In light of recent amendments adopted by the U.S. Securities and Exchange Commission (the SEC), the pool of potential investors for private fund managers may be expanding. As noted in a previous advisory, on August 26, the SEC modified its definitions under the Securities Act of 1933 for “accredited investors” in Regulation D Rule 501(a) and “qualified institutional buyers” (QIBs) in Rule 144A ( press release). Despite the SEC’s efforts to make the private offering exemptions more accessible, many private funds are subject to additional requirements imposing higher eligibility standards that must be complied with to maintain their regulatory status. Accordingly, while certain new categories of accredited investors and QIBs will be a welcome change for private fund managers, some of the other new categories may not actually increase their potential pool of otherwise eligible investors.

The modified definitions for accredited investors and QIBs do not take effect until 60 days after publication in the Federal Register, which has yet to occur. Private fund managers should use the pre-effective period to review and update their fund offering documents as well as their related policies and procedures. However, all solicitations and offerings—not just sales—conducted before the effective date must comply with the rules and definitions currently in effect.

New Categories of Accredited Investors

The SEC added the following new categories of accredited investors:

• Natural persons qualifying based on certain professional certifications, designations or credentials, (and, by a separate order of the SEC, initially includes holders in good standing of the Series 7, Series 65, and Series 82 licenses), which remains subject to further evaluation, adjustments and additions by the SEC;
• Private fund “knowledgeable employees,” [1] as defined under Rule 3c-5(a)(4) of the Investment Company Act of 1940, with regard to that private fund’s securities;
• Limited liability companies (LLCs) with $5 million in assets;
• SEC and state-registered investment advisers, exempt reporting advisers, and rural business investment companies (RBICs);
• Entities, including Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries, that own “investments,” [2] as defined in Rule 2a51-1(b) under the Investment Company Act in excess of $5 million that were not formed for the specific purpose of investing in the securities offered;
• “Family offices” [3] with at least $5 million in assets under management and their “family clients,” [4] each as defined under the Investment Advisers Act of 1940; and
• “Spousal equivalent”, permitting spousal equivalents to pool their finances for the purpose of qualifying under the original income test.

Expanded Definition of QIBs

The SEC modified the definition of “qualified institutional buyer” to include the following:

• Institutional investors that qualify under the “accredited investor” definition that are not otherwise covered in the definition of QIB so long as the $100 million threshold is satisfied; and
• LLCs and RBICs that meet the $100 million in securities owned and invested threshold.

Be Cautious of Additional Private Fund Eligibility Requirements

Not all investors qualifying under the new categories of accredited investor will ultimately be eligible to invest in private funds. In addition to eligibility requirements such as meeting minimum investment amounts, residency requirements and certain tax status, private funds may have additional eligibility requirements to meet the conditions of certain regulatory exemptions under the Investment Advisers Act and the Investment Company Act. Under Section 205(a)(1) of the Investment Advisers Act, registered private fund managers are prohibited from charging investors performance-based compensation (i.e., carried interest, performance fees, incentive allocations) unless the investors are “qualified clients” as provided under Advisers Act Rule 205-3’s exemption from the compensation prohibition. [5] Private funds relying on Investment Company Act Section 3(c)(7)’s exclusion from the definition of an investment company to avoid registration requirements as such generally must limit their investors to only those who are “qualified purchasers” as defined in Investment Company Act Section 2(a)(51). [6] Both the qualified client and qualified purchaser standards are generally harder to satisfy than the Securities Act accredited investor standard, narrowing the pool of prospective investors. [7]

The expanded definitions of accredited investor and QIB do provide welcome relief for certain private fund manager employees who satisfied the Investment Advisers Act Rule 205-3 exemption and Investment Company Act Section 3(c)(7) exclusion requirements by virtue of being “knowledgeable employees” under those standards, but were otherwise precluded from investing because of the current accredited investor standard. In particular, adding the new accredited investor category of “knowledgeable employees” harmonizes the SEC’s position that such employees, through their knowledge and active participation in the investment activities of the private fund, are likely to be financially sophisticated and capable of fending for themselves and therefore should be eligible to participate in investment opportunities that do not have the additional protections afforded under these securities laws.

Similarly, the expanded definition of QIBs may provide relief for certain private fund investors looking to satisfy not only QIB requirements, but also the qualified purchaser requirement as the definition of qualified purchaser includes certain QIBs.

Compliance Takeaways

During the pre-effective period, private fund managers should consider the following actions:

• Review and update, as applicable, private fund organizational and offering documents, including subscription documents and investor questionnaires to be used upon the effective date;
• Update private offering compliance policies and procedures;
• Provide training to business development and marketing personnel to ensure familiarity with the revised definitions and that the new policies and procedures are implemented properly; and
• For those private funds conducting Securities Act Regulation D Rule 506(c) offerings (e., those private offerings with certain permitted general solicitation and advertising), confirm sufficient methods for verifying accredited investor status will be in place upon the effective date, whether verifications are conducted internally or through a third party vendor. For example, according to the amended definitions’ adopting release, firms may use FINRA’s BrokerCheck or the SEC’s Investment Adviser Public Disclosure database to verify whether prospective investors are eligible accredited investors based on their status as registered representatives and investment adviser representatives.

For more information regarding the amended accredited investor and QIB definitions, please see our August 27 client advisory, related herein.

[1] Rule 3c-5(a)(4) under the Investment Company Act defines a “knowledgeable employee” with respect to a private fund 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 (as defined in Rule 3c-5(a)(1)) of the private fund; 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 that 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.

[2] The term “investments” for this purpose generally means: (1) securities (as defined by Section 2(a)(1) of the Securities Act, other than securities of an issuer that controls, is controlled by, or is under common control with, the prospective investors that owns such securities, unless the issuer of such securities is: (i) an investment vehicle (as defined under Investment Company Act Rule 2a51-1(b)); (ii) a public company (as defined under Investment Company Act Rule 2a51-1(b)); or (iii) a company with shareholders' equity of not less than $50 million (determined in accordance with generally accepted accounting principles) as reflected on the company's most recent financial statements, provided that such financial statements present the information as of a date within 16 months preceding the date on which the prospective investor acquires the securities of a Section 3(c)(7) company; (2) real estate held for investment purposes; (3) commodity interests (as defined under Investment Company Act Rule 2a51-1(b)) held for investment purposes; (4) physical commodities (as defined under Investment Company Act Rule 2a51-1(b)) held for investment purposes; (5) to the extent not securities, financial contracts (as such term is defined in Investment Company Act Section 3(c)(2)(B)(ii) entered into for investment purposes; (6) in the case of a prospective investor that is a Section 3(c)(7) company, a company that would be an investment company but for the exclusion provided by Investment Company Act Section 3(c)(1), or a commodity pool, any amounts payable to such prospective investor pursuant to a firm agreement or similar binding commitment pursuant to which a person has agreed to acquire an interest in, or make capital contributions to, the prospective investor upon the demand of the prospective investor; and (7) cash and cash equivalents (including foreign currencies) held for investment purposes.

[3] The term “family office” for this purpose generally means a company (including its directors, partners, members, managers, trustees, and employees acting within the scope of their position or employment) that (1) has no clients other than family clients; provided that if a person that is not a family client becomes a client of the family office as a result of the death of a family member or key employee or other involuntary transfer from a family member or key employee, that person shall be deemed to be a family client for one year following the completion of the transfer of legal title to the assets resulting from the involuntary event; (2) is wholly owned by family clients and is exclusively controlled (directly or indirectly) by one or more family members and/or family entities; and (3) does not hold itself out to the public as an investment adviser.

[4] The term “family client” for this purpose generally means (i) any family member; (ii) any former family member; (iii) any key employee; (iv) any former key employee, provided that upon the end of such individual's employment by the family office, the former key employee shall not receive investment advice from the family office (or invest additional assets with a family office-advised trust, foundation or entity) other than with respect to assets advised (directly or indirectly) by the family office immediately prior to the end of such individual's employment, except that a former key employee shall be permitted to receive investment advice from the family office with respect to additional investments that the former key employee was contractually obligated to make, and that relate to a family-office advised investment existing, in each case prior to the time the person became a former key employee; (v) any non-profit organization, charitable foundation, charitable trust (including charitable lead trusts and charitable remainder trusts whose only current beneficiaries are other family clients and charitable or non-profit organizations), or other charitable organization, in each case for which all the funding such foundation, trust or organization holds came exclusively from one or more other family clients; (vi) any estate of a family member, former family member, key employee, or, subject to certain conditions, former key employee; (vii) any irrevocable trust in which one or more other family clients are the only current beneficiaries; (viii) any irrevocable trust funded exclusively by one or more other family clients in which other family clients and non-profit organizations, charitable foundations, charitable trusts, or other charitable organizations are the only current beneficiaries; (ix) any revocable trust of which one or more other family clients are the sole grantor; (x) any trust of which: each trustee or other person authorized to make decisions with respect to the trust is a key employee; and each settlor or other person who has contributed assets to the trust is a key employee or the key employee's current and/or former spouse or spousal equivalent who, at the time of contribution, holds a joint, community property, or other similar shared ownership interest with the key employee; or (xi) any company wholly owned (directly or indirectly) exclusively by, and operated for the sole benefit of, one or more other family clients; provided that if any such entity is a pooled investment vehicle, it is excepted from the definition of “investment company” under the Investment Company Act.

[5] The term “qualified client” generally means (a) natural person who, or a company that, immediately after entering into the contract has at least $1 million under the management of the private fund manager; (b) a natural person who, or a company that, the private fund manager entering into the contract (and any person acting on his behalf) reasonably believes, immediately before entering into the contract, either: (i) has a net worth (together, in the case of a natural person, with assets held jointly with a spouse) of more than $2.1 million; or (ii) is a qualified purchaser as defined in section 2(a)(51)(A) of the Investment Company Act at the time the contract is entered into; or (c) a natural person who immediately prior to entering into the contract is: (i) an executive officer, director, trustee, general partner, or person serving in a similar capacity, of the private fund manager; or (ii) an employee of the private fund manager (other than an employee performing solely clerical, secretarial or administrative functions with regard to the private fund manager) who, in connection with his or her regular functions or duties, participates in the investment activities of such private fund manager, provided that such employee has been performing such functions and duties for or on behalf of the investment adviser, or substantially similar functions or duties for or on behalf of another company for at least 12 months (a knowledgeable employee). Note, Section 418 of the Dodd-Frank Act requires the SEC to issue an order every five years to adjust for inflation the dollar amount thresholds in Rule 205-3’s assets-under-management and net worth tests based on the Personal Consumption Expenditures Chain-Type Price Index (PCE Index, published by the United States Department of Commerce), rounded to the nearest $100,000. The last increase became effective in August 2016.

[6] The term “qualified purchaser” generally means, (a) an individual who owns not less than $5 million in “Investments” either separately or jointly or as community property with his or her spouse; (b) an entity, acting for its own account or the accounts of other “qualified purchasers,” that in the aggregate owns and invests on a discretionary basis not less than $25 million in “Investments”; (c) a “family company” (as defined under the Investment Company Act) that owns not less than $5 million in “Investments”; (d) an entity (other than a trust), each of the beneficial owners of which is a “qualified purchaser”; or (e) certain QIBs. For purposes of determining the whether the outstanding securities of a Section 3(c)(7) Company are owned exclusively by qualified purchasers, funds excluded securities beneficially owned by knowledgeable employees pursuant to Investment Company Act Rule 3c-5.

[7] Not all additional eligibility requirements, regulatory or otherwise, are discussed in this client advisory. Please consult legal counsel to determine the interplay of any such requirements with the new expanded definitions of accredited investors and QIBs.