SEC Proposes to Expand Definition of Accredited Investor
On December 18, 2019, the SEC proposed amendments (Proposal) to the definition of "accredited investor." This definition is a central component of several exemptions from Securities Act registration, including Rules 506(b) and 506(c) of Regulation D, and plays an important role in other federal and state securities law contexts.
As discussed more fully below, the Proposal would, among other things: (i) permit natural persons to qualify as accredited investors based on certain professional credentials or, with respect to investments in private funds, based on the person's status as a "knowledgeable employee" of the fund; (ii) add limited liability companies and other specified entity types to the current list of entities that may qualify as accredited investors, and add a "catch-all" category for unspecified entities that may qualify (although with different quantitative standards); (iii) add the term "spousal equivalent" to the accredited investor definition; and (iv) codify certain related staff interpretive positions. In addition, the Proposal would revise the definition of "qualified institutional buyer" in Securities Act Rule 144A to include additional entity types that meet the $100 million threshold to avoid inconsistencies between the types of entities that are eligible for accredited investor status and those that are eligible for qualified institutional buyer status under Rule 144A.
The Proposal would expand the definition of accredited investor to include natural persons holding one or more professional certifications or designations or other credentials issued by an accredited educational institution that the SEC designates from time to time. The initial proposed list includes: (i) Licensed General Securities Representative (Series 7); (ii) Licensed Investment Adviser Representative (Series 65); and (iii) Licensed Private Securities Offerings Representative (Series 82). Where applicable, an individual would be required to maintain an active certification, designation, or credential, but would not be required to practice in such fields, except to the extent that continued affiliation with a firm is required to maintain the certification, designation, or credential.
The Proposal would also define "knowledgeable employees" of a private fund as accredited investors for investments in the fund. The proposed new category would be the same in scope as that in Rule 3c-5(a)(4) of the Investment Company Act, which defines a "knowledgeable employee" with respect to a private fund as: (i) 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 (as defined in Rule 3c-5(a)(1)) 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.
The definition would include, among other persons, trustees and advisory board members, or persons serving in a similar capacity, of a Section 3(c)(1) or 3(c)(7) fund or an affiliated person of the fund that oversees the fund's investments, as well as employees of the private fund or the affiliated person of the fund (other than employees performing solely clerical, secretarial, or administrative functions) who, in connection with the employees' regular functions or duties, have participated in the investment activities of such private fund for at least 12 months.
Under Rule 501(a)(8), private funds with assets of $5 million or less may qualify as accredited investors if all of the fund's equity owners are accredited investors. Amending the accredited investor definition as described above would allow knowledgeable employees to invest in these small private funds without jeopardizing the funds' qualification as accredited investors under Rule 501(a)(8).
Joint Net Worth
The Proposal clarifies that the calculation of "joint net worth" for purposes of the accredited investor definition can be the aggregate net worth of an investor and his or her spouse or spousal equivalent (cohabitant occupying a relationship generally equivalent to that of a spouse), and that the securities being purchased under the joint net worth test need not be purchased jointly.
The accredited investor definition includes enumerated categories of entities in paragraphs (1) through (3), (7), and (8) of Rule 501(a).The Proposal would revise Rule 501(a)(1) to include investment advisers registered under Section 203 of the Investment Advisers Act of 1940, investment advisers registered under the laws of the various states, and rural business investment companies (RBICs). Rule 501(a)(3) would be amended to include limited liability companies in the list of entities that qualify as accredited investors if they have total assets in excess of $5 million and were not formed for the specific purpose of acquiring the securities being offered. Because other types of entities, including, but not limited to, Indian tribes, labor unions, and governmental bodies and funds, are not specifically listed in the accredited investor definition, proposed Rule 501(a)(9) would add a new category for any entity of a type not covered elsewhere in Rule 501(a) that is not formed for the specific purpose of acquiring the securities being offered. Unlike the specified entities in Rule 501(a)(3), these other types of entities would qualify on the basis of investments, not total assets, in excess of $5 million. The proposal incorporates the definition of investments from Rule 2a51-1(b) under the Investment Company Act, which includes, among other things: securities; real estate, commodity interests, physical commodities, and non-security financial contracts held for investment purposes; and cash and cash equivalents.
The Proposal also adds new categories to the accredited investor definition for "family offices" (as defined in the SEC's family office rule) with at least $5 million in assets under management (proposed Rule 501(a)(12)) and its "family clients" (proposed Rule 501(a)(13)). To qualify, the purchase must be 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. In addition, the family office could not have been formed for the specific purpose of acquiring the securities offered.
Under Rule 501(a)(8), an entity qualifies as an accredited investor if all of the equity owners of that entity are accredited investors. Because an equity owner of an entity may be another entity, the Proposal clarifies that, in determining accredited investor status under Rule 501(a)(8), one may look through various forms of equity ownership to natural persons.
The Proposal would amend the accredited investor definition in Securities Act Rule 215 (related to the small offering exemption) to conform to the proposed accredited investor definition amendments.
Pursuant to Securities Act Rule 163B, an issuer may engage in test-the-waters communications with potential investors that are, or that the issuer or person authorized to act on its behalf reasonably believes are, qualified institutional buyers or institutions that are accredited investors as defined in Rule 501(a)(1), (a)(2), (a)(3), (a)(7), or (a)(8). The Proposal would amend Rule 163B to include accelerated investors defined in proposed Rules 501(a)(9) and (a)(12).
Broker-dealers are required to disclose certain specified information to their customers prior to effecting a transaction in penny stocks. Exchange Act Rule 15g–1 exempts transactions from these disclosure requirements if the customer is an institutional accredited investor, as defined in Rule 501(a)(1), (2), (3), (7), or (8). The Proposal would amend Rule 15g-1(b) to include a reference to proposed Rules 501(a)(9) and (a)(12).
Qualified Institutional Buyers
Rule 144A provides a non-exclusive safe harbor exemption from the registration requirements of the Securities Act for resales to qualified institutional buyers of certain restricted securities. The Proposal would expand the qualified institutional buyer definition by adding RBICs to Rule 144A(a)(1)(i)(C) and limited liability companies to Rule 144A(a)(1)(i)(H). Further, to ensure that entities that qualify for accredited investor status may also qualify for qualified institutional buyer status when they meet the $100 million in securities owned and invested threshold in Rule 144A(a)(1)(i), the Proposal would add new paragraph (J) to Rule 144A(a)(1)(i) to permit institutional accredited investors under Rule 501(a), of an entity type not already included in paragraphs 144A(a)(1)(i)(A) through (I) or 144A(a)(1)(ii) through (vi), to qualify as qualified institutional buyers when they satisfy the $100 million threshold.
Request for Comments
The Proposal includes requests for comment on all aspects of the proposed rule, including whether the net worth tests for accredited investor status (which are not addressed by the Proposal) should be amended. In addition, comments are also solicited on the implications of the proposed amendments in other securities laws contexts, including registration thresholds, Regulation A offerings, state registration of investment advisors, and verification requirements under the existing Rule 506(c) exemption. We anticipate that many comments will be submitted on the Proposal, and in fact, 28 comments letters were made publicly available on the SEC's website during the first 2 days following release of the Proposal. Interested parties may consider adding their views to the mix.
© Arnold & Porter Kaye Scholer LLP 2019 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.