In its Final Rule1 issued on August 26, 2020, a divided Securities and Exchange Commission (SEC) expanded the group of individuals and entities permitted to invest in private securities by amending the definitions of “accredited investor” and “qualified institutional buyer.”
Current Definitions
Accredited Investor
With limited exceptions, federal securities laws and regulations restrict investments in privately placed securities (i.e., not publicly registered or traded) for investors who do not qualify as “Accredited Investors.” Currently, stated simply, an individual who has a minimum annual income of $200,000 (or $300,000 for joint income) for the past two years or has a net worth of at least $1 million (excluding the value of the investor’s primary residence) is an accredited investor. Trusts having assets over $5 million and entities in which all the equity owners are accredited investors are also categories of accredited investors.
Qualified Institutional Buyer
A “qualified institutional buyer” (QIB) is an entity viewed as financially sophisticated enough to engage in certain private placements of securities. Securities Act Rule 144A specifies the types of institutions currently eligible for qualified institutional buyer status if they meet the $100 million in securities owned and invested criterion. Other criteria apply to banks and registered dealers.
New Definitions
The SEC’s amendments revise Rule 501(a), Rule 215 and Rule 144A of the Securities Act of 1933. They will be effective 60 days after their publication in the Federal Register.
Accredited Investor
In its amendments to the accredited investor definition, the SEC leaves in place the income and net worth requirements and adds separate qualifying criteria. As a result, investors will additionally qualify as accredited investors based on certain professional knowledge, experience and certifications. The new amendments also allow for more entities that could qualify as accredited investors, including by permitting any entity that meets an investments test to qualify.
Specifically, the amendments to the accredited investor definition in Rule 501(a) provide:
- A new category allowing natural persons to qualify as accredited investors based on specific professional certifications, designations or credentials, or other credentials issued by accredited educational institutions. The SEC will designate such institutions in the future. Holders of the Series 7, Series 65 and Series 82 licenses are designated as qualifying natural persons.
- With regard to investments in a private fund, individuals who are “knowledgeable employees” of the fund and have been for 12 months will be accredited investors.
- Limited liability companies (LLCs) with at least $5 million in assets will be accredited investors. Additionally, SEC- and state-registered investment advisers, exempt reporting advisers, and rural business investment companies will be added to the list of entities that qualify as accredited investors.
- A new category for any entity—including Indian tribes, governmental bodies, funds and entities organized under the laws of foreign countries—that owns “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.
- The addition of “family offices” having at least $5 million in assets under management and their “family clients,” as these terms are defined in the Investment Advisers Act.
- The addition of the term “spousal equivalent” to the accredited investor definition.2
Qualified Institutional Buyer
The SEC’s amendments modify the definition of QIB in Rule 144A by adding limited liability companies and rural business investment companies so long as they meet the $100 million in securities owned and invested threshold in the existing definition. Further, any institutional investors included in the accredited investor definition that are not otherwise listed in the definition of QIB are also added to the QIB list if they satisfy the $100 million threshold. We believe this was done largely to fix a glitch that LLCs, an increasingly popular fund vehicle, did not technically fall within the QIB definition.
Rationale
As with other SEC rulemakings and amendments, the SEC explains that the amendments are part of its “ongoing effort to simplify, harmonize, and improve the exempt offering framework, thereby expanding investment opportunities while maintaining appropriate investor protections and promoting capital formation.”3 In announcing the amendments, SEC Chairman Jay Clayton noted, “For the first time, individuals will be permitted to participate in our private capital markets not only based on their income or net worth, but also based on established, clear measures of financial sophistication.”4
The move comes as part of an uproar from investors following the liberalizing of offering rules related to private securities following the Jumpstart Our Business Startups Act of 2012, which, among other things, allowed for advertised private placements under Rule 506 of Regulation D. There has long been a cry for qualitative criteria to be considered in qualifying for accredited investor status, although the issuer’s executive officers and directors have been accredited for many years. Some commentators do not believe the new rules go far enough. Some wanted a qualification based on college or advanced degree, some wanted accredited status achieved by taking a written exam. Still, the move does signal some liberalizing of a definition that has changed little in the past few decades.
Why It Matters
While Chairman Clayton did not mention that the amendments were related to the COVID-19 pandemic and ensuing economic fallout, the amendments could lead to increased investing activity and fundraising for private companies in a time when liquidity is needed most. Indeed, as the SEC notes, “[T]he significance of the exempt securities markets has increased both in terms of the absolute amount raised and relative to the public registered markets.”5
Despite new efforts to allow for alternative investments by non-accredited investors through, for example, Regulation A+ and Regulation CF (public crowdfunding), private placements still dominate the nonpublic investment landscape. In 2019, Regulation D offerings raised an estimated $1.5 trillion in capital, which is greater than the $1.2 trillion raised in registered offerings.6 Accredited investors are key players in the large field of private capital markets. Broadening the definition of who qualifies as an accredited investor could thus lead to an increase in investments in private capital markets. In recent years, the SEC estimates that approximately 92% of U.S. persons live in non-accredited households. Broadening the definition increases the number of investors who are eligible to invest in private placements.
Further, the SEC reasons that the amendments could reduce private issuer costs for finding investors, transaction costs, and cost of capital.7 Such effects would most likely be more significant for smaller private offerings.8 The SEC also notes that investors will have broader investment opportunities, but acknowledges that investors could assume more risk when engaging in private capital markets.9
This Client Alert is meant as a news notification and brief summary of a complex area of securities law. It does not constitute legal advice. Please read the full text of the amendments.
1 https://www.sec.gov/rules/final/2020/33-10824.pdf
2 https://www.sec.gov/news/press-release/2020-191
3 Id.
4 Id.
5 https://www.sec.gov/rules/final/2020/33-10824.pdf
6 Id.
7 Id.
8 Id.
9 Id.