On August 26, the U.S. Securities and Exchange Commission (SEC) adopted amendments expanding the definition of “accredited investor” to allow additional categories of investors to invest in unregistered private offerings. The new definition moves beyond the long-standing reference to wealth and income to determine whether individuals may be deemed accredited investors. In addition, the definition adds several new categories of entities that now qualify as institutional accredited investors. According to the SEC, “the amendments update and improve the definition to more effectively identify institutional and individual investors that have the knowledge and expertise to participate in those markets.” The amendments will become effective 60 days after the SEC’s rule release is published in the Federal Register.
The amendments to the accredited investor definition:
- add 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 SEC may designate from time to time by order. In conjunction with the adoption of this new category, the SEC designated by order holders in good standing of the Series 7 (licensed general securities representative), Series 65 (licensed investment adviser representative), and Series 82 (licensed private securities offerings representative) licenses as qualifying natural persons. The SEC will reevaluate or add certifications, designations, or credentials in the future, and will consider proposals regarding additions or other changes from members of the public;
- include as accredited investors, with respect to investments in a private fund, natural persons who are “knowledgeable employees” of the fund;
- officially deem limited liability companies not formed for the specific purpose of investing in the securities offered, with total assets in excess of $5 million to be accredited investors;
- SEC- and state-registered investment advisers, exempt reporting advisers, and rural business investment companies (RBICs) to the list of entities that may qualify, without any requirement for a minimum level of total assets;
- add a new catch-all category for 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;
- add “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; and
- add the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances to satisfy the income and net worth tests of the accredited investor definition. The term spousal equivalent is defined as a cohabitant occupying a relationship generally equivalent to that of a spouse.
Issuers of securities in private offerings will need to update their accredited investor and QIB questionnaires for future offerings. This includes privately held companies, private equity, venture capital and hedge funds.
As context to understand the amendments, under the federal securities laws, offers and sales of securities must be registered with the SEC under the Securities Act of 1933 (the Securities Act) unless an exemption from registration applies. Registration of a securities offering is an expensive and time-consuming enterprise, particularly for private companies, i.e. companies that have not already conducted a registered initial public offering and are not otherwise already required to file reports with the SEC. Accordingly, most securities offerings are conducted through exemptions from registration. According to the SEC’s rule release, in 2019, registered offerings accounted for $1.2 trillion (30.8%) of new capital raises, while exempt offerings accounted for approximately $2.7 trillion (69.2%). The estimated amount of capital reported as being raised in offerings under Rule 506(b) and 506(c) of the SEC’s Regulation D was approximately $1.56 trillion, or more than half of the total exempt offerings in 2019.
The principle behind the Securities Act’s registration requirement for the offer and sale of securities is to provide adequate disclosure to prospective investors concerning all material aspects of an issuer’s business, management, and financial condition, including the risks of investment, so as to afford prospective investors with a reasonably informed basis to decide whether or not to invest in the issuer’s securities.
Investors in unregistered offerings can be subject to investment risks not associated with registered offerings, because some securities law liability provisions do not apply to private offerings, issuers of unregistered securities generally are not required to provide information comparable to that included in a registration statement, and the SEC does not receive or review any information that may be provided to investors in these offerings. As a result, the SEC places a significant emphasis on the protection of investors when evaluating the adoption or amendment of an exemption from registration. The new amendments constitute a welcome expansion of the “accredited investor” definition that will extend investment opportunities to additional categories of financially sophisticated investor groups, while maintaining appropriate investor protections and promoting capital formation.
The “accredited investor” definition is a central component of several exemptions from registration, such as Rules 506(b) and 506(c) of Regulation D, as accredited investor status serves as a proxy, according to SEC rules, for having the necessary financial sophistication and ability to sustain the risk of loss of investment or to fend for oneself so that the protections of the Securities Act’s registration process are unnecessary. Qualifying as an accredited investor is significant, because accredited investors may, under SEC rules, participate in investment opportunities that may not be available to non-accredited investors, such as unregistered offerings for investments in start-up and early stage companies, hedge funds, private equity funds, and venture capital funds.
Representations and warranties as to accredited investor status in subscription agreements, stock purchase agreements, and some M&A transactions will need to be updated to address the new amendments.
The exemptions in Regulation D are the most widely used transactional exemptions for securities offerings by issuers. The most frequently used exemption under Regulation D is found in Rule 506. Rule 506(b) allows an issuer to conduct an exempt private placement of securities to an unlimited number of accredited investors and up to 35 non-accredited investors who have enough knowledge and experience in financial and business matters to evaluate the merits and risks of the prospective investment. Limiting the investors in a Rule 506(b) offering to only accredited investors has the added benefit of eliminating the requirement to provide specified business and financial disclosures to offerees, which can be burdensome. In addition, offerings made under Rule 506(c), promulgated in 2013 pursuant to the JOBS Act, are permitted to make use of general solicitation and general advertising, provided that the issuer takes reasonable steps to verify that all investors are accredited investors. A further benefit of conducting a private placement under a Rule 506 exemption is that state securities law (a/k/a “blue sky” law) registration requirements are preempted. Without such preemption, the issuer would need to register the offering in each state where a prospective investor resides, unless a state-specific exemption were available.
Before the adoption of these new rules, in the case of individuals, the accredited investor definition has used wealth – in the form of a certain level of income or net worth – as a proxy for financial sophistication. The accredited investor standard for individuals has remained largely unchanged since it was first adopted in 1982, requiring an individual to have a net worth in excess of $1 million or annual income in excess of $200,000 or a joint annual income with one’s spouse in excess of $300,000. Under the new rules, the SEC has determined that wealth should no longer be the sole means of establishing financial sophistication of an individual for purposes of the accredited investor definition. Rather, the expanded accredited investor definition reflects the SEC’s current view that the characteristics of an investor may be demonstrated in a variety of ways, including the ability to assess an investment opportunity, to analyze the risks and rewards of a prospective investment, the capacity to allocate investments so as to mitigate or avoid risks of unsustainable loss, the ability to gain access to information about an issuer or about an investment opportunity, or the ability to bear the risk of a loss. The new rules create new categories of individuals and entities that qualify as accredited investors irrespective of their wealth, on the basis that they have demonstrated the requisite ability to assess an investment opportunity.
Certain enumerated entities with more than $5 million in assets have historically qualified as accredited investors, while others, including regulated entities such as banks and registered investment companies, have qualified without regard to an asset test. The new rules create additional categories of entities considered to be institutional accredited investors, expanding on the historical definition.
The amendments also clarify certain concepts that were not well-defined under pre-existing rules. One such clarification clarifies that the calculation of “joint net worth” for purposes of satisfying the $1 million net worth requirement for individual accredited investors can be the aggregate net worth of an investor and his or her spouse or spousal equivalent, and that the securities being purchased by an individual investor relying on the joint net worth test need not be purchased in joint names.
Another clarification involves the pre-existing prong of the accredited investor definition, which treats an entity as an accredited investor if all of the equity owners of that entity are accredited investors. This prong of the definition is useful where an entity does not qualify as an accredited investor on its own merits, such as if it does not have more than $5 million in assets or if it was formed for the purpose of making the investment (if it is the type of entity where these factors are preconditions to institutional accredited investor status). Questions might arise if the equity owners of an investing entity were themselves entities; there may be several layers of entities before one or more natural persons are finally reached as the ultimate equity owner(s) of the investing entity. The amendments make clear that one may look through various levels of equity ownership to natural persons, and if those natural persons are themselves accredited investors, and if all other equity owners of the entity are accredited investors, the entity would be an accredited investor.
The new rules modify Rule 144A, which is an exemption that permits resales of securities by existing securityholders to “qualified institutional buyers,” or QIBs. The term “qualified institutional buyer” applies to specified types of institutions that own and invest on a discretionary basis at least $100 million in securities of issuers that are not affiliated with the institution. Examples of eligible entities include insurance companies, registered investment companies and investment advisers, ERISA employee benefit plans, small business investment companies licensed by the SBA, and 501(c)(3) tax-exempt charitable organizations. Historically, entities that were institutional accredited investors were not included among the litany of the types of entities that could qualify as QIBs. The new amendments add all categories of institutional accredited investors to the list of entities that may qualify as QIBs, provided that they meet the $100 million in securities owned and invested threshold. A note to the newly amended QIB definition confirms that an entity may be formed for the purpose of acquiring the securities being offered, a factor that would otherwise disqualify certain types of entities from qualifying as accredited investors.
The amendments also make certain technical changes to maintain consistency. In one case, the definition of “accredited investor” is harmonized across different SEC rules. In another, the newly established categories of institutional accredited investors are now included among the types of potential investors that an issuer contemplating a registered public offering may contact with oral or written “test-the-waters” communications before the filing of a registration statement with the SEC. In a third case, the SEC rule governing the requirement for brokers to deliver specified information to prospective investors in “penny stocks” has been amended to exclude transactions with the newly established categories of institutional accredited investors.
- Robert A. Friedel, Partner, TROUTMAN PEPPER
- Bruce K. Fenton, Partner, TROUTMAN PEPPER
- Alexander “Alec” F. Watson, Partner, TROUTMAN PEPPER
- Brett A. Hubler, Associate, TROUTMAN PEPPER
- Todd R. Kornfeld, Counsel, TROUTMAN PEPPER
- Rachael M. Bushey, Partner, TROUTMAN PEPPER
Compliments of Troutman Pepper – a member of the EACCNY.