Regulatory Alert — SEC’s Expanded “Accredited Investor” Definition Becomes Effective
Investors and financial advisors alike should be aware that on December 8, 2020, amendments to the “accredited investor” definition in Rule 215 and Rule 501(a) of Regulation D under the Securities Act of 1933 became effective. The Securities and Exchange Commission (SEC) initially proposed the changes on December 18, 2019 and issued its adopting release on August 26, 2020. A Final Rule, in addition to a supplemental Order, were formally published in the Federal Register on October 9, 2020. Primarily, the Final Rule and Order expand the range of accredited investors eligible to participate in the private capital markets by identifying individual and institutional investors that have a presumptive level of knowledge and expertise. The SEC also made changes to its definition of a “qualified institutional buyer” in Rule 144A under the Securities Act, a topic beyond the scope of this blog.
In the vast majority of instances, in order to participate in private capital markets, individual investors have been required to be “accredited” based on overall net worth or level of income, as set forth under Rule 506 of Regulation D (Reg D). Reg D, established in 1982, simplified the rules for securities offerings by creating an exemption to the requirement that offers of securities in the United States must be registered with the SEC. This exemption applies to so-called private placements, which enable smaller private companies and entrepreneurs to raise money in the capital markets. Reg D allows accredited investors to participate in investment opportunities not generally available to the public, including certain investments in private companies and offerings by hedge funds, private equity funds, and venture capital funds. The SEC has recognized the importance of the private capital markets, given that in 2019, registered offerings accounted for $1.2 trillion of new capital, whereas $2.7 trillion is estimated to have been raised through exempt offerings.
The underlying theory of the exemption has been that investors having certain levels of net worth or income are presumably sophisticated enough to participate in the purchase of unregistered equity or debt securities. As such, the SEC has exempted, in addition to certain types of entities, individuals having a net worth of at least $1 million (excluding the value of a primary residence) or annual income of at least $200,000 for the previous two years (or $300,000 combined for married couples) with the reasonable expectation of reaching the same income level in the current year.
The Final Rule maintains these net worth and income thresholds, while also allowing investors having certain professional credentials or experience levels to qualify without meeting these thresholds. With respect to individuals qualifying as accredited investors, the SEC has created a category of investors who hold, in good standing, certain professional certifications, designations, and other credentials. In its Order issued alongside the Final Rule, the SEC has initially designated the General Securities Representative license (Series 7), the Private Securities Offerings Representative license (Series 82), and the Investment Adviser Representative license (Series 65) as qualifying, provided the licensed individual is also in good standing. The SEC could potentially expand this list in the future.
The Final Rule also provides for additional categories of individuals and entities. Briefly, the amendments create an accredited investor category for investors who are “knowledgeable employees” of certain private fund issuers of the securities being offered or sold, under the Investment Company Act of 1940. Other categories include investment advisers registered with the SEC, state-registered investment advisers, exempt reporting advisers, rural business investment companies, limited liability companies with more than $5 million in assets, certain family offices and family office clients, and entities owning more than $5 million in investments.
In addition to these specific changes, the Final Rule creates a catch all provision for entities that, not already considered accredited investors under the definition, own in excess of $5 million in investments and were not formed for the specific purpose of acquiring the securities offered. The term “investments” in this context is defined in rule 2a51-1(b) under the Investment Company Act to include securities, cash and cash equivalents, and real estate, commodity interests, physical commodities, and non-security financial contracts held for investment purposes.
Finally, it is important to remember that while these amended rules are now effective, regulations can be further amended or, in some cases, partially or completely repealed by subsequent administrations. It is therefore uncertain whether the incoming Biden Administration, acting through a democratically run SEC, will seek to make further changes to the accredited investor framework via a new rulemaking. One potential area of review could involve the net worth and income thresholds for individuals, which were left unchanged in the Final Rule despite public comments calling for upward adjustments to account for inflation.
The attorneys at Giarrusso Law Group LLC have considerable experience with issues unique to the financial services industry, including SEC and FINRA rules and regulatory developments affecting both investors and financial advisors. If you have a question regarding this recent announcement or any other regulatory matter, you may contact us at (201) 771-1115 or info@gialawgroup.com for a no-cost and confidential consultation.