Orchestra musicians can’t take their instruments out of their cases and immediately start playing. Every instrument requires several steps of preparation. Some steps are required for the instrument to be playable. Other steps are necessary to play the instrument well.
A violinist has to ready both their violin and bow for playing. Because bows are stored with their hair loose, the bow hair must be tightened before the bow is playable. Also, a violinist will put rosin (sticky substance obtained from trees) on the bow hair so it grips it the violin strings better.
A violin doesn’t require preparation to be playable, but it does require several steps before it can be played well. The most obvious preparation is tuning. Violin strings stretch and change pitch when the instrument is stored, so the violinist must tune the violin before playing it. Otherwise, the music is likely to be out of tune.
Also, violins slide around on a shoulder if there isn’t something to hold them in place. Many violinists use shoulder rests, which both fill the space between the violin and the shoulder and provide friction so the violin doesn’t slide. Other violinists use a cloth like a chamois to prevent sliding.
To make their instruments playable, woodwind players must assemble their instruments. Those who play reed instruments must insert a reed into the instrument to make it playable. Some woodwind players, such as saxophone players, attach neck straps that go around their neck to help hold the instrument in place.
Brass instrument players must attach their mouthpieces before they can play them. And trombone players also must put the slide on the instrument to play it. Like string instruments, all wind instruments must be tuned before they can be played well.
Preparing for a regulatory change is like preparing to play an instrument. There are things a business must do to implement the change. And there are additional steps the business should take for a sound compliance program.
This article discusses steps issuers of private placement securities should take to implement the changes to the accredited investor exemption that took effect on December 9, 2020. I discussed those changes in SEC Expands Accredited Investor Definition and SEC Adds Knowledgeable Issuer Employees to List of Accredited Investors in Private Placements
How the Accredited Investor Definition Has Changed
The new rule adds four types of new accredited investors:
Individuals with Series 7, 65, and 82 securities licenses;
For private funds, natural persons who are “knowledgeable employees” of the fund sponsor (these individuals are accredited only to invest in that specific fund);
Any entity, including Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries not formed specifically to invest in the specific securities, that own $5 million or more in “investments” (as defined in the Investment Company Act of 1940 (ICA)); and
Family offices with at least $5 million in assets under management and family clients of those offices.
In addition, the rule clarifies some items:
An individual may pool finances with a “spousal equivalent” as well as a spouse to determine whether they are an accredited investor;
Limited liability companies with $5 million in assets may be accredited investors; and
Registered investment advisers, exempt reporting advisers, and rural business investment companies also may qualify as accredited investors.
Issuers that want to sell securities to investors in these new categories should evaluate their offering materials and make appropriate changes.
Just Because It is Legal Doesn’t Mean it is a Good Idea
Just as there are things a musician must do for their instrument to be playable, an issuer needs to take steps to sell to individuals meeting the new definition of accredited investor.
Most issuers have standard investor questionnaires, which are used to establish whether an investor is accredited. These questionnaires should be updated to include questions designed to identify whether investors fall into the new categories of accredited investor.
Issuers also should modify their questionnaires so they explain that individuals may pool finances with both a “spousal equivalent” and a spouse. This will require consultation with a securities attorney to develop easily understood language explaining who is a “spousal equivalent” to assure investors only pool finances with permissible individuals.
If an issuer plans to allow “knowledgeable employees” to invest in its offerings, the issuer should work with securities counsel to evaluate which employees are eligible to invest. The issuer should have a written policy describing which positions are “knowledgeable employees” and why those positions qualify.
Issuer Best Practices to Implement the Rule Changes
A playable instrument doesn’t always sound good unless the musician takes additional steps, such as tuning. Likewise, reputable sponsors should take extra steps to help assure only accredited investors invest.
Investors with open offerings should supplement their private placement memoranda and other offering documents to reflect the new accredited investor rule. Investors who use a broker-dealer for their offerings should review their agreements to assure that the broker-dealer may sell to investors who now qualify as accredited.
The “knowledgeable employee” category of accredited investor is prone to exploitation. Employees should not feel pressured to invest in their employer’s securities simply because those employees now are accredited. Although the new rule does not require an employee to have a particular income or net worth to qualify as a “knowledgeable employee,” issuers may develop policies to categorize employees as “knowledgeable” only if they meet individual income or other financial requirements.
Employees, who depend upon a salary, naturally will depend highly on their employer’s financial success. For some employees, this may equate to being overly saturated in the employer. This doesn’t mean those employees should never invest in their employer’s securities. But best practices dictate that the employer take particular care when selling securities to employees.
Issuers are not legally required to assure that an investment is suitable for an investor who is otherwise qualified. However, issuers can use suitability concepts when determining whether to sell securities to employees. The focus should be on determining both which employees have the knowledge to make an investment decision and have the financial wherewithal to withstand the risk of the investment. Issuers also should consider dollar limitations on how much an employee can invest, possibly based upon the employee’s annual income. When making these decisions, employers should use objective criteria that pass muster under equal employment laws.
Some issuers may need to evaluate employee purchases under insider trading concepts. Although insider trading laws may not apply to private placements, “knowledgeable employees” may have access to information that allows them to better assess risk and time investments more advantageously than ordinary investors. In an extreme case, this could give rise to claims that the omitted a material disclosure to outside investors.
Issuers Should Evaluate their Unique Circumstances
In music, there are things that, while possible, aren’t a good idea. It’s not a good idea to play the clarinet with a split reed, and it’s not a good idea to play an out-of-tune violin. Similarly, issuers are not obligated to sell securities to the new categories of accredited investors if the issuers objectively determine those sales pose an unacceptable risk.
Although many of the new categories provide welcome updates to the accredited investor definition, the “knowledgeable employee” change is prone to abuse and risk. There may be real or perceived pressure from senior management for employees to invest in their employer’s securities. Or the issuer’s securities might not be suitable for the employee’s investment portfolio.
An employee with a significant investment in their employer’s securities might be incentivized to make decisions that benefit that investment, possibly to the detriment of other issuer offerings. Plus, issuer policies establishing which employees are “knowledgeable” might have a disparate impact on a protected group under equal employment laws.
Best practices demand that issuers carefully consider the required disclosures and evaluate the risk of expanding the availability of their securities to employees. Therefore, every issuer should consult with a securities attorney before selling securities to investors in the new accredited investor categories.
This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.