets and expand investment opportunities for investors in such markets. The underlying effect of the Adopting Amendment is to expand the universe of individuals and entities eligible to participate in the unregistered offering of securities pursuant to Regulations D through the addition of new categories of individuals and/or entities eligible for accredited investor status or the expansion of existing rules concerning such parties’ treatment as accredited investors under Regulation D. Although the changes made to the definition of accredited investor do affect all offerings of securities conducted in reliance on Regulation D, this article focuses on those changes of primary interest relating to investors in private investment funds. For more detailed coverage and explanation of all the revisions affected pursuant to the Adopting Amendment, including the expanded the definition of “qualified institutional buyer” in Rule 144A under the Securities Act, please refer to the SEC’s adopting release: https://www.sec.gov/rules/final/2020/33-10824.pdf.
Changes for Individual Investors
1. Professional Certifications, Designations or Credentials
Traditionally, the sole avenue by which an individual investor could meet the accredited investor definition was through that investor’s relative wealth or income.[i] However, through the Adopting Amendment, the SEC will now also look to the professional certifications, designations and/or credentials of an individual issued from an approved educational institution as evidence of one’s requisite financial sophistication and ability to assess the related risks of a securities offering to meet the accredited investor definition, regardless of an individual’s level of wealth or income. The SEC has stated that, for now, the only recognized individuals eligible for accredited investor status under this new category are those individuals in good standing holding a Series 7, Series 65 and/or Series 82 license. Notwithstanding this, the SEC has the ongoing authority to adjust and add to those professional certifications, designations and credentials they deem sufficient to confer accredited investor status on an individual, and thus, it is likely further types of credentialed and licensed professionals will be added in time by the SEC to the list of those individuals permitted to be treated as accredited investors under this new professional certification category. For now, the movement away from a wealth and income-based analysis in this category is a good first step by the SEC to open the private offering markets to potential additional individuals. However, it is still very early days with this new and expansive category to fully comprehend yet the potential implications for funds and their investors, especially with respect to the more complex fund private offerings such as those conducted under Rule 506(c) of Regulation D (i.e., general solicitation offerings) which require a much greater degree of independent verification of each investor’s accredited investor status. Further, it remains to be seen whether this new professional certification method of qualifying for accredited investor status will be materially additive to the overall number of potential accredited investors eligible to participate in fund and other private offerings, given that many of such individuals may, by the very nature of their qualifications and profession, already meet the wealth or income requirements in the first instance.
2. Knowledgeable Employees
As applicable solely to investments by individuals in private funds, the Adopting Amendment adds a new category of accredited investor for individuals who qualify as “knowledgeable employees” of the fund sponsor as defined in Rule 3c-5(a)(4) under the Investment Company Act of 1940, as amended (the “ICA”). Pursuant to the ICA, an individual that is a knowledgeable employee is allowed to invest in private funds sponsored by the fund manager employing such individual without affecting the fund’s ability to qualify for the exclusions from the definition of “investment company” under Section 3(c)(1) or Section 3(c)(7) of the ICA. Individuals meeting this category are deemed to possess the requisite information and financial sophistication regarding the particular fund offering due to their intimate involvement with the firm sponsoring such fund and its investment portfolio. Individuals qualifying as knowledgeable employees include (a) executive officers, directors, trustees, general partners, advisory board members or persons serving in a similar capacity of a fund exempt from the ICA under Section 3(c)(1) or 3(c)(7), or affiliated persons of the fund who oversee the fund’s investments and (b) employees or affiliated persons of the fund (other than employees performing solely clerical, secretarial or administrative functions) who, in connection with the employees’ regular functions or duties, have participated in the investment activities of such private fund (or other private funds) for at least 12 months. Thus, the key take away here is that, while the underlying analysis is a fact specific one, it is likely that only mid to senior level personnel with heavy involvement in and responsibility for the investment activities of the firm will be eligible for accredited investor treatment under this new category.
3. Spousal Equivalent
The Adopting Amendment broadened the scope of the existing income and net worth tests applicable to individuals by not only permitting the income and/or net worth of a spouse of the individual to be considered when determining the individual’s status as an accredited investor[ii] but also the income and/or net worth of that individual’s “spousal equivalent” (in lieu of the individual’s spouse). A spousal equivalent is generally considered to be a cohabitant occupying a relationship with the individual equivalent to that of a spouse without the requirement for a formal official recognition of such status (e.g., a domestic partnership or civil union). While this specific change will not likely result in a material influx of new qualifying investors, it does reflect the SEC’s broader thinking about social norms and family constitution and tying those relationships to greater market access.
Changes for Entity Investors
1. Regulatory Profile or Form of Certain Entities
- A new category of accredited investor has been added for those investors that are investment advisers registered under Investment Advisers Act of 1940, as amended (the “Advisers Act”), exempt reporting advisers under the Advisers Act and/or investment advisers registered under applicable state laws, regardless of whether such entities meet the $5M total asset threshold for entities generally under the accredited investor definition.
- Limited liability companies that have not been formed for the purpose of making the investment in a fund and that have total assets in excess of $5M will qualify as an accredited investor. This change is more of a codification for how practitioners traditionally dealt with LLCs under the existing accredited investor definition than a material change to the fabric of the definition itself.
2. General Catch-all Entity Category
A new category of accredited investor has been added for those entity investors that are not otherwise specified in the accredited investor definition and not formed for the specific purpose of acquiring the securities offered that owns more than $5M in “investments.”[iii] It is important to highlight that this new category looks specifically to “investments” and not “assets” held by the entity, which is a change in construct from most of the primary financial determinations applicable to entities under the accredited investor definition. Thus, not only does this new category not look to entity construction and constitution for purposes of meeting the accredited investor definition, it also veers away from the traditional asset-based mindset of analyzing whether an entity should or shouldn’t be considered an accredited investor. This new more amorphous bucket will include entities such as Native American tribes, governmental bodies, foreign entities and other entities whose structure and nature do not fit within the other identified categories in the accredited investor definition.
3. Family Offices and Family Office Clients
The Adopting Amendment has added a new category for those entities that (a) can meet the definition of “family office” pursuant to rules issued under the Advisers Act, (b) have at least $5M in assets under management, (c) were not formed for the purpose of making the investment in the fund and (d) are managed by an individual who has such knowledge and experience in financial and business matters that the family office is deemed capable of evaluating the merits and risks of the prospective investment. Further, in the event that the family office can meet the above criteria, any “family client” of the family office (as defined by the rules issued under the Advisers Act) shall also be deemed to meet the definition of accredited investor regardless of whether such family client can meet any other parts of the definition of accredited investor. Most family office structures can and do meet the existing rubric of the accredited investor definition, thus, the import of these new rules be mainly for non-traditional family office structures and/or family clients that may not themselves be eligible for accredited investor status.
Adopting Amendment Timing
While the Adopting Amendment was announced by the SEC on August 26, 2020, it will not become effective until 60 days after its publication in the Federal Register.
Many funds and those investing in them are heralding the changes promulgated by the Adopting Amendment as an encouraging sign that the SEC is desirous of expanding market access to a greater number of investors. Such parties view changes such as providing non-wealth based categories of measurement for accredited investor status, expanded categories and natures of entities that can qualify for accredited investor treatment and revisions to the accredited investor rules to take into account evolving social norms and ideals as necessary steps in the right direction.
The above notwithstanding, given that the Adopting Amendment did not make any inflation-based adjustments to the existing financial thresholds applicable throughout the accredited investor definition, many (if not most) individuals that can meet the new and/or expanded categories will likely already have satisfied the language and requirements under the existing accredited investor rules. Thus, it remains foggy at best as to the actual number of additional investors that will be eligible for accredited investor status, and thus, access to private fund and other securities offerings. While we hope that these new changes effectuated by the Adopting Amendment do, in fact, live up to the promise and intentions pursuant to which they were enacted, only time will tell just how much of a true impact they will have given the above.
Regardless of the ultimate direction these additions and changes to the accredited investor rules take us, we do know that their effective date is fast approaching us. To get prepared, your fund subscription agreements, transferee investor questionnaires and other recordkeeping efforts related to oversight of your investors’ accredited investor status should be made ready for the changed rules, especially for any funds or other vehicles you are managing that will have a closing after the effective date of the Adopting Amendment. We encourage you to call your fund counsel soon and consult with them on the best plan for getting your documents and operations in order related to these issues moving forward.
[i] For instance, an individual could only be considered an accredited investor if such individual either had (a) an income in excess of $200,000 in each of the two most recent years or joint income with that individual’s spouse in excess of $300,000 in each of those years and had a reasonable expectation of reaching the same income level in the current year or (b) a net worth, or joint net worth with that individual’s spouse, in excess of $1,000,000.
[ii] See Footnote 1 for clarification on income and net worth thresholds for individuals.
[iii] “Investments” are defined by reference to Rule 2a51-1(b) under the ICA, which is used to determine an investor’s status as a “qualified purchaser” under such rules.