On Wednesday, August 26, 2020, the Securities and Exchange Commission (“SEC”) adopted a Final Rule amending the “accredited investor” definition. These amendments increase the pool of investors who now qualify for “accredited” status and “are part of the Commission’s ongoing effort to simplify, harmonize, and improve the exempt offering framework, thereby expanding investment opportunities while maintaining appropriate investor protections and promoting capital formation.” SEC Chairman Jay Clayton stated: “For the first time, 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…, that may qualify to participate in certain private offerings.”
The Accredited Investor Definition and Amendments
The current rule contained several categories of accredited investors, with the most common categories summarized as:
Any nonprofit organization, corporation, business trust, trust or partnership not formed for the specific purpose of acquiring the securities offered with total assets in excess of $5 million;
Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer;
Any natural person whose individual net worth, or joint net worth with that person's spouse, exceeds $1,000,000, not including the value of such person’s primary residence; and
Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person's spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.
The amendments to the accredited investor definition set forth in Rule 501(a) of Regulation D implement the following revisions:
Added a new category to the definition that permits natural persons to qualify as accredited investors based on certain professional certifications, designations or credentials or other credentials issued by an accredited educational institution, which the Commission may designate from time to time by order. Furthermore, the Commission designated holders in good standing of the Series 7, Series 65, and Series 82 licenses as qualifying natural persons;
Expanded the rule that included directors, executive officers and general partners of an issuer to include as accredited investors, natural persons who are “knowledgeable employees” of an issuer that is a private fund;
Clarified that limited liability companies with $5 million in assets may be accredited investors and added SEC- and state-registered investment advisers, exempt reporting advisers, and rural business investment companies (RBICs) to the list of entities that may qualify;
Added a new category for any entity, including Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries that own “investments” in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered;
Added “family offices” with at least $5 million in assets under management and their “family clients”; and
Added the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors.
The amendments revise Rule 501(a), Rule 215, and Rule 144A of the Securities Act and will go into effect 60 days after the Final Rule was published in the Federal Register.
Why This Matters
Generally speaking, only accredited investors have an opportunity to participate in private equity offerings, usually pursuant to Rule 506 of Regulation D (the Private Placement Exemption) of the securities laws. Rule 506(c), which allows issuers to generally solicit investors and advertise their offerings to the public, does not allow any unaccredited investors to participate, and the accredited status of all the investors in such offerings must be verified by a third party. Rule 506(b) does not allow general solicitation/advertising, but does allow up to 35 non-accredited investors (who must be sophisticated) to participate in an issuer’s Offering. However, if any non-accredited investors are included, the Rule imposes a significant disclosure requirement on the issuer, which substantially raises the cost of the Offering. These increased costs rarely make it worthwhile for issuers to include non-accredited investors in their private offerings. From 2009 to 2019, only between 3.4% and 6.9% of the aggregate number of offerings conducted under Rule 506(b) included non-accredited investor purchasers. Furthermore, the impact of the JOBS ACT, which allows for alternative capital investments by non-accredited investors through Regulation A+ (the “mini” I.P.O.) and Regulation CF (public crowdfunding), is most likely dwarfed by private investments made by accredited investors. In 2019, Regulation D offerings raised an estimated $1.5 trillion in capital, which is greater than the $1.2 trillion raised in registered offerings.
Broadening the definition of who qualifies as an accredited investor increases the number of investors who are eligible to invest in private placements and could thus lead to an increase in private capital investments. The SEC believes that these changes could also in certain circumstances, reduce the costs of finding investors (i.e., search costs) for issuers in private offerings, as well as reduce their transactional costs (e.g., through a potentially lower cost of determining and verifying accredited investor status and a potentially lower level of intermediation) and cost of capital, thereby facilitating capital formation in those circumstances.
Although the SEC did not mention that the amendments were related to the COVID-19 pandemic and ensuing economic fallout, the short-term impact of these amendments could lead to increased fundraising for private companies at reduced costs, during a time when many private businesses require capital.
The long-term effects of these amendments may make it possible for sophisticated investors who do not meet the financial tests to qualify as an accredited investor as a result of receiving a certification from an SEC-designated educational institution. While no such designations have been made, it is possible that such designations will be awarded in the future. Depending on how long it takes for a potential investor to achieve accredited investor status based on an educational certification, non-accredited investors may have a path that will allow them to get themselves accredited in order to participate in a private offering of their choosing. This could spur significant investment in future private capital markets.