SEC proposes allowing more investors to participate in Regulation D offerings
If adopted, the amendments would mark the first time in decades that the SEC has expanded the accredited investor or QIB pools
In a shift in the way the US Securities and Exchange Commission (the “SEC”) has traditionally viewed investors in private offerings, the SEC has proposed to expand the definition of “accredited investor” under Regulation D to include consideration of a natural’s person financial sophistication, rather than focusing only on the person’s financial status. The proposed amendments would also add new categories of entities to both the definitions of “accredited investor” under Regulation D and “qualified institutional buyer” (“QIB”) under Rule 144A. If adopted, the amendments would mark the first expansion of the definition of accredited investors since 1989, and of the definition of QIBs since 1992.
At the same time, despite criticism that the financial thresholds for natural person accredited investor status have not been adjusted for inflation since their establishment in 1982, the SEC declined to propose changes to such thresholds. Had the SEC determined to adjust such thresholds to reflect inflation, that could have significantly decreased the number of natural persons that could qualify as accredited investors.
The SEC’s proposed expansion of the accredited investor pool is significant because of Regulation D’s importance to the US capital markets. In 2018, the amount of capital (including both equity and debt) raised in the United States in 2018 under Rule 506 is estimated to be $1.7 trillion, compared to $1.4 trillion raised in SEC-registered offerings.
Rule 506 is the key safe-harbor exemption from SEC registration for private offerings of securities under Regulation D. Under Rule 506(b), an issuer may offer and sell an unlimited amount of securities without SEC registration, if the offers are made without the use of “general solicitation or general advertising” and sales are made only to accredited investors and up to 35 non-accredited investors who meet an investment sophistication standard. Rule 506(c) provides another registration exemption without any offering limit, under which general solicitation or general advertising is permitted, as long as the purchasers are limited to accredited investors only and the issuer takes reasonable steps to verify their accredited investor status.
Currently, the definition of accredited investor under Rule 501(a) includes entities of a certain status (e.g., SEC-registered broker-dealers); certain entities (including corporations, trusts and partnerships) with more than $5 million in assets; directors, executive officers and general partners of the issuer; and natural persons who satisfy certain financial tests.
Expansion of accredited investor definition of natural person
Except for directors, executive officers and general partners of the issuer, currently, natural persons can only be accredited investors under Regulation D if they meet certain financial thresholds that are exclusively numerical: (1) at least $1 million in net worth; or (2) at least $200,000 in annual income (or $300,000 jointly with a spouse).
The new categories that the SEC are proposing to add to the natural person accredited investor definition are noteworthy because they focus on a person’s knowledge and education rather than only on financial numbers. These new categories would include: (1) those who hold certain professional certifications or designations or other credentials (together “credentials”); and (2) those who are “knowledgeable employees” of a private fund and are investing in the private fund.
Professional certifications, designations or credentials
The proposed amendments would add as a new accredited investor category any natural person holding in good standing one or more professional certifications or designations or credentials from an accredited educational institution that the SEC has designated as qualifying, based on a non-exclusive list of attributes. The proposed attributes focus on exams that would demonstrate comprehension and sophistication in the areas of securities and investing. The proposing release suggests that the SEC accept the passage of the following examinations as qualifying a natural person for accredited investor status:
- Licensed General Securities Representative (Series 7);
- Licensed Investment Adviser Representative (Series 65); or
- Licensed Private Securities Offerings Representative (Series 82).
- As proposed, the individual would be required to maintain an active credential to qualify as an accredited investor, but would not be required to practice in fields related to the credential, except to the extent that continued affiliation with a firm is required to maintain the credential.
Although some commenters suggested that the SEC allow natural persons with college degrees or advanced degrees to qualify as accredited investors, the proposing amendments chose to focus on credentials that directly relate to securities and investing. SEC Chair Jay Clayton has indicated that he is skeptical of any approaches to expanding the natural person accredited investor definition that do not have either demonstrated financial sophistication of the individual investor or clear, ongoing alignment of interest with the sponsor.
Knowledgeable employees of private funds
The SEC is also proposing to add “knowledgeable employees” of a private fund as a new category of natural person accredited investors.
Private funds, such as hedge funds, venture capital funds, and private equity funds, usually rely on Section 3(c)(1) or Section 3(c)(7) of the US Investment Company Act of 1940 (the “Investment Company Act”) to avoid having to register as an investment company. Rule 3c-5 under the Investment Company Act allows a knowledgeable employee of a private fund or of an affiliated person that manages a private fund’s investment activities to invest in the fund without counting toward the 100-person limit under Section 3(c)(1) or needing to be a “qualified purchaser” as required by Section 3(c)(7).
The new category would include, among other persons, trustees and advisory board members, or persons serving in a similar capacity, of a Section 3(c)(1) or 3(c)(7) 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 12 months.
Other expansions of natural person accredited investor definition
The proposed amendments would also make the following changes intended to expand the pool of natural person accredited investors:
- Clarifying that the calculation of “joint net worth” can be the aggregate net worth of an investor and his or her spouse, and that the securities being purchased by an investor relying on the joint net worth test of Rule 501(a)(5) need not be purchased jointly;
- Adding the term “spousal equivalent” (i.e., a cohabitant occupying a relationship generally equivalent to that of a spouse) to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors; and
- Adding “family clients” of “family offices” (as discussed further below).
Expansion of the accredited investor entity categories
The SEC is also proposing to expand the other categories of accredited investors. Under the proposed amendments, the accredited investor definition would also include:
- Limited liability companies, codifying an SEC staff position that limited liability companies that satisfy the other requirements of the definition qualify as accredited investors under Rule 501(a)(3) (i.e., the category that currently includes corporations, tax-exempt charities, Massachusetts or similar business trusts, or partnerships, not formed to acquire the securities offered, with total assets exceeding $5 million);
- “Family offices” with at least $5 million in assets under management and their “family clients” (as each term is defined under the US Investment Advisers Act of 1940) that is not formed for the specific purpose of acquiring the securities offered, and whose prospective investment is directed by a person who has such knowledge and experience in financial and business matters that such family office is capable of evaluating the merits and risks of the prospective investment; and
- A “catch-all” category for any entity (such as Indian tribes, labor unions, governmental bodies and funds, and entities organized under the laws of a foreign country) not formed for the specific purpose of acquiring the securities offered, owning investments exceeding $5 million.
No financial threshold adjustment for inflation
Although the SEC staff’s 2015 report on accredited investors discussed whether the SEC should adjust for inflation the accredited investor financial thresholds applicable to natural persons, the SEC has not proposed any revisions to such financial thresholds, which have not been changed since they were established in 1982.
According to the proposing release, if the $5 million asset test for certain entities were adjusted for inflation, it would result in a $13 million asset test in 2019. Similarly, adjusting the $200,000 income test for natural persons results in a $520,000 threshold in 2019. About 0.53% of the US population met the $200,000 income threshold in 1982, while 8.9% do in 2019. Only 1.4% met the $1 million net worth threshold in 1982, while 9.4% qualify in 2019.
The proposing release observes, however, that the current accredited investor income and net worth levels still significantly exceed the mean and median household income and household net worth in all regions of the United States. Also, in 1982, the calculation of net worth included the value of the primary residence, which the calculation now excludes. Finally, the release notes that there does not appear to be any widespread problems or abuses associated with Regulation D offerings that indicate that an adjustment to the financial thresholds is warranted.
Testing the waters
Assuming the amendments to the accredited investor definition are adopted, the SEC would also revise Rule 163B, a rule under the US Securities Act of 1933 (the “Securities Act”) that permits issuers to engage in “test-the-waters” communications with QIBs or institutions that are accredited investors to gauge their interest in a contemplated offering. The proposed amendment would add proposed Rules 501(a)(9) (i.e., the catch-all category) and 501(a)(12) (i.e., the family offices category) to the list of accredited investors with whom issuers may test the waters.
Qualified institutional buyers
Rule 144A under the Securities Act provides a safe harbor exemption from registration for resales of securities to QIBs. With the exception of registered dealers, a QIB must in the aggregate own and invest on a discretionary basis at least $100 million in securities of unaffiliated issuers, and banks and other specified financial institutions are subject to an additional minimum net worth requirement of $25 million.
In order to avoid inconsistencies between the types of entities that are eligible for accredited investor status and those that are eligible for QIB status, the SEC is proposing to amend the definition of QIBs in Rule 144A(a)(1) to include additional entity types that meet the $100 million threshold.
Specifically, the proposed amendments would add limited liability companies and rural business investment companies to the types of entities that are eligible for QIB status if they meet the $100 million in securities owned and investment threshold in the definition. The proposed amendments would also add a “catch-all” category that would permit institutional accredited investors of an entity type not already included in the QIB definition to qualify as QIBs when they satisfy the $100 million threshold.
The SEC’s proposed expansion of the accredited investor pool is noteworthy in light of Regulation D’s significance to the US capital markets.
As noted in the release, however, it is difficult to determine the precise impact of the proposed changes on the pool of natural person accredited investors, as it is possible that many natural persons who would qualify to be an accredited investor through professional credentials would also meet the current financial threshold tests. Perhaps more important to the size of the natural person accredited investor pool is what the SEC chose not to propose – i.e., indexing the financial thresholds for inflation. For entities, the SEC’s economic analysis anticipates that the effect of the proposed amendments could be more significant than the effect on the natural person accredited investor pool, as the amendments would include a broad range of entities that are not covered under the current definition.
The proposal is subject to a 60-day public comment period.
We will continue to monitor developments in this area and welcome any queries you may have.