If you have ever raised money as a startup, done private securities deals, raised money for private equity, or done other similar private securities market activities, you know how important the “Accredited Investor” standard is. HINT: if you want to get to exactly what the changes were, then please skip to Part 3 In the United States, the basic rule is that every offering of securities must be either registered with the Securities and Exchange Commission (SEC) or fall under an exemption from registration. Those exemptions generally have restrictions on (i) the amount that may be raised, (ii) the solicitation that may be done, and/or (iii) who may participate. Most relevant to the third of these considerations – who may participate – is the “Accredited Investor” standard set forth in Rule 215 and Rule 501(a) of Regulation D promulgated under the Securities Act of 1933, as amended (the 1933 Act), which flows through several of the other exemptions under the 1933 Act. This is very relevant because the process of filing a registration statement in the United States is very expensive, and the price of simply being a public company is also very high. In extreme summary, the basic idea behind the “Accredited Investor” standard is to allow sophisticated individuals who can “fend for themselves” to invest in securities not registered with the SEC (despite the expense to the company of said registration and compliance). While the goal behind this structure of exemptions for private offerings is to prevent securities fraud or abusive practices from taking advantage of the public at large (at which goal most would agree it has generally succeeded), this structure has received some criticism as sequestering the best, juiciest opportunities (exempt private securities offerings) for those who are already rich. And there’s probably a lot of truth to that criticism – several trillion dollars worth of truth, in fact; the SEC estimates that in 2019 issuers raised approximately 25% more funding through Regulation D exempt private securities offerings than through registered securities offerings open to the public ($1.56 Trillion vs. $1.2 Trillion). On August 26, 2020, the SEC took steps to address this by putting forward amendments to expand the definition of “Accredited Investor” found in Rule 215 and Rule 501(a). The amendments will open the doors for new people to qualify as “Accredited Investors” on the basis of their professional skills and knowledge, certificates, and experience, as well as for entities to qualify not on the basis of an asset test, but on the basis of an investment test. With the new expansion of this definition of Accredited Investor, SEC also expanded the definition of the qualified institutional buyer (QIB) in Rule 144 (A) under the 1933 Act. These amendments become effective 60 days after their publication. 1. Historical Background & The Original Definition As noted above, under the Rules promulgated under the 1933 Act, Accredited Investors and QIBs can participate in investment opportunities that are not available to the general public. These private investment opportunities generally involve more risk, as well as more potential upside (for example, private companies, private equity, hedge funds, and venture capital). The SEC has been considering changes to the accredited investor structure for quite some time. The criteria for being an “Accredited Investor” have not changed much since 1982. The previous definition, set forth in Rule 501 of Regulation D, was (again, in extreme summary):
  • Individual with annual income above $200,000 ($300,000 with  spouse) and expectation of maintaining the same income;
  • Individual with net worth of over $1 million, exclusive of primary residence (individually or with spouse);
  • Entity with assets above $5 million not formed for the express purpose of making the investment;
  • Certain affiliates of an issuer (e.g. executive officers) may be considered accredited with respect to that issuer.
Under regulation D, the SEC defines an accredited investor as those investors whose level of financial sophistication warrants a reduced need for protection. Essentially, accredited investors are knowledgeable and experienced enough to understand the risk that comes with investing in unregistered securities. 2. Criticism of the Original Definition As noted in the introduction above, many investors, regulators, and practitioners have observed that the previous method of determining “Accredited Investor” status – i.e., primarily based on income and assets (with very narrow non-asset or non-income qualification criteria) – may not adequately capture other individuals with enough expertise to allow them to competently evaluate and participate in these private, unregistered, less-regulated offerings. Also as mentioned above, there has been, over the years, various academic and popular criticism of the function and definition of Accredited Investors, such as this, this and this. 3. Amendments to Accredited Investor Definition Presumably after taking all of this into consideration, the SEC proposed the following amendments to the definition of Accredited Investor (AI):
  • Adding as AI those individuals who qualify based on professional certifications, designations, or credentials as designated by the SEC from time to time (by order)
  • Simultaneously with the foregoing, issuing an order that holders in good standing of Series 7, Series 65, and Series 82 licenses qualify as AIs under (1);
  • An “invitation” for members of the public to propose to the SEC other professional certifications, designations, or credentials that they believe should qualify the holders thereof as AIs by order;
  • Adding as “accredited investors” with respect to investments in a particular private fund the individual employees of the private fund who are “knowledgeable employees” of the fund
  • Clarify that the following may qualify as AIs
    • LLCs with >$5M that otherwise satisfy the definition of AI
    • State-registered or SEC-registered investment advisers (section 203 Investment Advisers Act)
    • exempt reporting advisers
    • rural business investment companies (RBICs)
  • Add a new category of AI for any entity, including Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries, that own “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered;
  • Include as AIs “family offices” with at least $5M in AUM and their “family clients” not specifically formed for the purpose of acquiring the offered securities, etc (as defined in the Investment Advisers Act; for more detail, see Rule 202(a)(11)(G)-1); and
  • Add “spousal equivalent” to the AI definition, to permit spousal equivalents  to permit their assets to qualify as AIs;
Most notably, the “professional certifications, designations, or credentials” amendment gives the  SEC the power and flexibility to subsequently designate categories of AI on an ongoing basis, based on its evaluation at that time. For instance, if self-regulatory organizations, educational institutions, industry bodies, or members of the public complete a program that provides the required level of sophistication, education, etc. then they can apply and the SEC could issue an order including them as AIs. 4. Amendments to QIB Definition Rule 144A, a rule under the 1933 Act, is a nonexclusive safe harbor provision that provides an exemption from registration for the sale of restricted securities to certain entities. Specifically, the rule is only available to entities that qualify as Qualified Institutional Buyers (or QIBs). The previous definition for QIBs included:
  • Insurance Companies under the Securities Act of 1933
  • Investment Companies under the Investment Company Act of 1940
  • Small Business Investment Companies under the Small Business Investment Act of 1958
  • Certain public employee benefit plans
  • Certain trust funds
  • Business Development Companies under the Investment Advisers Act of 1940
  • Certain 501(c)(3) organizations
  • Investment Advisers registered under the Investment Advisers Act of 1940
Similarly to the exemptions for Accredited Investors, the basic idea behind the 144A exemption for QIBs is that they are sophisticated parties who can look after themselves and therefore ought to be permitted to buy and sell restricted stock without SEC oversight. In the August 26, 2020 release, the SEC expanded the QIB definition in some similar ways to the expansion of the definition of AIs, namely including LLCs and RBICs in the list of entities that  may qualify under Rule 144A. In addition, the SEC added a new category (paragraph J) to the list of covered entities in Rule 144(a)(1)(i), which requires $100 million in owned and invested securities. The new paragraph will allow certain entities to qualify automatically upon meeting the required $100 million threshold (analogous to the “catch all” category of the Accredited Investor definition for those who own more than $5 million in assets). As a further result, Governmental bodies, bank-maintained collective investment trusts, and Indian tribes may now qualify and become eligible as QIBs. 5. Takeaways This isn’t as much of a seismic shift as it might seem. But it is a slight expansion. No doubt that some of those who level criticism at the AI definition as unfairly favoring the wealthy would view this development as too small of an update, not making any major changes to the “core” of the AI definition. And that perspective is fair. However, this is an expansion. Even if it’s a small expansion. So, there may still be some work to be done here, but the definition of AI and QIB has been modernized and updated – at least a bit – to reflect – at least some of – the developments in the landscape surrounding the definition since it was first promulgated. For private companies, startups, and investors seeking to take advantage of exemptions for private securities offerings, some updates to accredited investor documentation and diligence are likely in order. Stay tuned to the blog for more updates.     This blog post is provided by Law Offices of Ryan Reiffert, PLLC for educational and informational purposes only and is not intended and should not be construed as legal advice.