This Fall 2020 has seen an unprecedented number of rulemaking by the Securities and Exchange Commission (the “SEC”) that will be remembered for years to come. I will attempt to summarize the changes for you in a series of blog posts. Altogether, the changes will have lasting ramifications for the U.S. capital markets, enabling (I predict) an even greater flow of capital to the private markets. The changes come at an important time when, due to the pandemic, many have lost jobs and may be launching their own ventures.
Below are the notable changes:
1. A revised definition of “accredited investor”;
2. Introducing two exemptions for finders;
3. Proposing changes to Rule 701 enabling to issue equity to the participants in the gig economy;
4. Adopting sweeping changes to Regulation CF; and
5. Rule amendments to Regulation A+, integration, and other rules.
Today, I will focus on the amendments to the “accredited investor” definition. Subsequent blogs will cover the remaining rulemaking.
On August 26, 2020, the SEC published its final rules amending the “accredited investor” definition. These rules become effective on December 8, 2020. The definition of accredited investor is the cornerstone of private placements made pursuant to Regulation D and has not been substantially amended since its adoption in 1982 (except for the 2011 amendment excluding the value of the primary residence from the net worth test). Regulation D is the most relied upon exemption from registration requirements of the Securities Act for private placements of securities in the United States. According to the final rules, in 2019, out of $3.9 trillion raised by companies in the United States, Regulation D private placements accounted for $1.56 trillion.
Regulation D consists of Rule 504 (not frequently used) and Rules 506(b) and 506(c). Rule 506(b) allows issuers to offer and sell securities to an unlimited number of accredited investors and up to 35 non-accredited but financially sophisticated investors (although from 2009 to 2019, only between 3.4% and 6.9% of all Rule 506(b) offerings included non-accredited investors). Another popular rule within Regulation D, Rule 506(c), allows sales only to accredited investors. Therefore, being an accredited investor is essential for being able to participate in the private placements of securities by startups, which could at times be extremely lucrative.
Prior to the changes, the status of accredited investor, as applied to individuals, was determined based on such person’s wealth, with wealth being the only proxy for financial sophistication. The SEC estimates that approximately 13% of the U.S. households currently meet the wealth-based accredited investor tests. The final rules expand the definition by adding to the list of accredited investors those who hold certain professional degrees and are in good standing: the Licensed General Securities Representative (Series 7), Licensed Investment Adviser Representative (Series 65), and Licensed Private Securities Offerings Representative (Series 82). This list is subject to ongoing revision by the SEC based on the nonexclusive list of attributes that the SEC will consider in determining additional qualifying professional certifications. Although there are over 700,000 individuals who are currently Registered Securities Representatives and State Registered Investment Adviser Representatives, it is unlikely that the universe of qualifying investors will increase by that same number, given that some of these individuals may already qualify under the wealth tests. Even though this change will not have a significant effect on the number of qualifying individuals, it signals a change in the overall approach towards defining who accredited investors are.
Another new category of individuals who are now accredited investors are the “knowledgeable employees” of “private funds” (private equity or hedge funds that are investment companies but qualify for Section 3(c)(1) or 3(c)(7) exemptions). The term “knowledgeable employees” is already defined in Rule 3c-5(a)(4) under the Investment Company Act. Starting on December 8, 2020, such employees can participate in the private fund’s investments as limited partners. Making such individuals be accredited investors for the purpose of investing in the private fund for which they work (or are affiliated with) is reasonable and helps align their interests with the interests of the other limited partners.
The SEC has also added several categories of entities to the list of accredited investors:
• any investment adviser registered under federal or state law (and Exempt Reporting Advisers relying on Section 203(m) or 203(l) of the Investment Advisers Act of 1940) – this also applies to sole proprietorships;
• any rural business investment company (RBIC);
• any entity that owns investments in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered;
• any family office with at least $5 million in assets under management and that was not formed for the specific purpose of acquiring the securities offered, and whose investment is directed by a person capable of evaluating the merits and risks of the prospective investment; and
• any family client of a family office described above whose prospective investment is directed by that family office.
The SEC also clarified that limited liability companies with $5 million in assets and not formed for the specific purpose of acquiring the securities offered qualify as accredited investors.
Lastly, the SEC allowed natural persons to include joint income and net worth from spousal equivalents when calculating the wealth-based tests. “Spousal equivalent” is defined as a cohabitant occupying a relationship generally equivalent to that of a spouse.
Here is a helpful blackline prepared by Pillsbury that shows the changes to the definition of accredited investor.
In conclusion, the amendments to the definition of accredited investor will significantly increase the pool of qualifying investors, although mostly among entities rather than individual investors.
