The Securities and Exchange Commission is proposing to expand the definition of “accredited investor” to include additional entities that could bear the economic risks of investment and certain financially sophisticated persons irrespective of income or wealth. The Commission’s main objective is to identify more effectively institutional and individual investors that have the knowledge and expertise to participate in private capital markets and thus do not need the protections of registration. If adopted, the proposed expansion would significantly benefit issuers and investors alike.
Regulation D and Current Accredited Investor Definition
Private offerings conducted under Rule 506 of Regulation D play a significant role in capital formation in the United States. In 2018, an estimated $1.7 trillion was raised in Rule 506 offerings, as compared with $1.4 trillion raised in registered offerings. Of the $1.7 trillion raised in private offerings, $1.5 trillion went to investment funds and $228 billion to operating issuers.
Rule 506 allows an issuer to sell shares to an unlimited number of “accredited investors” and up to 35 non-accredited investors. As a practical matter, however, the vast majority of issuers in Rule 506 offerings offer and sell the offered securities only to accredited investors. The reason for this is a built-in disclosure bias in favor of accredited investor-only offerings: if you sell only to accredited investors, you do not have to satisfy the specific, mandated and rather onerous disclosure requirements set forth in Regulation D. Instead, an issuer selling only to accredited investors may determine for itself what is material and what is not, and satisfy its disclosure obligation through the concept of “access”, whereby the investors are given access to information offered to or requested by the investors and an opportunity to ask questions directly. The theory here is that an accredited investor is able to fend for himself and has the leverage to extract information.
Currently, the term “accredited investor” means anyone who fits any of the following categories:
- banks, registered broker-dealers, certain insurance companies and certain employee benefit plans with more than $5 million in assets;
- private business development companies;
- 501(c)(3) companies, corporations, business trusts and partnerships, in each case exceeding $5 million in assets and not formed to acquire the offered securities;
- directors, executive officers and general partners of the issuer of the securities, or any director, executive officer or general partner of a general partner of that issuer;
- individuals with net worth, or joint net worth with spouse, exceeding $1 million;
- individuals with income of over $200,000 (or $300,000 with spouse) in each of two most recent years, with reasonable expectation of earning at least same in current year;
- trusts with assets exceeding $5 million not formed to acquire the offered securities, whose purchase is directed by a sophisticated person; or
- entities in which all of the equity owners are accredited investors.
In June 2019, the Commission issued a concept release that solicited public comment on ways to simplify and improve the exempt offering framework to promote capital formation and expand investment opportunities while still maintaining appropriate investor protections. In the concept release, the Commission requested comments on possible approaches to amending the definition of “accredited investor” in Rule 501(a) of Regulation D.
Historically, the accredited investor definition used income level and wealth as a proxy for both capacity to sustain investment loss and for financial sophistication. The problem with the old approach is that it excluded investors who are financially sophisticated but do not meet the income and wealth criteria. In this regard, the concept release requested comment on the use of sophistication measures other than income and net worth to expand the universe of accredited investors.
Proposal to Expand Accredited Investor Definition
The Commission’s current proposal to expand the accredited investor definition was presented in its release dated December 18, 2019 entitled Amending the “Accredited Investor” Definition (the “Release”). The Release is premised on the Commission’s stated belief that wealth and income should not be the sole means of establishing financial sophistication for purposes of the accredited investor definition. Accordingly, it seeks to create new categories of individuals who would qualify as accredited investors irrespective of wealth and income on the basis that such investors have the requisite financial sophistication to assess an investment opportunity. It also seeks to add new categories and add to existing categories of entities that can fend for themselves as a result of asset ownership or investment in securities.
The proposed revised definition would add the following categories of individuals and entities as “accredited investors”:
- individuals with a license as a general securities representative (Series 7), investment adviser representative (Series 65) or private securities offerings representative (Series 82);
- “knowledgeable employees” of a private fund, as to investments in that fund;
- registered investment advisers (but not “exempt reporting advisers” relying on the venture capital adviser exemption or private funds adviser exemption);
- “family offices” with at least $5 million in assets under management, directed by a sophisticated person and not formed to invest in the offered securities, as well as their “family clients”;
- entities owning “investments” of more than $5 million, so long as the “investments” fall within Rule 2a51-1(b) of the Investment Company Act and so long as the entity was not formed for the specific purpose of investing in the offered securities;
- limited liability companies exceeding $5 million in assets not formed to acquire the offered securities; and
- rural business investment companies.
Benefit to Issuers and Investors
The proposed amendment to the accredited investor definition could prove enormously advantageous to issuers and investors beyond the obvious expansion of the universe of accredited investors who supply the vast majority of private capital in the U.S. The benefit of an expanded accredited investor definition to Regulation A issuers is that accredited investors are not subject to the Tier 2 investment cap. In Regulation Crowdfunding offerings, the expanded definition would mean enhanced resale opportunities inasmuch as securities purchased in a Regulation CF offering may not be resold for a one year period other than to accredited investors, the issuer or family members (or in a registered sale). The reasonable verification requirement has been identified as an impediment to Rule 506(c) offerings, and the expansion of the definition to include those with professional certifications would provide issuers with more palatable methods to verify status. For holders of restricted securities, an expanded accredited investor pool would make it easier to conduct a private resale under Rule 4(a)(7) which requires that the purchaser be an accredited investor. If the proposed rules indeed make it easier to conduct private resales of restricted securities, this could lead to lower liquidity discounts and thus higher prices.
Finally, the Release also proposes to amend the definition of “qualified institutional buyer” for purposes of the resale exemption under 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 Commission is seeking input on its proposed amendments to the accredited investor definition, and comments may be communicated using the Commission’s internet comment form, by email to email@example.com or by mail to Vanessa A. Countryman, Secretary, Securities and Exchange Commission, 100 F Street, NE, Washington, DC 20549-1090. Published comment letters, including your humble blogger’s January 13, 2020 comment letter regarding inclusion as accredited investors limited liability companies with more than $5 million in assets not formed to invest in the offering, as well as managers of manager-managed LLCs, could be found here. Comments need to be received by the Commission not later than March 15, 2020 (60 days after the Release’s January 15, 2020 publication in the Federal Register).