The U.S. Securities and Exchange Commission (the "SEC") proposed on December 18, 2019 amendments to, among other things, its current rules under the Securities Act of 1933 (the "Securities Act") relating to the definitions of an "accredited investor" and a "qualified institutional buyer."[1] As stated in the Proposing Release, those proposed amendments are intended to identify more effectively investors that have the knowledge and expertise to participate in the private capital markets and therefore, do not need the additional protections of registration under the Securities Act. The Proposing Release builds on a report published by the SEC Staff in December 2015[2], as well as a concept release published by the SEC itself in June 2019[3].

WHAT YOU NEED TO KNOW

This is only a proposal. You are not required to take any action at this time.

This proposal broadens the categories of investors to whom certain private offerings of securities, including offerings by hedge funds, private equity funds, venture capital funds, angel funds, and private real estate funds, may be made.

If adopted as proposed, the new rules would:

• Permit more categories of investors to invest in private funds
• Permit fund employees more opportunities to invest in funds sponsored by their firms
• Broaden the types of institutional investors that may invest in Rule 144A securities
• Require private funds to update their offering documentation

Offers and Sales of Securities

Current Regulation of Offers and Sales of Private Fund Securities in the U.S.

Section 5 of the Securities Act generally makes it unlawful for any person, such as hedge funds, private equity funds, venture capital funds, angel funds, and private real estate funds ("Private Funds"), to offer or sell a security through a prospectus unless a registration statement is in effect with respect to the security and the prospectus meets the requirements of Section 10 of the Securities Act.

Section 5, however, does not apply to offers and sales of a security by its issuer that do not involve a public offering, pursuant to Section 4(a)(2) of the Securities Act. Rule 506 of Regulation D under the Securities Act is a non-exclusive safe harbor under Section 4(a)(2) requiring, among other things, that the security is offered and sold primarily to persons who meet the conditions of an "accredited investor." The definition of an "accredited investor" for purposes of Regulation D is included in Rule 501(a). Most Private Funds comply with Rule 506 to avoid having to file registration statements relating to their securities.[4] For Private Funds that invest in securities (as opposed to, for example, derivatives and direct investments in real estate), complying with Rule 506 also serves the purpose of fulfilling a condition of Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940 (the "1940 Act").[5] A Private Fund that complies with the conditions of either Section 3(c)(1) or Section 3(c)(7) is excluded from the definition of an "investment company" in Section 3(a) of the 1940 Act, and thus, substantially all regulations applicable to investment companies. To rely on either section, a Private Fund may not make a public offering of its securities.

Section 5 also does not apply to offers and sales of a security by a person other than an issuer, underwriter, or dealer, pursuant to Section 4(a)(1) of the Securities Act. Rule 144A under the Securities Act is a non-exclusive safe harbor for resales of restricted securities, which excludes from the definition of "underwriter" any person who, among other things, offers or sells the subject securities to an entity that meets the conditions of a "qualified institutional buyer." Many investment managers rely on Rule 144A to purchase and sell certain securities (commonly referred to as "Rule 144A securities") for the portfolios of their clients that are mutual funds, hedge funds, and other types of large institutional investors.

2015 Staff Report

In December 2015, the SEC Staff published a report on the accredited investor definition as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act.[6] The 2015 Staff Report included an examination by the SEC Staff of the current definition of an "accredited investor," as well as various proposals to amend the definition. Many of those proposals suggested raising the current definition’s income and net worth thresholds and/or adding indicia of financial sophistication, such as professional certifications.

2019 Concept Release

In June 2019, the SEC itself published the 2019 Concept Release, which it described as part of its comprehensive review of the design and scope of the Securities Act’s framework for exempt securities offerings. The stated objective of the 2019 Concept Release was to seek comment on possible ways to simplify, harmonize, and improve the exempt-offering framework to promote capital formation, expand investment opportunities, and maintain investor protections. Among other things, the 2019 Concept Release discussed public comment on the 2015 Staff Report, as well as the private placement exemption and Rule 506 under the Securities Act.[7] While the 2019 Concept Release discussed Securities Act exemptions generally, it devoted one section to a discussion of the use of private placement exemptions by Private Funds. It also analyzed whether the definition of accredited investor in Rule 501(a) should be harmonized with other investor-eligibility standards, such as "qualified client," which applies, for example, when certain Private Funds managed by investment advisers registered under the Investment Advisers Act of 1940 (the "Advisers Act") apply a performance fee or incentive allocation[8], and "qualified purchaser," which applies to certain Private Funds intending to rely on the exclusion from the definition of an investment company in Section 3(c)(7) of the 1940 Act.[9] Public comments on the 2019 Concept Release varied substantially in how they would recommend the Securities Act apply to offerings of Private Fund interests.

Summary of Proposed Amendments

Proposed Amendments to Regulation D, Rule 501 ("Accredited Investor" Definition) and Related Rules

Currently, for purposes of Regulation D, an individual may be considered an accredited investor if at the time of investment, he or she had earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year. Alternatively, the individual must have a net worth over $1 million, either alone or together with a spouse (excluding the value of the person's primary residence). For an entity to be considered an accredited investor, the entity generally must hold total assets with an aggregate value exceeding $5 million.

The proposed amendments in the Proposing Release, if adopted as proposed, would broaden, rather than narrow, the categories of individuals and entities that qualify as accredited investors.

Additional Categories of Natural Persons. The proposed amendments to Rule 501(a) would add two new categories of individuals who would qualify as accredited investors based on their professional knowledge, experience, or certifications, which are intended to demonstrate the individual’s background and understanding of securities and investing.

• The proposed amendments would permit an individual to qualify as an accredited investor based on earning any of certain professional certifications and designations, such as a Series 7 license (licensed general securities representative), Series 65 license (licensed investment adviser representative), or Series 82 license (licensed private securities offerings representative), each issued by the Financial Industry Regulatory Authority (FINRA), or other credentials issued by an accredited educational institution. The Proposing Release notes that these credentials must relate to securities and investing. It also notes that an individual would be required to maintain an active certification, designation, or credential to continue to qualify as an accredited investor but he or she would not be required to be practicing in the field.
• The proposed amendments also would permit a "knowledgeable employee," as defined in Rule 3c-5 under the 1940 Act, of a Private Fund relying on Section 3(c)(1) or 3(c)(7) to qualify as an accredited investor for an investment in the Private Fund. A knowledgeable employee generally would include any officer or director of the Private Fund’s investment manager, as well as any employee of the investment manager participating in the investment activities of the Private Fund for at least 12 months.[10]

The proposed amendments also would note that the current references in the definition to "spouse," such as in the income and net worth tests applicable to individuals, would include spousal equivalents, which the proposed amendments define as a "cohabitant occupying a relationship generally equivalent to that of a spouse." The proposed amendments also would clarify that securities purchased in reliance on the joint net worth of a spouse or spousal equivalent would not have to be purchased jointly with the spouse or the spousal equivalent.

Additional Categories of Entities. The proposed amendments to Rule 501(a) would add four new enumerated categories of entities to the current list, a catch-all category based on the amount of investments, and family offices based on assets under management.

• In addition to the currently enumerated types of entities, the definition as proposed would include investments advisers, whether registered under the Advisers Act or under state law, and rural business investment companies ("RBICs"), regardless of the amounts managed or their asset sizes. In addition, the definition as proposed would include limited liability companies ("LLCs") with assets of more than $5 million and which have not been formed for the specific purpose of acquiring the securities offered. The latter change is intended to codify the SEC Staff’s current position regarding LLCs.
• The definition as proposed also would include a catch-all category for any entity owning investments – rather than assets - of more than $5 million and not formed for the purpose of acquiring the securities offered. For purposes of this catch-all provision, the definition would incorporate the current definition of "investments" in Rule 2a51-1(b) under the 1940 Act.
• Finally, the definition as proposed would include family offices with assets under management – rather than assets or investments – of more than $5 million and which have not been formed for the specific purpose of acquiring the securities offered, as well as each family client. The definitions of family offices and family client would incorporate the current definitions of "family offices" and "family client," respectively, in Rule 202(a)(11)(G)-1 under the Advisers Act.

Proposed Amendments to Securities Act Rules 215 and 163B and Securities Exchange Act Rule 15g-1.

The Proposing Release also includes two rule amendments relating to offers and/or sales other than in reliance of Regulation D.

• Section 4(a)(5) of the Securities Act excludes from Section 5 transactions involving offers or sales by an issuer solely to one or more accredited investors if, among other things, the aggregate offering price of an issue of securities offered in reliance on Section 4(a)(5) does not exceed $5 million. Rule 215 under the Securities Act defines an accredited investor for purposes of Section 4(a)(5) of the Securities Act, and currently that definition differs from the definition in Rule 501(a). The Proposing Release includes an amendment to Rule 215 to replace the current definition of an "accredited investor" in that rule with the proposed definition for Rule 501(a).
• Rule 163B under the Securities Act permits "testing the waters" communications to potential investors that the issuer or a person acting on behalf of the issuer reasonably believes are qualified institutional buyers, as defined in Rule 144A under the Securities Act (see discussion below), or accredited investors pursuant to Rule 501(a), other than those categories of accredited investors who are individuals. The Proposing Release includes an amendment to Rule 163B to permit communications with investors that fall within any of those additional categories of accredited investors applicable to entities described in amended Rule 501(a) (as amended, "Institutional Accredited Investors").
• Rule 15g-1 under the Securities Exchange Act of 1934 exempts broker-dealers from certain customer-disclosure requirements in penny-stock transactions if the customer is an "institutional accredited investor," that is, an accredited investor other than an individual. The Proposing Release includes an amendment to Rule 15g-1 also to extend the disclosure exemption to those institutional investors that would be accredited investors under the proposed amendments to Rule 501(a).

Proposed Amendments to Rule 144A ("Qualified Institutional Buyer" Definition)

Rule 144A currently defines a "qualified institutional buyer" as an entity that meets at least one of five categories of investors: (a) a financial institution that in the aggregate owns and invests on a discretionary basis at least $100 million in securities and, in the case of a banking institution, has an audited minimum net worth of at least $25 million; (b) a dealer that in the aggregate owns or invests on a discretionary basis at least $10 million in securities; (c) a dealer acting in a riskless principal transaction on behalf of a qualified institutional buyer; (d) an investment company acting for its own account or for the accounts of other qualified institutional buyers, which is part of a family of investment companies which own in the aggregate at least $100 million in securities; and (e) an entity, all of the equity owners of which are qualified institutional buyers, acting for its own account or the accounts of other qualified institutional buyers.

The Proposing Release includes amendments that would extend the definition of qualified institutional buyers in Rule 144A to RBICs, LLCs and any other Institutional Accredited Investors not otherwise enumerated in the current definition, provided that the entity has in the aggregate at least $100 million in securities owned or invested on a discretionary basis.

When Comments Are Due and How to Submit Comments

Under federal law, the public has a right to comment on the Proposing Release. The comment period is open for 60 days after the publication of the Proposing Release in the Federal Register. As of the date of this client alert, the Proposing Release had not yet been published in the Federal Register. Comments generally must be submitted through the SEC’s website at https://www.sec.gov/cgi-bin/ruling-comments.

Throughout the Proposing Release, the SEC has asked for comments on a variety of issues, and we would encourage anyone with an interest in this subject to submit comments for the SEC’s consideration.

[1] "Amending the ‘Accredited Investor’ Definition," Release No. 33-10734 (December 18, 2019) [hereinafter, the "Proposing Release"].

[2] "Report on the Review of the Definition of 'Accredited Investor,'" (December 18, 2015) [hereinafter, the "2015 Staff Report"].

[3] "Concept Release on Harmonization of Securities Offering Exemptions," Release No. 33-10649 (June 18, 2019) [hereinafter, the "2019 Concept Release"].

[4] Many closed-end, registered investment companies structured as tender offer or interval funds also are required to limit sales of their securities to accredited investors notwithstanding that those securities offerings are registered under Section 5.

[5] Section 3(c)(1) generally provides that an issuer is not an investment company if its outstanding securities are beneficially owned by not more than 100 persons and it is not making and does not presently propose to make a public offering of its securities. Section 3(c)(7) generally provides that an issuer is not an investment company if its outstanding securities are owned exclusively by qualified purchasers and it is not making and does not presently propose to make a public offering of its securities.

[6] Pub. L. No. 111-203; 124 Stat. 1376-2223 (July 21, 2010).

[7] The 2019 Concept Release also discussed exemptions under the Securities Act pursuant to Regulation A and Rule 504 of Regulation D, as well as intrastate and Crowdfunding offerings.

[8] See Rule 205-3 under the Advisers Act, which provides for an exemption from the prohibition applicable to registered investment advisers from receiving compensation in the form of a share of capital gains upon, or capital appreciation of, a client’s account if the client meets the conditions of a qualified client. "Qualified client" is defined in Rule 205-3(d)(1).

[9] See note 4, supra.

[10] Importantly, a knowledgeable employee of a Private Fund that may not rely on Section 3(c)(1) or 3(c)(7), such as a real estate fund that must rely on Section 3(c)(5), or a real estate fund or commodity pool that does not invest in securities and thus is not an investment company as defined in Section 3(a) of the 1940 Act, would not be an accredited investor with respect to that Private Fund unless he or she satisfied the income or net worth tests.