Since its inception in 1982, Regulation D under the Securities Act of 1933 has used only gross income, net worth, and (in some cases) gross assets as criteria for determining who can and cannot invest in the securities offerings of nonpublic companies and private investment pools such as hedge, venture capital and buyout funds – in other words, investments in most clients of most law firms. Heightened investor eligibility criteria based on financial sophistication and experience are a key element of nonpublic offerings, because they are exempt from registration under the Securities Act and therefore do not have the rigorous disclosure and procedural requirements – or the related investor protections – which such registration affords.
Regulation D’s income, net-worth and asset-based tests, embedded in its definition of the term “accredited investor,” have afforded two generations of investors, issuers and their attorneys with advantages of simplicity, objectivity, and a somewhat reliable way to distinguish persons who probably can afford the risk of losing their invested capital from those who probably cannot. For decades, they have helped keep transaction costs lower than they would have been in the absence of clear investment eligibility criteria. But as measurements of investor sophistication in exempt offerings, they have always been acknowledged to be, at best, a blunt instrument. Their application has resulted in the exclusion from many private investment opportunities of some genuinely financially sophisticated
That changed yesterday, when the U.S. Securities and Exchange Commission voted to adopt Release no. 33‑10824, amending Regulation D’s definition of “accredited investor” in ways that will enable several categories of individuals and entities to participate in most securities offerings that are made in reliance on Regulation D’s exemption from registration, even if such persons cannot satisfy any of the rule’s existing income, net-worth or asset tests. The amendments are the culmination of a process of policy analysis, public comment and formal rulemaking that began in earnest in late 2015.
The SEC has amended Regulation D several times over the years in more or less major ways, sometimes in response to statutory mandates from Congress and sometimes to keep pace with the evolution of capital markets or to maintain or enhance their
efficiency. The Commission stated in its adopting release that it does not expect this expansion of the accredited investor definition to increase significantly either the number of eligible investors or the amount of capital that will be raised in exempt offerings. Nevertheless, yesterday’s changes are probably the most significant in the rule’s 38-year history because they establish for the first time the principle that investor sophistication for exempt offerings can and should be measured in a qualitative way, as an optional alternative to measuring it in the traditional quantitative way.
Among other things, yesterday’s SEC’s action amended Rule 501(a) under Regulation D in the following ways:
- By adding a new category of accredited investor that includes individuals holding certain professional certifications, designations or credentials, or other credentials issued by an accredited educational institution, which the Commission may designate by order from time to time. At the same time that it adopted the amendments, the SEC also issued the first such order yesterday, designating any holder in good standing of a FINRA Series 7 (general securities representative), Series 65 (investment adviser representative), or Series 82 (private securities offering representative) license to be an accredited investor. The SEC may issue orders designating additional qualitatively based categories of accredited investors in the future.
- By including, as accredited investors with respect to a private investment fund such as a
hedge, venture capital or buyout fund, individuals who are knowledgeable employees of that fund or of its general partner or affiliated management company. For these purposes, “knowledgeable employee” has the same meaning as defined for purposes of the Investment Company Act of 1940.
- By including as an accredited investor any family office, and any family clients of a family office, as long as the family office has at least $5 million in assets under management, is not formed for the specific purpose of acquiring the securities offered, and is directed with respect to a prospective investment 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. For these purposes, “family office” and “family client” have the
same meanings as defined for purposes of the Investment Advisers Act of 1940.
- By including as accredited investors SEC-registered investment advisers, state-registered investment advisers, exempt reporting advisers (generally, investment advisers to smaller private funds), and rural business investment companies.
- By adding a new category of accredited investor which includes any entity (including Indian tribes, governmental bodies, funds and entities organized under the laws of foreign countries) that owns investments in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered. For these purposes, “investments” has the same meaning as defined for purposes of the Investment Company Act of 1940.
The amendments to the accredited investor definition will become effective during the fourth quarter of 2020, 60 days after Release no. 33‑10824 has been published in the Federal Register.
In addition to amending the accredited investor definition in Rule 501(a), Release no. 33-10824 also made certain amendments to the definition “qualified institutional buyer” under Securities Act Rule 144A and certain conforming amendments to Rule 215 and 163B under the Securities Act and to Rule 15g‑1 under the Securities Exchange Act of 1934.
As a result of the amendments to the accredited investor
definition, issuers in private placements relying on Regulation D and their investment bankers will need to update their capital-raising analyses, projections and communication strategies to account for this enlargement of the pool of potentially eligible purchasers in such offerings. All issuers in private placements will need to update the subscription agreements and associated investor questionnaires, which they use for fundraisings going forward in order to adequately capture the information necessary to establish the credentials of the newly eligible accredited investors created by Release no. 33‑10824.
The lawyers in Calfee’s Corporate and Capital Markets Group are available to assist issuers and investors alike in navigating the new “accredited investor” definition and taking
advantage of the business opportunities it presents.
SEC Release no. 33-10824, “Amending the ‘Accredited Investor’ Definition,” August 26, 2020.