The Securities and Exchange Commission (SEC) recently adopted a new amendment that adds additional categories of persons eligible to meet the accredited investor definition, expanding the pool of capital available to the private capital markets.

Background

Under the Securities Act of 1933 (Act”), offerings for the sale of securities must be registered with the SEC. Offerings provided to accredited investors, can qualify for a safe harbor under Regulation D for offers and sales of securities exempt from registration requirements. Accredited investors are a central component of Regulation D, as well as other exemptions and federal and state securities law contexts.[1]

On Aug. 26, 2020, by a vote of 3-2, the SEC amended and expanded the definition of accredited investor, which allows certain categories to participate in investment opportunities that were unavailable to them previously.[2] The amendment to the definition of accredited investor will become effective 60 days after the SEC’s release is published in the Federal Register.

Traditionally for individuals, the SEC used wealth as an indicator of financial sophistication.[3] By amending the definition of accredited investor, the SEC recognized that there are other ways for an individual to achieve a level of financial sophistication sufficient to enable them to analyze the risks and rewards associated with investment opportunities.[4] The SEC intends for these new categories to allow for better identification of investors that have sufficient knowledge to participate in investment opportunities and entities.

New Categories

The amendments add the following categories of people to the definition of accredited investor.

• Individuals who hold professional certifications or designations from SEC-accredited educational institutions, including
  
  • Licensed General Securities Representative (Series 7),
  • Licensed Investment Adviser Representative (Series 65), and
  • Licensed Private Securities Offerings Representative (Series 82).[5]
    
    
• Individuals based on their status as a “knowledgeable employee” of a fund. This amendment adopts the knowledgeable employee definition from Rule 3c-5(a)(4) of the Investment Company Act. Under the amendment, “knowledgeable employees” will be defined as: (i) an executive officer, director, trustee, general partner, advisory board member, or person serving in a similar capacity, of the private fund or an affiliated management person; and (ii) an employee of the private fund or an affiliated management person of the private fund (other than an employee performing solely clerical, secretarial, or administrative functions with regard to such company or its investments) who, in connection with his or her regular functions or duties, participates in the investment activities of such private fund, other private funds, or investment companies the investment activities of which are managed by such affiliated management person of the private fund, provided such employee has been performing such functions and duties for or on behalf of the private fund or the affiliated management person of the private fund, or substantially similar functions or duties for or on behalf of another company for at least 12 months.[6] The SEC believes adoption of this category is an effective way to identify non-executive employees who have sufficient knowledge and expertise to participate in private investment opportunities.[7]
  
  
• SEC and state registered investment advisers and exempt reporting advisers regardless of their assets under management.[8]
  
  
• Rural business investment companies (RBICs). RBICs promote economic development and advancement of wealth and job opportunities in rural areas and among the individuals living in such rural areas.[9] These investment companies are similar to small business investment companies, which were already included in the accredited investor definition. So this category is an attempt to maintain consistency between investment companies.
  
  
• Limited liability companies (LLCs) formed for a purpose other than for investing in those securities offered are now included in the definition.[10] This amendment updates the existing category that deems organizations described in Section 501(c)(3) of the Internal Revenue Code, corporations, Massachusetts or similar business trusts, and partnerships susceptible of being accredited investors. Since the last update to the accredited investor definition in 1989, LLCs have been widely adopted and used as an entity type, and the SEC intended to reflect LLCs’ official status as accredited investors, even though the SEC had unofficially been interpreting them as such.[11]
  
  
• Entities created for any purpose other than investing in the securities offered, and own investments in excess of $5 million.[12] This acts as a broad catch-all to include any entity types not specifically included in the definition. For example, this is intended to include Indian tribes, labor unions, governmental bodies and funds, and entities organized under laws of a foreign country.
  
  
• Family offices with assets under management in excess of $5,000,000, (i) formed for purposes other than to acquire the securities offered, and (ii) whose prospective investment is 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.[13] Family offices in this section will follow the definition in the family office rule. The use of this rule for the definition will also allow “family clients” of a family office to qualify as accredited investors.[14] Under this definition, the SEC is prepared to allow a person who receives assets upon the death of a family member or key employee (or other involuntary transfer from a family member or key employee) to qualify as a family client for purposes of the accredited investor definition for one year.[15]
  
  
• Spousal equivalents will be permitted to count their joint income when calculating joint net worth.[16] Spousal equivalents includes individuals who cohabitate and occupy a relationship generally equivalent to that of a spouse. By including spousal equivalents, the SEC attempts to create consistency between multiple regulations: The definition is consistent with the definition in the Advisers Act, Regulation Crowdfunding, and Title III of the Jumpstart Our Business Startups Act (JOBS Act), which use this definition of “spousal equivalent.”[17]
  
  

Rejected Categories

In the adopting release, the SEC specifically rejected the inclusion of customers of a broker-dealer or clients of a registered investment adviser from being included in the definition of accredited investor. The SEC reasoned, “[N]either a recommendation by a broker-dealer nor advice by a registered investment adviser should serve as a proxy for an individual investor’s financial sophistication or his or her ability to sustain the risk of loss of investment or ability to fend for him or herself.” Additionally, the SEC rejected the commentators’ suggestions to increase financial thresholds to account for inflation and the like.

Effects of Amendment

The actual effects of the expansion of the definition of accredited investor will be unknown for some time, but is it anticipated to increase the number of investors eligible to participate in Regulation D offerings. In 2019, Regulation D offerings raised $1.5 trillion, substantially more than the $1.2 trillion raised in public offerings. Significantly, although Regulation D permits up to 35 unaccredited investors to participate in an offering, over 90 percent of the aggregate number of Regulation D offerings in the past 10 years were limited solely to accredited investors – highlighting the importance of accredited investors in our private-offering systems and markets, while hinting at possible growth available under the amended definition.

It is clear investors will benefit from the changes to the definition by creating the opportunity to participate in investment opportunities that would have otherwise been unavailable. The availability of these investment opportunities will allow investors to expand their investment portfolios and increase the return on investments. [18] Ultimately, the changes will be most visible in and beneficial to offerings by smaller issuers, issuers that are in development states, or issuers that are in areas that currently have lower concentrations of accredited investors.

As well as acting as a benefit for the investors with these newly afforded opportunities, the SEC’s amendment has the potential to expand the pool of people who can meet the accredited investor definition while also making it easier for issuers to verify accreditation status, therefore reducing the cost of capital for funds, private companies, and public issuers of privately placed securities.

Companies with plans to raise capital through Regulation D, or other exemptions utilizing the accredited investor definition, should contact the authors: Madison Rittley, David Lavan, Christian Gonzalez, or their Dinsmore attorney for assistance.