SEC expands definitions of “accredited investor” and “qualified institutional buyer”

On August 26, 2020, the U.S. Securities and Exchange Commission (the "SEC") issued a final rule (the "Final Rule"), amending the definition of "accredited investor" in Rule 501(a) of Regulation D and the definition of "qualified institutional buyer" in Rule 144A under the Securities Act of 1933, as amended (the "Securities Act") as part of the ongoing effort to "modernize" the U.S. securities law. In SEC's own words, the amendments adopted in the Final Rule are intended to "identify more effectively institutional and individual investors that have sufficient knowledge and expertise to participate in investment opportunities that do not have the rigorous disclosure and procedural requirements, and related investor protections, provided by registration under the Securities Act."[1] 

The result of these amendments is to enlarge the pool of potential investors that are permitted to participate in private placement offerings, and consequently allow private issuers greater access to capital. The amendments will become effective 60 days after publication in the Federal Register.

Under Section 5 of the Securities Act, an issuer of securities is required to comply with the registration requirements under the Securities Act in the offer and sale of its securities unless it qualifies for an exemption from registration. The safe-harbor exemptions available under Regulation D, in particular those under Rule 506 of Regulation D, are commonly relied on by issuers offering securities in the United States or to U.S. investors through private placements, such as private investment funds. "Accredited investor" is a central concept to Regulation D private placement offerings in reliance on Rule 506, where such status is generally required in order to participate in most Rule 506 offerings, even though the Rule 506(b) exemption permits a limited number of investors that do not qualify for "accredited investor" status.

"Accredited investor" is defined in Rule 501(a), and is intended to capture those persons that, because of their financial sophistication and ability to sustain investment loss, do not need the protection of the registration process. Prior to the amendments contained in the Final Rule, the definition has primarily used wealth as a proxy for financial sophistication. The amendments created new categories of individuals and entities that qualify as accredited investors irrespective of their wealth, on the basis that such investors have demonstrated the requisite ability to assess an investment opportunity.

Under the Final Rule, the SEC may from time to time designate by order professional certifications, designations, and other credentials qualifying an individual for accredited investor status. The SEC will consider a nonexclusive list of attributes in determining which professional certifications and designations or other credentials qualify a person for accredited investor status, including:

1. the certification, designation, or credential arises out of an examination or series of examinations administered by a self-regulatory organization or other industry body or is issued by an accredited educational institution;
2. the examination or series of examinations is designed to reliably and validly demonstrate an individual's comprehension and sophistication in the areas of securities and investing;
3. persons obtaining such certification, designation, or credential can reasonably be expected to have sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of a prospective investment; and
4. an indication that an individual holds the certification or designation is either made publicly available by the relevant self-regulatory organization or other industry body or is otherwise independently verifiable.

In the Final Rule, the SEC decided to designate the General Securities Representative license (Series 7), the Private Securities Offerings Representative license (Series 82), and the Licensed Investment Adviser Representative (Series 65) as initial qualifying certifications, designation or credentials that qualify their holders for accredited investor status. These licenses are granted to securities professionals who have taken and passed the relevant exams developed and administered by the Financial Industry Regulatory Authority ("FINRA"), a U.S. securities industry self-regulatory organization.

The Series 7 license qualifies a candidate "for the solicitation, purchase, and/or sale of all securities products, including corporate securities, municipal securities, municipal fund securities, options, direct participation programs, investment company products, and variable contracts." The Series 65 exam is designed to qualify candidates as investment adviser representatives and covers topics necessary for adviser representatives to understand and provide investment advice to retail advisory clients. And the Series 82 license qualifies candidates seeking to make sales in private securities offerings[2].  

Another category of natural-person accredited investors added by the Final Rule is that of "knowledgeable employees" of a private fund with respect to investments in the fund. "Knowledgeable employee" is defined in Rule 3c-5(a)(4) under the Investment Company Act of 1940, as amended (the "'40 Act"). It includes, with respect to a private fund, any person who (i) an executive officer, director, trustee, general partner, advisory board member, or person serving in a similar capacity of the private fund, or (ii) an employee of the private fund or the fund's manager has participated in investment activities as part of his or her regular functions or duties for at least 12 months.

A private fund under the Final Rule is a fund that is excluded from the definition of "investment company" under Section 3(a)(1) of the '40 Act by Section 3(c)(1) or Section 3(c)(7) thereof. Section 3(c)(1) and Section 3(c)(7) of the '40 Act are two exemptions most commonly used by private investment funds such as private equity funds, hedge funds and venture capital funds, to avoid registration as investment companies under the '40 Act.

Among the new categories of entities added to the definition of accredited investor are (i) registered investment advisers, including those registered with the SEC under Section 203 of the Investment Advisers Act of 1940, as amended (the "Advisers Act"), or with any state securities regulator, and (ii) exempt reporting advisers that are venture capital fund advisers or private fund advisers exempted from registration with the SEC under Section 203(l) and (m), respectively, of the Advisers Act. Under Section 203(m) of the Advisers Act, investment advisers solely advising private funds and with a total amount of regulatory assets under management less than $150 million are exempted from registration with the SEC. Section 203(l) of the Advisers Act provides a similar exemption from registration for investment advisers solely advising qualifying venture capital funds.

The Final Rule also made rural business investment companies (a "RBICs"), defined in Section 384A of the Consolidated Farm and Rural Development Act, a new category of accredited investors. RBICs are investment vehicles created to promote economic development and the creation of wealth and job opportunities in rural areas, and intended to increase access to capital for growth stage businesses in such areas.

While limited liability companies ("LLCs") are a popular form of business entity among market participants in the alternative investments space, which comprises a significant portion of private placement issuances, LLCs are not among the types of entities included in Rule 501(a)(3) that are eligible to qualify for accredited investor status. Notwithstanding that, the SEC has long taken the position that LLCs that satisfy the requirements of Rule 501(a)(3), including the $5 million assets test, are eligible to qualify as accredited investors under Rule 501(a)(3). The Final Rule made that position official, and added LLCs to Rule 501(a)(3) as a category of business entities that are eligible for accredited investor status.

A "family office" is an investment adviser that provides investment advisory and management services solely to clients that are either related to each other as family members or certain employees or former employees of the family office, as provided in the definition of "family client" in Rule 202(a)(11)(G)-1(d)(4) under the Advisers Act. A family office that satisfies certain regulatory requirements set forth in the rule promulgated under the Advisers Act[3] is excluded from the definition of investment adviser and therefore not subject to the registration requirements thereunder. The Final Rule added family offices and family clients of such family offices that satisfy the following conditions as two new categories of accredited investors: (i) having at least $5 million in assets under management, (ii) not formed for the specific purpose of acquiring the securities offered, and (iii) the prospective investment is directed by a person having 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.

Finally, the Final Rule also added, as a catch-all category of accredited investors, any entity (including entities organized under the laws of a foreign country) (i) not formed for the specific purpose of acquiring the securities being offered, and (ii) owning "investments" (as defined in Rule 2a51-1(b) under the '40 Act) in excess of $5 million. Investments, as defined in Rule 2a51-1(b), include securities, real estate, commodity interests, physical commodities, and non-security financial contracts, in each case held or entered into for investment purposes, and cash and cash equivalents.

The current Rule 501(a)(5) and (6) designate as qualifying for accredited investor status any natural person whose joint net worth or joint income with that person's spouse exceeds certain thresholds. As part of the amendments to the accredited investor definition, the Final Rule added "spousal equivalent" to each reference to spouse in Rule 501(a)(5) and (6). The Final Rule adopted the definition of "spousal equivalent" included in the family office rules under the Advisers Act, which defines such a person as a cohabitant occupying a relationship generally equivalent to that of a spouse. In connection with this amendment, the SEC clarified that the securities being purchased by an investor in reliance on the joint net worth test of Rule 501(a)(5) need not be purchased jointly with the investor's spouse or spouse equivalent.

Rule 144A under the Securities Act provides another commonly used safe-harbor exemption from the registration requirements of Section 5 of the Securities Act. In a Rule 144A offering, an issuer first sells the offered securities to financial intermediaries (commonly known as the "initial purchasers") in a transaction exempt from registration under the Securities Act, followed by the immediate resale of the securities by the initial purchasers to qualified institutional buyers in reliance on Rule 144A.

Rule 144A(a)(1) specifies the types of institutions that are eligible for qualified institutional buyer status. For those that are not banks or SEC-registered dealers, a qualifying institution is required to, acting for its own account or the accounts of other qualified institutional buyers, own and invest on a discretionary basis in the aggregate at least $100 million in securities of non-affiliated issuers.

In conformity with the amendments made to the "accredited investor" definition, the Final Rule added RBICs, LLCs, and institutional accredited investors, as defined in Rule 501(a), of a type not currently listed in Rule 144A(a)(1)(i) through (vi) as new categories of institutions eligible to qualify for qualified institutional buyer status. There is one difference though. While Rule 501(a) generally requires an entity accredited investor not to be formed for the specific purpose of acquiring the securities offered, the SEC clarified in a new note added under Rule 144A that the new category of institutional accredited investors eligible for qualified institutional buyer status may be formed for the purpose of acquiring the Rule 144A securities being offered.

As is SEC's stated goal, the amendments in the Final Rule are intended to modernize the two definitions central to two safe-harbor exemptions commonly relied on by participants in the private placement markets. The SEC believes the categories of persons and institutions added to the two definitions are investors that possess the requisite knowledge and sophistication to make informed and sound investment decisions, and therefore do not need the protection of the registration requirements for public securities offerings.

As a result, they should not be denied investment opportunities available only in the private placement markets. While the SEC does not believe the addition of the new categories would significantly alter the mix of accredited investors or qualified institutional buyers, it is nonetheless of the view that these changes will open up additional capital source and help private issuers in their capital raising efforts. Given that many of the new categories of qualified investors are the types of persons or institutions already involved in the private investment fund space, private investment funds and their fund managers should be among the ones that will benefit primarily from these rule changes.

If you have any questions regarding the issues discussed in this client alert, please contact any of the listed Key Contacts.

[1] The Final Rule, p.4.

[2] See https://www.finra.org/registration-exams-ce/qualification-exams.

[3] See 17 C.F.R. § 275.202(a)(11)(G)-1.