Young musicians frequently ask what it takes to be a professional musician. Guitarist Tom Hess, formerly with the band Rhapsody of Fire, believes he has the answer. Hess offers both online guitar lessons and mentoring services to would-be professional musicians.
What’s interesting about Hess’ philosophy (as stated on his website) is what he thinks isn’t essential to success. Hess believes advanced music degrees are mainly useful for those seeking to teach at the college level. Hess also believes that many high-level musicians spend too much time honing their skills and neglect learning critical information about the music business.
Hess also believes that it’s rarely helpful for a musician to play multiple instruments well. He recommends specializing in a single instrument. Hess feels the same about musicians with the knowledge and the ability to perform numerous styles of music. Although this skill might help a studio musician, he believes that for most musicians, the key to success is honing skills about a specific genre, such as classical, blues, or rock.
Hess’ perspective undoubtedly comes from his background as a musician for a band, so it might not translate to other music careers. Still, he appears less impressed by credentials and knowledge than by competence in one’s instrument and business sense. It is competent performances and business sense, rather than credentials or musical knowledge, that bring in the dollars.
Initially, the Securities and Exchange Commission’s (SEC) definition of “accredited investor” under Rule 501 of Regulation D (Reg D) took a similar approach to Hess. The accredited investor definition focused on investor financial wherewithal. Most investors were accredited because of their net worth or income (for individuals) or their total assets (for business entities). For non-accredited investors, there was a concept of “sophistication, which is similar to competence under Hess’ theory.
In December, the accredited investor definition will expand to include new categories. I wrote about those changes in SEC Expands Accredited Investor Definition. The new categories of accredited investors move beyond financial wherewithal and allow individuals to be accredited based solely upon their credentials and knowledge of investors, without consideration of their sophistication.
Current Accredited Investor Definition
Rule 501 of Reg D created several categories of investors who qualified as accredited investors, which have changed little since 1982. The current categories include investors that the SEC determined can afford to withstand the loss of their investment.
Banks, investment companies, employee benefit plans, business development companies, and small business investment companies are accredited investors. Also, corporations, partnerships, charities, and trusts with more than $5 million in assets also are accredited investors.
Individuals also are accredited if they meet income or net worth requirements:
Have a net worth with a spouse of more than $1 million, not counting net equity in their primary residence; or
Have an income of at least $200,000 (or joint income with a spouse of at least $300,000) in each of the two most recent calendar years and reasonably expect the same income level in the current year
Business enterprises in which all equity owners are accredited investors also may be accredited investors, as are grantor trusts (usually trusts where the grantor is both the trustee and beneficiary) controlled by accredited investors. And individual directors, executive officers, or general partners of the securities issuer, all of who presumably have substantial financial wherewithal, are accredited.
Additions to Accredited Investor Definition
For entities, the new rule expands the application of the $5 million in assets category to additional entities, including:
Any entity, including Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries not formed for the specific purpose of investing in the particular securities offered, that own $5 million or more in “investments” (as defined in the Investment Company Act of 1940 (ICA));
Family offices with at least $5 million in assets under management and family clients of those offices; and
Limited liability companies with $5 million in assets.
The rule also clarifies that registered investment advisers, exempt reporting advisers, and rural business investment companies may qualify as accredited investors.
But additional categories of accredited individual investors stray from financial status and instead focus on the investor’s credentials or knowledge:
Individuals with Series 7, 65, and 82 securities licenses; and
For private funds, natural persons who are “knowledgeable employees” of the fund issuer (these individuals are accredited only for purposes of investing in that specific fund).
The new rule also allows individuals to pool finances with a “spousal equivalent,” as well as a spouse, to determine whether they are an accredited investor.
Also, the SEC indicated that it might add additional categories of individuals as accredited investors. The factors the SEC says it will consider when adding categories indicate further movement toward accepting credentials, besides financial wherewithal, to qualify someone as an accredited investor:
“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 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.”
“An indication that an individual holds the certification or designation is either made publicly available by the relevant self-regulatory organization or other industry body or is otherwise independently verifiable.”
Individual Credentials and Knowledgeable Employees
The use of credentials to establish accredited status creates a “bright-line,” objective test, which issuers will welcome. But it’s not as clear-cut which issuer employees are “knowledgeable employees.”
In the new rule, the SEC attempted to help with that analysis by applying the standard for “knowledgeable employee” under Rule 3c-5(a)(4), adopted under the ICA. That rule defines “knowledgeable employee” to include
“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 of the private fund”; and
“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 regarding 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.”
Although the SEC appeared to expand accredited investor status beyond executive officers, the language in the adopting release clarifies that few non-executive employees will qualify as “knowledgeable employees”:
The definition is intended to cover non-executive employees only if they actively participate in the investment activities of the fund, any other private fund or any investment company the investment activities of which are managed by the fund’s affiliated management person. We believe that participating in the management of a fund’s investments is what gives the employee sufficient knowledge and expertise to participate in investment opportunities that do not have the additional protections provided by registration under the Securities Act. (emphasis added)
Fortunately, there are more 20 years of SEC interpretations of Rule 3c-5(a)(4), which issuers can look to for guidance on who is a “knowledgeable employee.” Unfortunately, there is still no safe harbor or bright-line test for determining what employees are “knowledgeable.”
For instance, in 1999, the American Bar Association Section of Business Law obtained a no action letter (ABA No Action Letter) clarifying that the following are NOT “knowledgeable employees”:
“marketing and investor relations professionals who must explain potential and actual portfolio investments of a fund and the investment decision-making process and strategy being followed to clients and prospective investors and who, from time to time, interface among the fund, the portfolio managers and the fund's clients”;
“research analysts who investigate the potential investments for the fund”;
“attorneys who, as part of their duties, provide advice with respect to, or who participate in, the preparation of offering documents, and the negotiation of related agreements and who also are familiar with investment company management issues and respond to questions or give advice concerning ongoing fud investments, operations and compliance matters”; and
“financial, compliance, operational and accounting officers of a fund who have management responsibilities for compliance, accounting and auditing functions of funds”.
In 2014, in a no action letter issued to the Managed Funds Association (2014 No Action Letter), which discussed “knowledgeable employees” under the ICA and could be viewed as backtracking from the ABA No Action Letter. In the 2014 No Action Letter, the SEC clarified that the following might be “knowledgeable persons” if they have regularly performed the stated functions for at least 12 months:
“a member of the analytical or risk team who regularly develops models and systems to implement the fund’s trading strategies by translating quantitative signals into trade orders or providing analysis or advice that is material to the investment decisions of a portfolio manager (in contrast to someone who merely writes the code to a program used by the portfolio manager)”;
“a trader who regularly is consulted for analysis or advice by a portfolio manager during the investment process and whose analysis or advice is material to the portfolio manager’s investment decisions based on the trader’s market knowledge and expertise (in contrast to a trader that simply executes investment decisions made by the portfolio manager)”;
“a tax professional who is regularly consulted for analysis or advice by a portfolio manager typically before the portfolio manager makes investment decisions and whose analysis or advice is material to the portfolio manager’s investment decisions, such as when a tax professional’s analysis of whether income from an offshore fund’s investment may be considered “effectively connected income” is material to a portfolio manager’s decision to invest in certain debt instruments (in contrast to a tax professional who merely prepares the tax filings for the fund)”; and
“an attorney who regularly analyzes legal terms and provisions of investments and whose analysis or advice is material to the portfolio manager’s investment decisions, such as where the attorney’s legal analysis of tranches of a distressed debt investment is material to a portfolio manager’s decision to invest in the loan (in contrast to an attorney who negotiates agreements that effectuate transactions evidencing the investment decisions of the portfolio manager or an attorney or compliance officer who evaluates whether an investment is permitted under a fund’s governing documents)”.
Issuer Next Steps
Both the ABA No Action Letter and the 2014 No Action Letter conclude determination of “knowledgeable employees” for an issuer will be made on a case-by-case basis. Therefore, an issuer will need to determine which non-executive employees are “knowledgeable” before allowing employees who don’t meet the income or net worth standards to invest.
Employees who have been employed by an issuer for less than a year won’t qualify as “qualified.” Of longer-term employees, issuers will need to review employee job descriptions and the actual tasks performed by employees to determine whether they qualify as “knowledgeable.” And then, issuers will need to determine if the employee performs the required tasks “regularly.”
This article provides only a few examples of SEC guidance in the area and isn’t a substitute for legal advice specific to an issuer. Any issuer desiring to expand its offering to non-executive employees should contact securities counsel to establish which employees might qualify as “knowledgeable.”
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.