On Wednesday, August 26, 2020, the Securities and Exchange Commission (the “SEC”) changed the investment landscape as we know it by modestly relaxing the eligibility rules for investment in private offerings. The Adopting Release publishing and explaining the amendments (the “Amendments”), approved by a 3-2 vote of the Commission, follows years of policy analysis and public input.
Other important changes have been made to the SEC’s private offering rules in the 38-year history of Regulation D. This is the first time, however, that the SEC has provided by rule that “accredited investor” status can be achieved by virtue of knowledge rather than income, wealth, ownership or position. Market participants who had hungered for more relief will feel the Amendments are “too little” to address the need. The Commission, though, is characterizing the Amendments as but one part of a broader initiative to simplify, harmonize and improve the exempt offering framework to promote capital formation while maintaining investor protection. In other words, further relief may be on the way.
The Amendments will be effective 60 days after publication in the Federal Register; i.e., in early November 2020. Below, we summarize core aspects of the Amendments and provide some insights on the implications of the Amendments.
We highlight the following practical take-aways for prompt consideration by all investors and issuers:
- Subscription Documents: Subscription documents and questionnaires for ongoing offerings and offerings preparing to launch should be revised to incorporate the substance of the Amendments.
- Re-Evaluation of “Accredited Investor” Status: Investors who previously did not qualify as “accredited investors” under existing criteria should contact their professional advisors to determine whether they now qualify as “accredited investors.”
- Renewed Focus on Disclosure Documents: As issuers solicit a wider range of potential investors, extra care should be taken to ensure that all material information is provided to offerees, particularly by ensuring that the private placement memorandum discloses material assumptions and includes risk factors specific to the offering.
Background on Securities Regulation and Exempt Offerings
As a preliminary matter, protecting unwary and perhaps unsophisticated investors is a key goal of securities regulation. The SEC and state securities commissions seek to protect the general public largely through detailed and rigorous disclosure and reporting requirements for those issuing or offering securities.
A cardinal rule of securities law is that all lawful securities offerings are either registered or exempt from registration under the Securities Act of 1933 (the “Securities Act”). Regulation D includes rules pursuant to which exempt offerings may be conducted under the Securities Act. Rule 501 of Regulation D contains the definitions used throughout Regulation D’s other rules, including Rule 506, sub-sections (b) and (c) of which are crucial (and popular) “safe harbors” for exempt offerings.
Rule 501(a) contains the definition of “accredited investor,” which is being updated and expanded by the Amendments. Also impacted by the Amendments is the definition of “qualified institutional buyer” (“QIB(s)”) in Rule 144A under the Securities Act, as well as aspects of Rules 163B and 215 under the Securities Act and Rule 15g-1 under the Securities Exchange Act of 1934 (the “Exchange Act”).
Overall, the expansive nature of the Amendments should increase the number of investors that have access to private investment opportunities, while better harmonizing how the revised definition of “accredited investor” interacts with other important rules and regulations that pertain to “penny stock” transactions, “test-the-water” communications, and other matters relevant to the private capital markets.
Summary of the Amendments
Rule 501(a)’s Definition of “Accredited Investor”
First, the definition of “accredited investor” in Rule 501(a) is being clarified and expanded through the inclusion of new individuals and entities that qualify as “accredited investors,” such as:
- Natural Persons Holding Professional Certifications and Designations or Other Credentials: Individuals presently in possession of certain professional certifications, credentials, or designations (e.g., FINRA Series 7 (General Securities Representative), 65 (Investment Adviser Representative), or 82 (Private Securities Offerings Representative) licenses) approved by the SEC from time to time; FINRA’s BrokerCheck service can verify such a claim (https://brokercheck.finra.org/);
- “Knowledgeable Employees”1 of Private Funds: Individuals who are “knowledgeable employees” of a private fund, or of an investment adviser to such fund, or such person’s spouse (with respect to offerings of that fund’s securities);
- Entities Owned by “Accredited Investors”: An entity, on the basis that all of the entity’s equity is owned directly or indirectly by “accredited investors”;
- Certain LLCs, Advisers, and Rural Business Investment Companies: Limited liability companies with assets in excess of $5 million and that were not formed for the purpose of investing in securities offered in a given case, exempt reporting advisers, registered investment advisers, and rural business investment companies (“RBICs”);
- Other Entities Meeting an Investments-Owned Test: Any entity, including any Indian tribe or governmental body, that owns “investments” (as defined in Rule 2a51-1(b) under the Investment Company Act of 1940 (the “Investment Company Act”))2 – as opposed to “assets” – valued in excess of $5 million and not formed for the specific purpose of investing in securities offered in a given case;
- “Family Offices”1 and “Family Clients"2: “Family offices” with at least $5 million in assets under management and their “family clients,” as each term is defined under the Investment Advisers Act of 1940 (the “Advisers Act”), provided that the family office is not formed for the specific purpose of acquiring the securities offered and that the investment is directed by a person who has such knowledge and experience in financial and business matters that the family office is capable of evaluating the merits and risks of the investment; and
- “Accredited Investor” Status by Pooling Resources with “Spousal Equivalents”: Unmarried couples in “spousal equivalent” relationships (who may now pool finances to qualify as “accredited investors”).
Rule 144A’s Definition of “Qualified Institutional Buyer”
Rule 144A’s resale registration exemption centers around “qualified institutional buyers,” as defined by Rule 144A(a)(1), which has now been expanded by the Amendments. QIB-status eligibility hinges on two factors: first, the entity in question fitting into one of the categories of institution specified by Rule 144a(1), and second, actively having investments of at least $100 million in the securities of unaffiliated issuers.
The Amendments expand the list of qualifying institutions under Rule 144(a)(1) to include institutional investors included in the expanded definition of “accredited investor.” Again, though, to be a QIB, an entity would also need to satisfy the $100 million threshold. In brief, with the implementation of the Amendments, QIB status will now be available to certain RBICs, LLCs, and other institutional “accredited investors” (this latter category being what the SEC calls the “catch-all” category from the revised “accredited investor” definition for entities owning investments (note, not assets) valued in excess of $5 million and that were not formed for the purpose of investing in securities, which includes, e.g., Indian tribes, governmental bodies, and bank-maintained collective investment trusts), provided they satisfy the $100 million threshold. A benefit identified with the revised QIB definition is that it now harmonizes with the definition of “accredited investor,” which should prevent any confusion or inconsistencies between the definitions that previously existed.
Alongside the expansions to the definition of “accredited investor” in Rule 501(a), Rule 215’s definition of “accredited investor,” which used to be somewhat narrower than the definition in Rule 501(a) (e.g., it excluded banks, insurance companies, and other entities from its applicability), is replaced by cross-reference to Rule 501(a)’s definition. An effect of cross-referencing to Rule 501(a)’s definition is that Rule 215 now has a less restrictive “reasonable belief” standard with respect to “accredited investor” status.
Rule 163B under the Securities Act – allowing “test-the-waters” communications – is amended, as well, to include the new types of institutional “accredited investors” added by the Amendments (presently, it references Rules 501(a)(1), (2), (3), (7) and (8), but, after the Amendments are implemented, it will also include clauses (9), (12) and (13)). The result is that a greater variety and number of investors may now be approached for such “test-the-waters” communications.
Additionally, Rule 15g-1, which outlines transactional exemptions for certain disclosures required from broker-dealers under Exchange Act Rules 15g-2 through 15g-6 (pertaining to “penny stock” transactions), is updated in a similar fashion to Securities Act Rule 163B. Rule 15g-1 used to reference the types of institutional “accredited investors” in specific sub-sections of Rule 501(a) and is now updated to reflect all applicable categories pursuant to the Amendments (see the discussion of Rule 163B above for the specific section references). The impact is that there are more institutional “accredited investors” than there were and thus a broader group of offerees as to whom broker-dealers can rely on disclosure exemptions in “penny stock” transactions.
The Amendments are moderate expansions of the “accredited investor” and QIB definitions, enabling somewhat broader participation in private capital markets. The Amendments also contain some nuances and complexities that should not be overlooked.
In that connection, we suggest that these important details be kept in mind:
- No Self-Certification of Financial Sophistication to Establish “Accredited Investor” Status: The SEC does not permit individuals to self-certify that they have the requisite financial sophistication to be an accredited investor. Rather, the Amendments are tailored to permit investors with reliable alternative indicators of financial sophistication, as outlined in the definition of “accredited investor,” to participate in private offerings.
- Determining Whether Person has Sufficient Knowledge in Financial Matters in “Family Office” Context: This “accredited investor” standard requires a determination that the person directing the investment have such “knowledge and experience in financial and business matters” that the person is capable of evaluating the merits and risks of the prospective investment. Given the SEC’s decision not to permit individuals to certify their own financial sophistication, determining that a person directing an investment is sufficiently knowledgeable in financial matters to evaluate the merits and risks of the investment seems to require some extrinsic evidence that would justify that conclusion.
- The SEC May Add New Eligible Credentials and Licenses Later: The SEC’s set of qualifying credentials is subject to additional designations, from time to time, by SEC order.
- LLC Managers Are Considered Equivalent to Executive Officers of Corporations: While the SEC expressly declined amending Rule 501(a)(4) or (f) to include managers of limited liability companies, it did so because it believes that it is already well-accepted that LLC managers are considered the equivalents of executive officers of corporations.
- Customers and Clients Not Included: The SEC expressly declined to expand the “accredited investor” definition to include customers of broker-dealers or clients of registered investment advisers, without more, because it refused to extend the financial sophistication of broker-dealers or registered investment advisers to their customers and clients.
- Limitations of “Knowledgeable Employee” Qualification: Despite expanding the “accredited investor” definition for “knowledgeable employees” of private funds, the SEC clarifies in the Adopting Release that “accredited investor” status applies only for eligible employees of a given private fund as to investing in that private fund’s securities (as opposed to any other private fund), and re-emphasizes that the definition is not intended for “employees performing solely clerical, secretarial, or administrative functions.”
- Participation in Investment Activities is Key to be Knowledgeable Employee: Also with respect to “knowledgeable employees” of private funds, the SEC expressly indicates in the Adopting Release that “[t]he 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.”
- Definition of “Affiliated Management Persons” Expands Number of Persons Qualifying as Accredited Investors: For example, the SEC has concluded that persons who participate in the investment activities of “foreign or offshore investment companies” should be eligible for knowledgeable employee status, which would allow them to be accredited investors.
- Rule 2a51-1 Definition of “Investments” Does Not Include Control Interests: “Securities,” as defined in the Investment Company Act, generally count as “investments.” Nevertheless, control interests are not treated as investments unless the issuer is a public company or a financial company or has more than $50 million in equity (as shown in recent financial statements).
- Rule 2a51-1 Definition of “Investments” Includes Real Estate Not Used for Business Purposes: Real estate may be counted as “investments” as long as it is not used by the prospective accredited investor for business purposes.
1 As defined by Rule 3c-5(a)(4) under the Investment Company Act, a ”knowledgeable employee” of any Covered Company is any natural person who is: (i) an Executive Officer, director, trustee, general partner, advisory board member, or person serving in a similar capacity, of the Covered Company or an Affiliated Management Person of the Covered Company; or (ii) an employee of the Covered Company or an Affiliated Management Person of the Covered Company (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 Covered Company, other Covered Companies, or investment companies the investment activities of which are managed by such Affiliated Management Person of the Covered Company, provided that such employee has been performing such functions and duties for or on behalf of the Covered Company or the Affiliated Management Person of the Covered Company, or substantially similar functions or duties for or on behalf of another company for at least 12 months.
2 The definition of “investments” in Rule 2a51-1 is complex and contains many nuances, some of which are discussed later.
3 As defined by Rule 202(a)(11)(G)-1(b) under the Advisers Act, a “family office” is a company (including its directors, partners, members, managers, trustees, and employees acting within the scope of their position or employment) that: (1) has no clients other than family clients; provided, that if a person that is not a family client becomes a client of the family office as a result of the death of a family member or key employee or other involuntary transfer from a family member or key employee, that person shall be deemed to be a family client for purposes of this section for one year following the completion of the transfer of legal title to the assets resulting from the involuntary event; (2) is wholly owned by family clients and is exclusively controlled (directly or indirectly) by one or more family members and/or family entities; and (3) does not hold itself out to the public as an investment adviser.
4 As defined by Rule 202(a)(11)(G)-1(d)(4) under the Advisers Act, a “family client” is: (i) any family member; (ii) any former family member; (iii) any key employee; (iv) any former key employee, provided that upon the end of such individual's employment by the family office, the former key employee shall not receive investment advice from the family office (or invest additional assets with a family office-advised trust, foundation, or entity) other than with respect to assets advised (directly or indirectly) by the family office immediately prior to the end of such individual's employment, except that a former key employee shall be permitted to receive investment advice from the family office with respect to additional investments that the former key employee was contractually obligated to make, and that relate to a family-office advised investment existing, in each case prior to the time the person became a former key employee; (v) any non-profit organization, charitable foundation, charitable trust (including charitable lead trusts and charitable remainder trusts whose only current beneficiaries are other family clients and charitable or non-profit organizations), or other charitable organization, in each case for which all the funding such foundation, trust, or organization holds came exclusively from one or more other family clients; (vi) any estate of a family member, former family member, key employee, or, subject to the condition contained in paragraph (d)(4)(iv) of this section, former key employee; (vii) any irrevocable trust in which one or more other family clients are the only current beneficiaries; (viii) any irrevocable trust funded exclusively by one or more other family clients in which other family clients and non-profit organizations, charitable foundations, charitable trusts, or other charitable organizations are the only current beneficiaries; (ix) any revocable trust of which one or more other family clients are the sole grantor; (x) any trust of which: each trustee or other person authorized to make decisions with respect to the trust is a key employee; and each settlor or other person who has contributed assets to the trust is a key employee or the key employee's current and/or former spouse or spousal equivalent who, at the time of contribution, holds a joint, community property, or other similar shared ownership interest with the key employee; or (xi) any company wholly owned (directly or indirectly) exclusively by, and operated for the sole benefit of, one or more other family clients; provided that if any such entity is a pooled investment vehicle, it is excepted from the definition of “investment company” under the Investment Company Act.