On August 26, 2020, the Securities and Exchange Commission (SEC) adopted amendments to the definition of “accredited investor” in Rule 501(a) of Regulation D under the Securities Act of 1933 (Amendments). The Amendments, which will become effective 60 days after they are published in the Federal Register, expand the pool of individuals and entities that qualify as accredited investors. The definition of accredited investor is relevant, among other things, to the operation of Rule 506 of Regulation D, which is a safe harbor under Section 4(a)(2) of the Securities Act. Rule 506 is the most commonly-used exemption for private offerings, accounting for the vast majority of the trillions of dollars raised through unregistered offerings every year. Unregistered, private offerings of securities have supplanted public offerings as the dominant form of capital-raising in the United States. Since regulatory requirements are much greater for offerings that include non-accredited investors, an overwhelming majority of Rule 506 offerings are offered only to accredited investors.
The tests that must be met for individuals to qualify as accredited investors have remained virtually unchanged since the adoption of Regulation D over 35 years ago, and are predominantly based on an individual’s income and net worth. Inflation has gradually eroded the significance of this proxy for investor sophistication—in 1983, less than 2 percent of U.S. households qualified as accredited investors, while 30 years later, over 10 percent of U.S. households could meet the definition. However, since Regulation D’s adoption, there has been dissatisfaction with using income and wealth as the sole means of judging an investor’s sophistication and ability to evaluate risks. The SEC’s adoption of new, knowledge-based criteria for qualification represents a significant step forward in broadening the pool of individuals who are accredited investors.
The SEC is expanding the definition of “accredited investor” in Rule 501(a) to include the following:
The SEC is also clarifying in Rule 501(a) its long-standing position that limited liability companies with $5 million in assets and not formed for the specific purpose of acquiring the securities offered qualify as accredited investors.
The SEC is also amending Rule 501(a) so that a “spousal equivalent” (defined as a cohabitant occupying a relationship generally equivalent to that of a spouse) is treated the same as a spouse under Rule 501(a).
See Annex A to this client alert for a redlined comparison that shows the changes being made by the SEC to the definition of “accredited investor” in Rule 501(a).
The SEC is also making similar changes to the following SEC rules:
As discussed above, individuals with certain professional certifications, designations or other credentials will now qualify as accredited investors under Rule 501(a)(10). The qualifying professional certifications, designations and other credentials will be designated by the SEC from time to time. Initially, the SEC has designated for qualification the following three FINRA-established professional certifications:
Prior to designating any new professional certifications, designations or credentials for qualification under Rule 501(a)(10), the SEC will provide notice and opportunity for public comment. A current list of the qualifying credentials will be maintained on the SEC’s website.
While the holder of the qualifying certification, designation or credential is not required to practice in the related fields, the SEC will require that the holder maintain the certification, designation or credential in good standing.
Knowledgeable Employees of Private Funds
The Amendments add a new category to the accredited investor definition under Rule 501(a)(11) to cover “knowledgeable employees” of a private fund. This category will cover the same individuals that are included in the definition of “knowledgeable employee” in Investment Company Act Rule 3c-5(a)(5) and includes, among other persons, trustees and advisory board members of a private fund or an affiliated person of the private fund that oversees the private fund’s investments, as well as employees of the private fund or the affiliated person of the private fund who, in connection with the employees’ regular functions or duties, have participated in the investment activities of such private fund for at least 12 months.
Prior to the Amendments, employees of private funds that have assets of $5 million or less were often restricted from investing in the private fund due to the fact that, under Rule 501(a)(8), such a private fund, itself, may qualify as an accredited investor only if all of the private fund’s equity owners, themselves, are accredited investors. By including knowledgeable employees in the definition of accredited investor, such employees may invest in the private fund without the private fund itself losing accredited investor status when the private fund has assets of $5 million or less.
Implications and Effects of Amendments
The inclusion of knowledgeable employees as accredited investors will remove a recurring issue that arises when issuers want to permit employees to participate in offerings, but cannot offer their securities to employees who are not accredited investors or to groups that include employees who are not accredited investors. This single change may be the one most appreciated by companies that make offerings pursuant to Rule 506.
The inclusion of securities professionals with FINRA-based certifications also avoids uncomfortable situations in which securities professionals, who may know more about an offering than any investors, are unable to invest themselves.
The SEC’s action is welcome and responds to longstanding criticisms of the definition of investor accreditation. The expanded definition also brings the rule closer to long-standing U.S. Supreme Court jurisprudence as to the proper scope of Section 4(a)(2) of the Securities Act (see, e.g., SEC v. Ralston Purina Co., 346 U.S. 119 (1953)). Significantly, issuers can now consider whether certain private offerings that would previously have been “naked” 4(a)(2) offerings (i.e., outside the safe harbor afforded under Regulation D and Rule 506) can now be properly made in compliance with Rule 506 as a result of the Amendments. In this way, the Amendments may well provide additional regulatory certainty for issuers, investors and counsel.
Further, the expanded definition may have the effect of expanding the opportunities for investors to participate in private funds and the investment opportunities that private funds are established to seek. Historically, sophisticated (but not accredited) investors have been restricted in their ability to invest in private funds because their offerings are limited to accredited investors. As a result, many sophisticated investors seeking to make “fund” investments could only do so in funds offered pursuant to registered securities offerings (for example, mutual funds). The wealth test for accreditation presumed that those who had wealth were smart enough to fend for themselves in investing in private funds, but those who were sophisticated and well-educated on the subject of private funds were not.
As a practical matter, issuers (including private funds), investors, financial advisers, investment advisers and counsel need to look to their documentation for new and ongoing offerings to make sure that the requirements for accreditation are properly updated. Investor questionnaires and subscription documents usually repeat the rule-based tests, rather than simply asking if an investor is an accredited investor, so revision of the questionnaires and other documents will be necessary to take advantage of the changes.
Market participants (including private funds) also need to revisit restrictions on resales of securities purchased in Rule 506 offerings in order to permit resales of those securities to the broader population of accredited investors.