SEC Increases Access to Private Investment Markets by Expanding Definition of “Accredited Investor”
October 7, 2020
- The SEC has expanded the definition of “accredited investor” to include more categories of natural persons and entities.
- Participation in private placements is often limited to “accredited investors” due to securities law restrictions, and the expansion will increase investor access to private placements.
- In 2019, companies raised more than twice as much capital in private placements as they did through public offerings.
After years of speculation and proposals, the Securities and Exchange Commission (the “SEC”) has adopted amendments to broaden the definition of “accredited investor” under Regulation D of the Securities Act of 1933, as amended (the “Securities Act”). The changes become effective 60 days after publication in the Federal Register (which publication has not occurred as of the date of this article).
These amendments are designed to increase access to private capital markets for additional classes of both individual and institutional investors. Under these amendments, an individual investor may qualify as an accredited investor based on certain standards of professional knowledge, experience, or certifications, in addition to the legacy standards tied to net worth or annual income. These amendments also expand the types of entities that may qualify as accredited investors.
The Securities Act requires all offers and sales of securities to be registered with the SEC, unless an exemption from those registration requirements is available. Thus, a company not undertaking a registered public offering must conduct its offering as a private placement in compliance with the conditions of a registration exemption. The SEC’s preamble to the rule change outlines that more than two-thirds of all new capital raised in 2019 was raised through private placements, with a majority of that capital raised in private placements conducted in reliance on Regulation D.
The definition of accredited investor is so important to private markets because often the best, and sometimes the only, path to satisfying the Regulation D conditions is to limit the offer and sale to only investors that qualify as accredited investors. Persons who are not accredited investors are provided with far fewer opportunities to participate in private placements than accredited investors due in large part to the complex and costly disclosure requirements and other burdens that Regulation D imposes on offerings that include non-accredited investors. These burdens often result in non-accredited investors being excluded from private placements conducted not only under Regulation D, but also under other private placement exemptions.
Expansion of Categories of Individual Investors
Prior to these amendments, individuals could participate in private placements as “accredited investors” only if they met one of two financial tests:
- annual income in the preceding two years in excess of $200,000 (or in excess of $300,000 jointly with such person’s spousal equivalent), with a reasonable expectation of reaching the same income level in the current year; or
- a net worth (individually or jointly with such person’s spousal equivalent) in excess of $1,000,000 (exclusive of any equity in the person’s primary residence, and reduced by the amount (if any) that any secured debt in that primary residence exceeds its estimated fair market value).
According to the SEC, only 13 percent of U.S. households can satisfy one of those financial tests. In other words, 87 percent of U.S. households do not have access to most private placements. While the SEC did not change those financial thresholds in the latest amendments, the SEC did expand the joint income and joint net worth tests by expanding the “joint” person from “spouse” to “spousal equivalent,” meaning a cohabitant occupying a relationship generally equivalent to that of a spouse.
The amendments to the definition of “accredited investor” now includes two new categories of individuals unrelated to the existing financial tests: “individuals with certain certifications or credentials” and “knowledgeable employees of a private fund.”
Under the first new category of individual accredited investors, individuals who hold, and are in good standing under, certain professional certifications, designations, or other credentials that the SEC designates from time to time as meeting specified criteria may now qualify as accredited investors. The first such certifications designated by order of the SEC as qualifying as accredited investors are individuals holding, and in good standing under, a Series 7 (General Securities Representative), Series 65 (Licensed Investment Adviser Representative) or Series 82 (Private Securities Offerings Representative) license. The SEC invites the public to propose, and in the future the SEC may adopt, additional professional certifications, designations, or credentials to include in the definition of “accredited investor” to further increase access to private placements.
Under the second new category of individual accredited investors, knowledgeable employees of a private fund who are investing in that private fund may now qualify as accredited investors. The term “knowledgeable employees” generally includes an executive officer, director, trustee, or advisory board member of a private fund, or any person who participates in the investment activities of that private fund for at least 12 months (other than persons performing solely clerical, secretarial, or administrative functions).
Expansion of Categories of Entities
In addition to expanding the definition of “accredited investors” for individuals, the SEC also expanded the definition to add the following new categories of entities:
- Limited liability companies meeting the same conditions as corporations, such as having more than $5,000,000 in assets and not being formed for the specific purpose of acquiring the offered securities, which simply codifies the SEC’s existing position;
- Investment advisors registered with the SEC or under state law;
- Exempt reporting advisers under Section 203(l) or Section 203(m) of the Investment Advisers Act of 1940, as amended;
- Rural business investment companies;
- Other types of entities (including Native American tribes and labor unions) that own investments in excess of $5 million and were not formed for the specific purpose of acquiring the offered securities;
- “Family offices,” which are generally defined as entities established by wealthy families to manage the family’s net worth that have at least $5 million in assets under management and were not formed for the specific purpose of acquiring the offered securities and have no clients other than “family clients;” and
- “Family clients”, who generally are family members and certain key employees of the family office, as well as certain of their charitable organizations and trusts.
Paul Hess chairs Kegler Brown’s Securities practice group where he advises private and public companies, as well as sponsors, fund managers, and investors, on capital raising, fund formation, and compliance with federal and state securities laws and regulations. He can be reached at [email protected] or (614) 462-5441.
Andrew Doup is a business lawyer who advises clients on a range of securities law issues, including private investment finance and Reg D private placements for real estate, emerging company, and opportunity zone transactions. He can be reached at [email protected] or (614) 462-5488.