SEC Proposes Amendments to Update Accredited Investor and Qualified Institutional Buyer Definitions

The U.S. Securities and Exchange Commission on December 18, 2019 approved for publication a rulemaking proposal (Proposal)¹ to: amend the definition of “accredited investor;” introduce additional qualification methods; codify certain SEC interpretive positions; and generally expand the pool of eligible private fund investors.

Notably, the Proposal would:

• Update the definition of accredited investor to include: (i) natural persons with certain professional certifications, designations or other credentials; (ii) “knowledgeable employees” within the meaning of Rule 3c-5 under the Investment Company Act of 1940; (iii) a catch-all category for entities meeting an investment-based test; (iv) certain family offices and family clients; (v) registered investment advisers; and (vi) certain limited liability companies;
  
  
•  Make conforming amendments to the definition of qualified institutional buyer; and
  
  
• Retain the current financial thresholds to qualify as an accredited investor (although the SEC is continuing to seek comment on this matter).

The Proposal follows closely on the heels of the Concept Release on Harmonization of Securities Offering Exemption (Concept Release) the SEC published in June 2019.²  The Concept Release solicited feedback as to whether (among other things) the SEC should make certain revisions to the accredited investor definition and the Rule 144A safe harbor. If the Proposal is adopted, the accredited investor standard would receive the facelift that SEC Chairman Jay Clayton³ and many industry participants believe is long overdue.

Background on the Accredited Investor Definition under Regulation D

Section 4(a)(2) of the Securities Act of 1933 provides that an offering of securities that does not involve a “public offering” is exempt from registration. Regulation D under the Securities Act provides safe harbors from the registration requirements of the Securities Act for private offerings that are made primarily or exclusively to persons who are accredited investors. Generally, accredited investors are deemed to have the financial sophistication to participate in private offerings without the protections contained in the Securities Act. The current definition of accredited investor relies on income or net worth as the main proxies for financial sophistication.

Proposed New Categories of Individual Accredited Investors

The Proposal would add the following categories of natural persons to the definition of accredited investor:

• Individuals with Professional Certifications/Designations and Other Credentials. The amendments would add natural persons who hold certain professional certifications, designations or credentials from accredited educational institutions that the SEC has designated on its website. Such natural persons would be accredited investors even if they do not meet the current accredited investor financial thresholds.

In determining whether to approve a credential, factors that the SEC will consider include (among others) that:

- 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;

- 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;

- Persons obtaining such a 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

- An indication that an individual holds the certification or designation is made publicly available by the relevant self-regulatory organization or other industry body.

It is expected that the following certifications or designations will appear on the initial list of approved credentials: Series 7, Series 65 and Series 82 licenses.

•  Knowledgeable Employees of Private Funds. The amendments would include knowledgeable employees as accredited investors for purposes of investing in private offerings. Private funds often rely on the registration exception provided under Section 3(c)(7) of the 1940 Act, which requires that all investors be either qualified purchasers or knowledgeable employees. Thus, for a Section 3(c)(7) private fund, a knowledgeable employee must independently meet the accredited investor definition, but not the qualified purchaser definition (which contains significantly higher financial thresholds). This amendment would harmonize the Securities Act and the 1940 Act by permitting knowledgeable employees to bypass the financial threshold requirements under both the accredited investor and qualified purchaser definitions.
  
  
•  Pooled Finances for Spousal Equivalents. The Proposal would expressly allow income from spousal equivalents (i.e., a cohabitant occupying a relationship generally equivalent to that of a spouse) to be included when determining the joint net worth and joint income thresholds contained in the current accredited investor definition. The SEC noted in the Proposal that it sees “no reasons to distinguish between different types of relationship structures for the purposes of these rules” and that the clarification would “remove unnecessary barriers to investment opportunities for spousal equivalents.”
  

• Entities Satisfying a $5 Million “Investments-Owned” Test. The SEC proposes to add a new catch-all category for entities that own more than $5 million of investments (as defined under 1940 Act), citing the increased reliability of an investment-based test as compared to an asset-based test. This category is specifically intended to capture all new and existing entity types not already contemplated by the accredited investor definition (including Indian tribes and governmental bodies), although the proposed use of the term “entity” may inadvertently exclude business organizations that are not considered to have separate legal identities.
  
  
• Certain Family Offices and Family Clients. The Proposal would add family offices (as defined in the Investment Advisers Act of 1940): (i) with more than $5 million in assets under management; (ii) that are not formed for the purpose of investing in the offered securities; and (iii) whose prospective investments are directed by individuals who have knowledge and experience in financial and business matters. The Proposal also would add family clients (as defined in the Advisers Act) of qualifying family offices.
  
  
• SEC- and State-Registered Investment Advisers. The Proposal would add investment advisers that are registered with the SEC or a state, on the basis that “investment advisers appear to have the financial sophistications to conduct meaningful investment analysis” and therefore should be permitted to participate in private offerings.
  
  
• Limited Liability Companies with Total Assets Exceeding $5 Million. The Proposal would add limited liability companies having total assets exceeding $5 million. The SEC notes that: limited liability companies have been widely adopted as a corporate form; and the amendment would codify a long-standing staff position that limited liability companies otherwise satisfying the requirements of the accredited investor definition qualify as accredited investors.⁴

Conforming Amendments to the Qualified Institutional Buyer Definition

The Proposal would make certain conforming amendments to Rule 144A (which provides a safe-harbor for certain resales of restricted securities to qualified institutional buyers from the registration requirements of the Securities Act), including a new catch-all category for entities that are institutional accredited investors (as defined in the Securities Act) that are not any of the types of entities expressly included in Rule 144A and which otherwise own and invest on a discretionary basis $100 million or more of assets in issuers that are not affiliated with the entity.

The Proposal sets forth a number of requests for comment regarding the proposed amendments. Industry participants should consider submitting feedback to the SEC on these proposed changes. The public comment period will remain open until March 15, 2020.

Footnotes:

1. Amending the “Accredited Investor” Definition, Securities Act Release No. 10734 (Dec. 18, 2019). The Proposal was approved by a 3-2 vote along party lines. Commissioner Robert J. Jackson Jr. dissented on grounds that the Proposal lacked adequate cost analysis and Commissioner Allison H. Lee dissented on grounds that the financial thresholds required for participation in private offerings are overly inclusive and not indexed to inflation.  
   
   
2. Concept Release on Harmonization of Securities Offering Exemptions, Securities Act Release No. 10649 (June 18, 2019). For further information, please refer to Dechert OnPoint, SEC Publishes Concept Release on Hormonization of Securities Offering Exemptions; Comment Deadline Approaching.
   
   
3. See e.g., Jay Clayton, Remarks to the Economic Club of New York (Sept. 9, 2019) ("We should … increase the type and quality of opportunities for our Main Street investors in our private markets.”)
   
   
4. The Proposal cites to the Wolf, Block, Schorr and Solis-Cohen, SEC Staff No-Action Letter (Dec. 11, 1996) and question number 255.05 of Securities Act Rules Compliance and Disclosure Interpretations.