The Securities and Exchange Commission (SEC) on August 26 adopted amendments (Amendments) to the “accredited investor” definition, which is one of the principal tests for determining who is eligible to participate in certain private securities offerings and if an issuance of securities is exempt from registration under Regulation D of the Securities Act of 1933 (Securities Act). In the press release announcing the Amendments, the SEC stated that the Amendments would “update and improve the definition to more effectively identify institutional and individual investors that have the knowledge and expertise to participate in [private] markets.”
As further described below, the Amendments allow individuals to qualify as accredited investors based on defined measures of professional knowledge, experience or certifications, in addition to the existing tests for income or net worth. The Amendments also expand the list of entities that may qualify as accredited investors, including by allowing any entity that meets an investments test to qualify. In addition, in part in order to conform with the new accredited investor definition and as described below, the Amendments expand the definition of “qualified institutional buyer” in Rule 144A of the Securities Act.
In December 2015, an SEC staff report examined the history of the accredited investor definition and considered comments and recommendations regarding potential amendments, and, in June 2019, the SEC requested public comment on its Concept Release on Harmonization of Securities Offering Exemptions. After taking into account the views expressed by members of the public and recommendations over the years from various SEC advisory committees and the annual SEC Government-Business Forum on Small Business Capital Formation, the SEC proposed in December 2019 to amend the accredited investor definition. In March 2020, the SEC proposed, and, on August 26, 2020, it adopted amendments to the definitions of accredited investor and qualified institutional buyer, the key takeaways of which are summarized below.
Summary of the Amendments
The amendments to the accredited investor definition in Rule 501(a):
- Existing Thresholds: Maintain the existing, objective income and net worth thresholds for individuals to qualify as accredited investors, reserving for future review whether those numeric thresholds should continue to be used or should be adjusted.
- Professional Credentials: Add a new category to the definition that permits individuals to qualify as accredited investors based on certain professional certifications, designations, or other credentials issued by an accredited educational institution. In conjunction with the adoption of the Amendments, the SEC designated by order holders in good standing of the Series 7, Series 65, and Series 82 licenses as qualifying individuals. This approach provides the SEC with flexibility to reevaluate or add certifications, designations, or credentials in the future.
- Knowledgeable Employees: Include as accredited investors, with respect to investments in a private fund, natural persons who are “knowledgeable employees” of such fund.
- LLCs, Advisers, and RBICs: Clarify that limited liability companies with $5 million in assets may be accredited investors and add SEC- and state-registered investment advisers, exempt reporting advisers, and rural business investment companies (RBICs) to the list of entities that may qualify as an accredited investor.
- Entity “Catch-All”: Add a new category for any entity, including Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries, that own “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act of 1940, as amended (Investment Company Act), in excess of $5 million, and that was not formed for the specific purpose of investing in the securities offered.
- Family Offices: Add “family offices” with at least $5 million in assets under management and their “family clients,” as each term is defined under the Investment Advisers Act of 1940, as amended;
- Spousal Equivalents: Add the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors.
- Treatment of Qualified Purchasers: Do not automatically treat qualified purchasers, as defined in the Investment Company Act, as accredited investors.
The amendments to the definition of “qualified institutional buyer” in Rule 144A under the Securities Act expand the definition to include limited liability companies and RBICs if they meet the $100 million in securities owned and invested threshold in the definition. The Amendments also expand the definition of qualified institutional buyer to include any institutional investors included in the accredited investor definition that are not otherwise enumerated in the definition of “qualified institutional buyer,” provided they satisfy the $100 million threshold.
Potential Practical Implications
Below is a brief discussion of some potential practical implications of the Amendments:
- Expansion of the Pool of Individuals Qualifying as Accredited Investors: Although it is likely that there will be significant overlap in the individuals captured by the amended definition and those individuals that were already captured by the prior definition, the expansion of the rule to capture individuals with the requisite experience, credentials, or sophistication will likely be helpful for asset management firms that want to offer private investment opportunities to their investment professionals who otherwise do not meet the income or net worth tests.
- Clarification Regarding Qualification of Knowledgeable Employees: The Amendments removed the prior ambiguity relating to the definition of “knowledgeable employees” in Rule 3c-5 under the Investment Company Act and whether knowledgeable employees need to separately satisfy the accredited investor eligibility requirement in the Securities Act; as noted above, the Amendments clarify that individuals who are “knowledgeable employees” of a private fund qualify as accredited investors with respect to such fund. This clarification will assist sponsors (and knowledgeable employees themselves) in determining eligibility to invest in certain private funds.
- Interplay of Accredited Investor and Qualified Purchaser Definitions: A common misconception regarding the definitions of accredited investor and qualified purchaser is that the latter is included in the former. This was not the case before the Amendments and is also not the case now. By declining to define accredited investor to include any qualified purchaser in the Amendments, it is still possible for an investor to be a qualified purchaser but not an accredited investor.
- Individual Thresholds Still Not Indexed to Inflation: As noted above, the Amendments did not change the income and net worth thresholds for individuals to qualify as accredited investors, nor did they break with precedent and index the thresholds to inflation. Accordingly, these thresholds, which were established in 1982, have over time given way to a broader population of individuals qualifying as accredited investors. In their dissent, Commissioners Allison Herren Lee and Caroline Crenshaw cited this concern, referencing the “steady expansion of the private market” and the risk to investors, particularly seniors, who continue to have greater access to less transparent and more illiquid offerings.
- Individuals with Professional Credentials: The new category of accredited investors that includes individuals with certain professional certifications and designations or other credentials issued by an accredited educational institution may give rise to other groups of professionals (e.g., graduates of law school or business school) lobbying for similar qualification as accredited investors in the future. Going forward, the SEC will need to grapple with where to draw the line on the qualification of certain professionals as accredited investors.
- Family Offices and Family Clients: Previously, the trusts, charitable organizations, and other “family entities” of a family office were generally required to separately qualify as accredited investors. The Amendments effectively remove this separate requirement, and allow such family entities to qualify as accredited investors as long as they are created and managed by a family office that itself qualifies as an accredited investor. Given the growth of the family office as an investment vehicle in recent years, this amendment may significantly expand the number of family clients that qualify as accredited investors.
- Benefit to Sponsors of 3(c)(1) Funds: Since the foregoing implications are likely to expand the pool of accredited investors to some extent, the Amendments should primarily benefit sponsors to private funds that are excepted from registration in reliance on Section 3(c)(1) of the Investment Company Act. The Amendments will not benefit sponsors of private funds that rely on the 3(c)(7) exemption to the same extent, since the SEC has not proposed changes to the definition of “qualified purchaser” and investors in those 3(c)(7) funds will continue to need to meet that generally higher standard.
- Subscription Documents: Since the overall effect of the Amendments is to broaden the scope of investors deemed to be accredited investors, private fund managers will likely be able to continue to rely on affirmative responses from existing investors to the questions seeking to determine status as an accredited investor. However, private fund managers should consider updating their accredited investor questionnaires in their subscription documents once the Amendments go into effect.
The Amendments and order become effective December 8, 2020.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
John J. O’Brien
Timothy W. Levin
Christine M. Lombardo
Christopher J. Dlutowski
Louis H. Singer
Jedd H. Wider
Joseph D. Zargari
John D. Cleaver
Richard A. Goldman
Barry N. Hurwitz
Roger P. Joseph
Daniel A. Losk
Gerald J. Kehoe
Toby R. Serkin
Stephen C. Tirrell
Carrie J. Rief
Ethan W. Johnson
Laurie A. Dee
Jarrod A. Huffman
Miranda Lindl O’Connell
Peter M. Phleger
Gregg S. Buksbaum
Thomas S. Harman
Christopher D. Menconi
Courtney C. Nowell
Monica L. Parry
 Rule 506 of Regulation D provides an exemption from registration to companies that sell their securities to accredited investors. Broadly, an accredited investor is generally defined as (i) an individual with more than $1 million in net worth (excluding the value of any primary residence) or who has earned more than $200,000 per year in each of the last two years (or, if married, $300,000 combined income), (ii) an organization with more than $5 million in assets, or (iii) a bank, institution or other entity that meets certain legal criteria.