SEC Expands Accredited Investor Definition
Many parents start exposing their children to music during their first year of life by enrolling in parent/child music classes. These classes provide a time for parents to engage with their children in a semi-social environment while clapping rhythms and singing songs with a teacher. My son started his first such class at the age of eight months.
One might think that anyone who can hold a tune and loved children could teach one of the early childhood music classes–not so! The first teacher we encountered in one of those classes had bachelor’s and master’s degrees in music education. The head of the early childhood music program arguably had even better credentials since she had bachelor’s, master’s, and doctorate degrees from three of the nation’s top music conservatories.
After two years of music “experience,” my son graduated to Suzuki violin lessons. His Suzuki teacher also was well-credentialed with she had a bachelor’s, master’s, and doctorate degrees from a well-known conservatory. She also was certified by the Suzuki Association of America to teach the entire ten-volume Suzuki violin curriculum–all to teach my three-year-old how to play “Twinkle, Twinkle, Little Star.”
If violin teachers must be so highly credentialed, maybe one would think individuals must be credentialed before they are allowed to invest in certain private placement securities. Until now, however, the opposite was true. Accredited status was largely linked to financial wherewithal—roughly the equivalent to credentialing violin teachers based upon the cost of their violins. Now, however, the SEC has adopted changes that expanded the definition of accredited investor to allow some individuals to invest based upon their personal credentials.
History of the Accredited Investor Definition
In 1982, the SEC adopted Regulation D (Reg D) under Section 4(2). Rule 506(b) of Reg D establishes a safe harbor for issuers wishing to rely upon the private placement exemption in Rule 506(b). That rule limits sales of securities to an unlimited number of accredited investors but no more than 35 non-accredited investors. Plus, non-accredited investors must receive enhanced disclosure and financial statements (usually audited) similar to those required of registered securities offerings.
Although all investors must receive accurate disclosure of material information, the requirements are relaxed if an offering is sold only to accredited investors. It can be costly and, sometimes, impossible to provide the disclosure required for non-accredited investors. Therefore, smaller Rule 506(b) offerings frequently are limited to accredited investors.
Rule 506(b) isn’t the only type of offering. In 2012, Congress adopted the Jumpstart our Business Startups Act, which made it easier for startups and small businesses to raise capital. Rule 506(c), which allows “private placement” sales to be advertised if sold only to accredited investors, followed, as did equity crowdfunding.
Current Accredited Investor Definition
Rule 501 of Reg D created several categories of investors who qualified as accredited investors. These categories included investors deemed able to look out for themselves and able to afford the loss of their investment.
It should be no surprise that banks, investment companies, employee benefit plans, business development companies, and small business investment companies are accredited investors. Corporations, partnerships, charities, and trusts with more than $5 million in assets also are accredited investors.
Individuals are accredited investors if they are a director, executive officer, or general partner of the securities issuer. Individuals also are accredited if they meet income or net worth requirements:
Have a net worth with a spouse of more than $1 million, not counting net equity in their primary residence
Have an income of at least $200,000 (or joint income with a spouse of at least $300,000) in each of the two most recent calendar years and reasonably expect the same level of income in the current year
Business enterprises in which all equity owners are accredited investors also may be accredited investors, as are grantor trusts (usually trusts where the grantor is both the trustee and beneficiary) controlled by accredited investors.
What’s New in the Accredited Investor Exemption?
The categories of accredited investors haven’t changed much since 1982 when Regulation D was adopted. However, now the SEC has adopted a rule that significantly expands the definition of accredited investor.
New categories of accredited investors include.
Individuals with Series 7, 65, and 82 securities licenses;
For private funds, natural persons who are “knowledgeable employees” of the fund sponsor (these individuals are accredited only for purposes of investing in that specific fund);
Any entity, including Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries not formed for the specific purpose of investing in the specific securities offered, that own $5 million or more in “investments”(as defined in the Investment Company Act of 1940 (ICA)); and
Family offices with at least $5 million in assets under management and family clients of those offices.
The new rule also clarifies some items:
Allows an individual to pool finances with a “spousal equivalent” as well as a spouse to determine whether they are an accredited investor;
Limited liability companies with $5 million in assets may be accredited investors; and
Registered investment advisers, exempt reporting advisers, and rural business investment companies also may qualify as accredited investors.
Foreshadowing Additional Categories of Accredited Investor
The new rule also hints at future additional accredited investor categories. Rule 501(a)(10) includes as an accredited investor “Any natural person holding in good standing one or more professional certifications or designations or credentials from an accredited educational institution that the Commission has designated as qualifying an individual for accredited investor status.”
The SEC also pulls back the curtain to show the categories of individuals the SEC is considering adding as accredited investors. Paragraph (a)(1) gives some of the factors the SEC will consider:
“The certification, designation, or credential arises out of an examination or series of examinations administered by a self-regulatory organization or other industry body or is issued by an accredited educational institution.”
“The examination or series of examinations is designed to reliably and validly demonstrate an individual’s comprehension and sophistication in the areas of securities and investing.”
“Persons obtaining such certification, designation, or credential can reasonably be expected to have sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of a prospective investment.”
“An indication that an individual holds the certification or designation is either made publicly available by the relevant self-regulatory organization or other industry body or is otherwise independently verifiable.”
From this, it appears the SEC may add additional licensed securities professionals and possibly certified public accounts, certified financial advisors, and individuals with similar certifications to the list. But for now, we can only guess.
When Will the Change Happen?
The new rule will be effective sixty days after publication in the Federal Register. That publication likely will occur in late September or early October. If so, the rule will be effective before the end of 2020. It’s unclear when the SEC might add additional professional certifications, designations, or credentials under Paragraph (a)(10).
© 2020 by Elizabeth A. Whitman
Any references clients and their legal situations have been modified to protect client confidentiality
DISCLAIMER: The content of this blog is for informational purposes only and does not provide legal advice to any person. No one should take any action regarding the information contained in this blog without first seeking the advice of an attorney. Neither reading this blog nor communication with Whitman Legal Solutions, LLC or Elizabeth A. Whitman creates an attorney-client relationship. No attorney-client relationship will exist with Whitman Legal Solutions, LLC or any attorney affiliated with it until a written contract is signed by all parties and any conditions in such contract are satisfied.