For nearly four decades, participation in private offerings has been reserved for only those investors with the financial resources to demonstrate their “sophistication” to invest by meeting specific wealth thresholds without regard to financial knowledge or expertise. On August 26, 2020, the Securities and Exchange Commission (the “SEC”), by a vote of 3-2, issued a final rule (the “Final Rule”) adopting amendments that expand the current “accredited investor” definition to add non-wealth based criteria for a natural person to qualify to become eligible to invest in unregistered private offerings of securities. Restricting access to the private market allows issuers to offer securities without the time, expense, and disclosure requirements of registration imposed by the Securities Act of 1933 (the “Securities Act”) which leaves potential investors subject to heightened risks of fraud and misrepresentation. The longstanding wealth thresholds for being an “accredited investor” require an income of over $200,000 (or $300,000 jointly with a spouse) in each of the prior two (2) years with a reasonable expectation to earn the same in the current year or that the individual possess a net worth of over $1 million, either alone or together with a spouse (excluding the value of the individual’s primary residence). Initially released for public comment on December 18, 2019, the Final Rule’s amendments to the accredited investor definition in Rules 215 and 501(a) of the Securities Act (1) allow additional individual investors to participate in private offerings by creating additional categories for qualification based on knowledge and expertise and (2) add new categories of entities that now qualify as institutional accredited investors by meeting an investments test, as summarized below. The Final Rule also amends the definition of “qualified institutional buyer” (“QIB”) to expand the list of entities eligible for QIB status under Rule 144A of the Securities Act, also summarized below.
Expansions to the Accredited Investor Definition
The SEC’s decision to amend and expand the “accredited investor” definition to allow investors to qualify based on defined measures of professional knowledge, experience, or certifications and expanding the list of entities that may qualify for such status by allowing any entity that meets an “investments test,” enables investors with the ability to appreciate the risks of exempt offerings as demonstrated through indicators of financial sophistication, no longer solely based on income and net worth, to do so by falling under any of the following new categories:
- be a holder, in good standing, of certain professional certifications and designations or other credentials that demonstrate an understanding in the areas of securities; such initial acceptable qualifications named by the SEC in the Final Rule are the General Securities Representative license (Series 7), the Private Securities Offerings Representative license (Series 82), and the Licensed Investment Adviser Representative (Series 65);
- be a “knowledgeable employee” of a private fund which includes, among other persons, trustees and advisory board members, or persons serving in a similar capacity for the fund or an affiliated person of the fund that oversees the fund’s investments, as well as employees of the private fund or the affiliated person of the fund (other than employees performing solely clerical, secretarial, or administrative functions) who, in connection with the employees’ regular functions or duties, have participated in the investment activities of such private fund for at least twelve (12) months;
- be a limited liability company that has not been formed for the purpose of making the investment and has total assets in excess of $5 million;
- be an SEC- or state-registered investment adviser or rural business investment company (RBIC);
- be any entity, including Indian tribes, owning “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered;
- be a “family office” with at least $5 million in assets under management and any “family clients” of family offices, as each term is defined under the Investment Advisers Act; or
- be a “spousal equivalent,” meaning a cohabitant occupying a relationship generally equivalent to that of a spouse, who pools finances for the purposes of qualifying as accredited investors.
It is important for individuals seeking accredited investor status based on certain professional certifications, designations, or other credentials to note that they will need to comply with the “good standing” requirement. The General Securities Representative license holder, the Private Securities Offerings Representative license holder, and the Licensed Investment Adviser Representative must have passed the required examinations and the individual must maintain their license or registration, as applicable, in good standing. The SEC has stated in the Final Rule that issuers and other market participants will be able to obtain registration and licensing information about registered representatives and investment adviser representatives “easily” through the Financial Industry Regulatory Authority’s BrokerCheck or the SEC’s Investment Adviser Public Disclosure database. The SEC has stated that they will consider other credentials after first gaining experience with the newly revised rules. Individuals who wish to have additional credentials recognized by the SEC for accredited investor status should make a request with the SEC that details the specific degree or program of study and address how the particular certification, designation, or credential satisfies the nonexclusive list of attributes set forth in the Final Rule, such as being able to assess investment opportunities, appropriately allocate capital based on the investor’s individual circumstances, and that the credentials be made publicly available for verification, and the requester should also include any additional information that they believe the SEC should consider.
Recent Developments to the Definition of Qualified Institutional Buyer
Rule 144A provides the definition of a QIB and specifies the types of institutions that are eligible for QIB status provided they meet the minimum threshold of managing at least $100 million in securities owned and invested. The Final Rule expands Rule 144A to add RBICs to Rule 144A(a)(1)(i)(C) and limited liability companies to Rule 144A(a)(1)(i)(H). The Final Rule also adds a new category in the QIB definition that encompasses the new category in the accredited investor definition for entities owning investments in excess of $5 million that are not formed for the specific purpose of acquiring the securities being offered under Regulation D, as well as any other entities that may be added to the accredited investor definition in the future, although such entities would still need to meet the existing $100 million threshold in order to attain QIB status. However, unlike in the amendments to the accredited investor definition, the SEC added a note to the above-mentioned new category to clarify that for the purposes of QIB status under Rule 144(a)(1)(i)(J), the entity may be formed for the purpose of acquiring the Rule 144A securities being offered.
Recent Updates to the “Test-the-Waters” Accommodation
Section 5(c) of the Securities Act prohibits any written or oral offers of securities prior to the filing of a registration statement. In 2012, the U.S. Congress passed the Jumpstart Our Business Startups Act which, among other things, established a “test-the-waters” accommodation for emerging growth companies. The accommodation originally permitted “emerging growth companies,” defined in Rule 405 as issuers that had total annual gross revenues of less than $1,070,000,000 during its most recently completed fiscal year, or any persons acting on their behalf, to gauge interest in a contemplated offering by engaging in oral or written communications with potential investors that are, or are reasonably believed to be, QIBs or institutional accredited investors, either before or after the filing of a registration statement. In September of 2019, the SEC adopted Securities Act Rule 163B, which extended the test-the-waters accommodation beyond emerging growth companies to all issuers, regardless of size or reporting status. The Final Rule now amends the test-the-waters accommodation to also include references to the following new subsections of Rule 501:
- (a)(9): Concerning entities owning investments in excess of $5 million that are not formed for the specific purpose of acquiring the securities being offered;
- (a)(12): Concerning family offices under the “family office rule” that also have at least $5 million in assets under management and investments that are directed by a person who has the requisite knowledge and experience in financial and business matters; and
- (a)(13): Concerning family clients that are institutions and qualify as accredited investors under such rule.
The amendments promulgated through the Final Rule have the effect of further opening access to the private capital markets and could potentially reshape the financial landscape for private companies as the amendments lower the cost of capital for emerging companies to facilitate capital formation by expanding the pool of eligible investors while still implementing and maintaining certain investor protections.
The amendments and order will become effective sixty (60) days after publication in the Federal Register.