The Securities and Exchange Commission on August 26, 2020 adopted amendments to the definition of “accredited investor” to: add new categories of investors (both for individuals and entities); codify long-standing SEC staff interpretations; and make conforming changes to the definition of “qualified institutional buyer” under Rule 144A.¹ This OnPoint provides further detail and analysis following the Dechert Newsflash published in August.

Notably, the amendments will update the accredited investor definition to include:

• Natural persons with certain professional certifications, designations or other credentials;
• “Knowledgeable employees” within the meaning of Rule 3c-5 under the Investment Company Act of 1940;
• A catch-all category for entities meeting an investment-based test;
• Certain family offices and family clients;
• Registered investment advisers and exempt reporting advisers; and
• Certain limited liability companies.

The rule amendments were proposed in December 2019,² and were adopted largely as proposed.

Background on the Accredited Investor Definition

Section 4(a)(2) of the Securities Act of 1933 provides that an offering of securities that does not involve a “public offering” is exempt from registration. Regulation D under the Securities Act created safe harbors from the registration requirements of the Securities Act for private offerings that are made primarily or exclusively to persons that are accredited investors (as applicable). Generally, accredited investors are deemed to have the financial sophistication to participate in private offerings without the protections contained in the Securities Act. Prior to these amendments, the definition of accredited investor applicable to individuals relied on income or net worth as the main proxies for financial sophistication, which the SEC has characterized as “suboptimal.”³

Adopted in 1982, the accredited investor definition has not undergone significant changes until recently.⁴ The SEC indicated that the amendments are intended to “update and improve” the accredited investor definition to more effectively identify investors that do not need the protections of the Securities Act.

New Categories and Rules for Individual Accredited Investors

The amendments add the following categories of natural persons to the accredited investor definition:

• Individuals with Professional Certifications/Designations and Other Credentials – Natural persons in good standing who hold certain professional certifications, designations or credentials from accredited educational institutions designated by the SEC. In connection with the adoption of the amendments, the SEC issued an order designating Series 7, Series 65 and Series 82 licenses as qualifying under this new category. The amendments also provide a non-exclusive framework by which the SEC may designate additional certifications, designations or credentials going forward. In determining whether to approve a credential, factors that the SEC will consider include (among others) that:
  • The certification, designation, or credential arises out of an examination or series of examinations administered by a self-regulatory organization or other industry body or is issued by an accredited educational institution;
  • The examination or series of examinations is designed to reliably and validly demonstrate an individual’s comprehension and sophistication in the areas of securities and investing;
  • Persons obtaining such a certification, designation or credential can reasonably be expected to have sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of a prospective investment; and
  • An indication that an individual holds the certification or designation is made publicly available by the relevant self-regulatory organization or other industry body or is otherwise independently verifiable.
• Knowledgeable Employees of Private Funds – Knowledgeable employees (within the meaning of Rule 3c-5 under the Investment Company Act of 1940) are accredited investors for purposes of investing in related private fund offerings. Private funds often rely on the registration exception provided under Section 3(c)(7) of the 1940 Act, which requires that all investors be either qualified purchasers or knowledgeable employees. Prior to the amendments, for a Section 3(c)(7) private fund, a knowledgeable employee was required to independently meet the accredited investor definition, but not the qualified purchaser definition (which contains significantly higher financial thresholds). The amendments harmonize the Securities Act and the 1940 Act by permitting knowledgeable employees to bypass the financial threshold requirements under both the accredited investor and qualified purchaser definitions. Sponsors of Section 3(c)(1) private funds also no longer are required to count otherwise non-accredited knowledgeable employee investors toward the 35 non-accredited investor limit in a Rule 506(b) private placement.

In addition, the accredited investor definition has been revised to permit the inclusion of assets and income from spousal equivalents (i.e., a cohabitant occupying a relationship generally equivalent to that of a spouse) in determining the joint net worth and joint income thresholds contained in the definition.

New Categories of Entity Accredited Investor

The amendments add the following categories of entities to the definition of accredited investor:

• Entities Satisfying a $5 Million “Investments-Owned” Test – A new catch-all category for entities that own more than $5 million of investments (as defined under the 1940 Act). This category is specifically intended to capture all new and existing entity types not already contemplated by the accredited investor definition (including, among others, Indian tribes, governmental bodies, and entities formed under foreign jurisdictions).
• Certain Family Offices and Family Clients – Family offices (as defined in the Investment Advisers Act of 1940): (i) with more than $5 million in assets under management; (ii) that are not formed for the purpose of investing in the offered securities; and (iii) whose prospective investments are directed by individuals who have knowledge and experience in financial and business matters. The amendments also add family clients (as defined in the Advisers Act) of qualifying family offices.
• Investment Advisers and Exempt Reporting Advisers – Investment advisers that are registered with the SEC or a state, as well as exempt reporting advisers (i.e., venture capital fund advisers and private fund advisers with less than $150 million in assets under management).
• Certain Limited Liability Companies – LLCs having total assets of more than $5 million. The addition of LLCs to the category of accredited investors having total assets greater than $5 million codifies the SEC’s long-standing position that LLCs that otherwise meet this definition are accredited investors.⁵
• Rural Business Investment Companies (RBICs) – A type of company sponsored by the Department of Agriculture under the Consolidated Farm and Rural Development Act to promote economic development in rural areas. The SEC noted in the Adopting Release that RBICs share a similar purpose with and should be treated the same as Small Business Investment Companies, which currently qualify as accredited investors.

Conforming Amendments to the Qualified Institutional Buyer Definition

Rule 144A provides a safe harbor from the registration requirements of the Securities Act for certain resales of restricted securities to qualified institutional buyers. To be a qualified institutional buyer, an investor must own and invest on a discretionary basis $100 million in securities of unaffiliated issuers and be one of several types of entities listed in the rule. The amendments conform the types of eligible entities to those under Rule 144A, to include: RBICs; LLCs; and institutional accredited investors under Rule 501(a) of the Securities Act that are not already listed in Rule 144A(a)(1). The SEC indicated in the Adopting Release that this last category will synchronize the definition with the new accredited investor category for entities having more than $5 million of investments, as well as new types of institutional accredited investors that the SEC may recognize in the future.

In response to a public comment, the SEC added a new instruction clarifying that entities formed for the purpose of acquiring 144A securities are eligible to be qualified institutional buyers. The SEC indicated in the Adopting Release that any requirement under Rule 501(a) that an accredited investor not be formed for the purpose of acquiring securities would not be imported into Rule 144A.

Other Items of Note

While making the revisions, the SEC expressly rejected various changes to the accredited investor definition, including the following:

• No New Financial Thresholds for Accredited Investors. The SEC sought public comment in the Proposing Release as to whether financial thresholds to qualify as an accredited investor (for natural persons, income exceeding $200,000 for individuals and $300,000 for married couples, or net worth exceeding $1 million) should be modified; this has been an area of SEC focus in recent years. The SEC declined to modify the financial thresholds for natural persons and entities, noting (among other reasons) that doing so: would be unfair to individual investors who currently qualify as accredited investors but might not qualify under modified thresholds; and could disrupt the Regulation D market, by reducing the current pool of accredited investors. The SEC also noted that it is not aware of widespread problems or abuses in the Regulation D market that might support modifying the thresholds.
• No Geography-Specific Thresholds. The SEC sought public comment in the Proposing Release as to whether it should create geography-specific thresholds to account for income and wealth disparities of in particular areas of the United States. The SEC declined to create these thresholds, noting in the Adopting Release that doing so would create complexities for issuers and investors.
• No New Category for Third-Party Advisers. The SEC sought public comment in the Proposing Release as to whether investors advised by a registered investment advisers or broker-dealers should qualify as accredited investors. The SEC declined to amend the rule to include these types of investors, noting in the Adopting Release that a recommendation by an adviser would not serve as an adequate proxy for investors’ financial sophistication, ability to bear losses or ability to fend for themselves.
• Managing Members Not Expressly Included. Although the SEC declined to add “managing members” to the category of accredited investors under Rule 501(a)(4) that includes any director, executive officer, or general partner of the issuer of the securities being sold, the SEC noted in the Adopting Release that managers of LLCs perform “policy making functions,” and therefore are executive officers under this category. The SEC further indicated in the Adopting Release that both member managers and third-party managers could be considered to be executive officers.
• No Changes to Diligence Requirements. The amendments do not modify the existing SEC framework for how private funds must determine whether investors satisfy the accredited investor requirement for purposes of Rule 506(b) (which currently permits issuers to rely on investor certifications) or Rule 506(c) (which currently requires issuers to reasonable steps to verify accredited investor status).

Conclusion

Although the amendments are significant, the SEC acknowledged in the Adopting Release that the amendments are not expected to greatly increase the total number of eligible accredited investors, or to provide a meaningful source of additional capital for private offerings.⁶ Asset managers should reach out to their legal counsel to discuss practical considerations as a result of the amendments, including updating subscription agreements. The amendments will go into effect 60 days after publication in the Federal Register.