On August 26, 2020, the Securities and Exchange Commission (the “SEC”) announced rule amendments intended to dramatically expand certain categories of investors who may participate in private placements of securities. The amendments to Rule 501 of Regulation D (“Regulation D”) under the Securities Act of 1933, as amended (the “Securities Act”) will confer “accredited investor” designation on several new categories of individuals or entities, dramatically expanding the number of persons who may take advantage of accredited investor status, which is often a condition to participating in private company and fund investment in the United States. The amendments to Rule 144A under the Securities Act confer “qualified institutional buyer” designation on two new categories of entities, and adopt a third catch-all category mirroring the amendments to Rule 501. The final amendments will take effect 60 days after being published in the Federal Register.
Regulation D, Rule 144 and Rule 144A, Accredited Investors and Qualified Institutional Buyers
Regulation D and Rule 144A each represent frequently utilized non-exclusive safe-harbors for certain investors to access private capital markets transactions.
Regulation D provides a number of exemptions from the general registration requirements under the Securities Act, and provides issuers with a safe harbor to sell securities without requiring registration of that offering with the SEC. Rule 506 is the most frequently utilized safe harbor utilized by issuers under Regulation D. Rule 506 provides for two distinct exemptions from registration. Provided that an issuer meets the applicable requirements under Rule 506(b), the issuer may sell its securities to an unlimited number of "accredited investors" and up to 35 other purchasers, and provided that an issuer meets the applicable requirements under Rule 506(c), that issuer may broadly solicit and generally advertise its securities provided that the issuer verifies that all investors in that offering are “accredited investors.” Section 4(a)(2) of the Securities Act exempts Rule 506(b) and 506(c) securities offerings from the SEC’s registration requirements. To qualify for the Section 4(a)(2) exemption, an issuer may only make offers and sales to either accredited investors (as defined under Regulation D) or to investors who either have enough knowledge and experience in finance and business matters to be “sophisticated investors” who are able to evaluate the risks and merits of the investment, or be able to bear the investment’s economic risk, and have access to the type of information normally provided in the prospectus included in a SEC registration statement.
In the case of a Rule 506(b) or 506(c) securities offering, the status of an individual or entity as an “accredited investor” may be a dispositive factor in determining whether that investor is permitted to participate in the offering. Rule 501 provides a list of various entities and individuals which meet the definition of “accredited investor,” subject to certain asset or income-based tests (e.g., a natural person with an individual income in excess of $200,000 in each of the last two years and an expectation of the same for the current year).
In general, securities acquired in private transactions are restricted securities, and may not be resold unless the resale is made pursuant to a registration statement or an exemption therefrom. Among other things, Rule 144 permits the resale of restricted securities if certain requirements are met. Rule 144 is not the sole means by which an investor may sell restricted securities, but it is one of the most often-relied upon exemptions. Rule 144A extends the Rule 144 safe harbor to “qualified institutional buyers.” Qualified institutional buyers must be institutions, and cannot be individuals; Rule 144A provides a list of the entities which meet the definition of “qualified institutional buyer,” subject to the requirement that such entity owns and invests at least $100 million in securities of unaffiliated issuers on a discretionary basis.
Expansion of Accredited Investor Status
In the press release announcing the adoption of the final amendments, SEC Chairman Jay Clayton wrote “individuals will be permitted to participate in our private capital markets not only based on their income or net worth, but also based on established, clear measures of financial sophistication…I am also pleased that we have expanded and updated the list of entities, including tribal governments and other organizations, that may qualify to participate in certain private offerings.”
The amendments to the definition of “accredited investor” under Rule 501(a) of Regulation D provide for six significant revisions to that definition.
- Accredited Investor Based on Professional Certification: The final amendments add a new category to the definition of “accredited investor” that permits natural persons to qualify as accredited investors based on specified professional accreditations or certifications, which may be named by the SEC from time to time by separate order, provided that the natural person is in “good standing” as required based on the applicable accreditation or certification. In a separate order released simultaneously with the final amendments, the SEC initially designated FINRA Series 7 (General Securities Representative), Series 65 (Licensed Investment Adviser Representative), and Series 82 (Private Securities Offering Representative) licenses as accepted certifications, and as such, the holders of those licenses shall be deemed accredited investors. The SEC elaborated in the adopting release that the list of accepted certifications may increase over time, and various comment letters cited in the adopting release included discussions regarding other professionals being added such as other FINRA licenses holders, and CPA, JD, CFA, and CAIA holders.
- Accredited Investor Based on Fund Affiliation: The final amendments add a new category to the definition of “accredited investor” which permits natural persons to qualify as accredited investors if they are “knowledgeable employees” of a “private fund.” “Private funds” are pooled investment funds excluded from the definition of “investment company” under the Investment Company Act of 1940, as amended (the “Investment Company Act”), the most common examples being hedge funds and private equity funds. “Knowledgeable employee” is defined in the Investment Company Act as a “[a]n 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 (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.” By utilizing the definition of “knowledgeable employee” set forth in the Investment Company Act, the final amendments create a substantial new category of accredited investor, as accredited investor status will now be available to any employee of a private fund who is involved in the investment decisions of the fund and has at least 12 months of experience participating in such investment decisions for the fund, or substantially similar functions or duties for or on behalf of another company for at least 12 months.
- Pooling Income and Assets with Spousal Equivalents: Historically, in order to meet the accredited investor criteria, spouses are permitted under Rule 501(a)(5) to pool their net worth and under Rule 501(a)(6) to pool their income. The final amendments clarify that “spousal equivalents” will now be able to take advantage of these sections as well. For purposes of the final rule, “spousal equivalent” will be defined as “…a cohabitant occupying a relationship generally equivalent to that of a spouse.”
- Clarification Regarding Accredited Investor Entities: The final amendments clarify that the following entities shall hereafter be considered accredited investors: (i) limited liability companies (“LLCs”) with $5 million or more in assets that were not formed for the specific purpose of acquiring the securities being offered; (ii) SEC and stated-registered investment advisers (“RIAs”) and exempt advisers with $5 million or more in assets; and (iii) rural business investment companies (“RBICs”), as defined in Section 384A of the Consolidated Farm and Rural Development Act, which are companies intended to promote economic development and the creation of wealth and job opportunities in rural areas and among individuals living in those areas.
- Expansion of Accredited Investor Entities: The final amendments add an omnibus catch-all category to the accredited investor definition that includes any entity owning “investments” as the term is defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million that is not formed for the specific purpose of acquiring the securities being offered. In the adopting release, the SEC stated “…we articulate that the intent of this new category is to capture all entity types not already included in the definition of accredited investor as well as those entity types that may be created in the future…[w]e believe the term ‘entity’ is sufficiently broad in this context to encompass Indian tribes and the divisions and instrumentalities thereof, federal, state, territorial, and local government bodies, funds of the types identified by commenters, and entities organized or under the laws of foreign countries.”
- Family Offices as Accredited Investors: The final amendments explicitly add entities which meet the definition of “family office” as defined in Rule 202(a)(11)(G)-1 of the Investment Advisers Act (the “Family Office Rule”) to the definition of “accredited investor,” provided that the family office (i) has at least $5 million in assets under management, (ii) is not formed for the specific purpose of acquiring the securities offered, and (iii) its prospective investment is directed by a person who has such knowledge and experience in financial and business matters that such family office is capable of evaluating the merits and risks of the prospective investment.” The final amendment also includes “family clients” (as defined in the Family Office Rule) as accredited investors, provided that their family office meets the aforementioned requirements, and the investment is directed toward the family client by the family office. In effect, the family client may “piggyback” off of the accreditation of the family office.
The final amendments represent a significant increase to the potential accredited investor pool, effectively including, subject to applicable financial thresholds and/or knowledge and experience thresholds, FINRA license holders, private fund employees, common-law spouses, RIAs and exempt advisers, RBICs, family offices and family clients, and any other entity meeting the $5 million “investments” threshold. We anticipate that this expansion will have far reaching impacts on public and private companies seeking to raise capital, as well as private funds, all of which may now take advantage of a much broader potential investor base.
Expansion of Qualified Institutional Buyer Status
The SEC adopted certain amendments to the definition of qualified institutional buyer to harmonize Rule 144A with the expanded definition of “accredited investor,” stating in the adopting release “[t]he final rules expand the list of entities eligible for qualified institutional buyer status to be consistent with the amendments to the accredited investor definition, maintaining the $100 million threshold for these entities to qualify for qualified institutional buyer status.”
The final amendments add RBICs and LLCs to the qualified institutional buyer definition. In addition, the SEC added a catch-all category to Rule 144A, similar to the catch-all category adopted with respect to the “accredited investor” definition above, providing that any institutional accredited investors under Rule 501(a) of an entity type not included in Rule 144A will qualify as qualified institutional buyers provided the $100 million threshold is met.
The final amendments should provide expanded access to private capital markets for additional investors. Issuers seeking to access this capital should be mindful of the importance of complying with the need to appropriately verify investor status per the amended rules and adjust these processes accordingly. Historically, investor status in private capital markets transactions is verified by the issuer, any placement agent, investment banker, financial advisor (or other similar party) involved in a transaction, and their respective counsel, through the use of an investor questionnaire submitted by a proposed investor together with any relevant transaction documents. An investor questionnaire will require that the potential investor provide information sufficient to prove their eligibility to participate in the purchase, including but not limited to their name (including the designated signatory and contact person if an entity), location, and any FINRA affiliation. Those seeking to take advantage of the final amendments should ensure that the questionnaires used to solicit information from potential investors are updated to include considerations for the new and amended investor categories, and confirm that their procedures to verify the information provided by potential investors are sufficient.
The final amendments to the definition of “accredited investor” illustrate the SEC’s interest in supporting the growth of private securities transactions. By expanding the scope of accredited investors to include licensed professionals, fund employees, family offices and family office clients, as well as many other entities which meet the applicable thresholds discussed herein (e.g., Indian tribes, non-U.S. entities, and government entities as specifically named in the SEC’s adopting release), there is now far greater potential for main-street investors and smaller entities to diversify their investment holdings in a way that would have previously been out of reach. In addition, the decision to specifically include spousal equivalents in the final amendments reflects the SEC’s interest in modernizing its existing rules to account for new family dynamics. This dramatic increase to the pool of potential accredited investors should allow public and private issuers seeking private investments to target previously-untapped market groups and improve access to capital. The final amendments may also have the effect of increasing the volume of private securities transactions, as individuals and entities which were previously unable to easily participate in such transactions have now explicitly been included in the safe harbor rules under Regulation D. Finally, the SEC-adopted final amendments to the definition of “qualified institutional buyer” indicates an initiative by the SEC to spur growth in entity-to-entity securities transactions. In particular, the new catch-all provision which states that any LLC meeting the applicable qualified institutional buyer thresholds may have the effect of increasing market participation in private securities transactions by LLCs, including passive investments, as well as strategic transactions as a precursor to future joint-ventures or M&A activity.