On August 26, 2020, the SEC announced that it was amending the definition of “accredited investor” to expand its coverage in several ways. The SEC adopted a final rule that will take effect 60 days after it is published in the Federal Register.
Definition of Accredited Investor.
The definition of “accredited investor” is a central part of SEC Rule 506, which governs securities offerings by private companies. Under the Securities Act of 1933, no one may issue securities unless those securities are either registered or exempt from registration. Nearly all start-ups and small and medium-sized businesses rely on exempt offerings to find equity financing. Since its revision after the 2012 JOBS Act, the exemption provided by SEC Rule 506 is the most popular exemption for private companies, raising more than $1.5 trillion in 2019 alone.
Before the change announced on August 26, 2020, an individual could be an accredited investor if they met either the “income test” or the “net worth test.”
Under the income test, an investor is accredited if the investor had “income in excess of $200,000 in each of the two most recent years or joint income with that person's spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.” The SEC has explained in other guidance that the income test will refer to the investor’s income tax filing status, so that an investor who files jointly with a spouse must look to the joint income level of $300,000 and an investor who files alone may look to the solo income level of $200,000.
Under the net worth test, an investor is accredited if the investor has a net worth of more than $1 million, provided that (1) the calculation must exclude the value of the investor’s primary residence, (2) the calculation may exclude indebtedness that is secured by the investor’s primary residence (provided, however, that if the indebtedness secured by the primary residence is greater than the value of the residence, then the amount of indebtedness that exceeds such value must be included).
Certain Financial Professionals Covered
With the change announced on August 26, 2020 becomes effective, the definition will include a third prong for certain accredited professionals. The SEC adopted a rule that would give it the flexibility to designate certain types of professionals as “accredited investors” regardless of their wealth or income. As part of the change, the SEC designated professionals who hold Series 7, Series 65, and Series 82 licenses as qualifying. In its discussion of the rule change, the SEC described how it had also considered attorneys, certified public accountants and other types of professionals, but was not yet ready to admit these groups without further consideration. The SEC suggested that it might designate additional groups of professionals in future rule-making proceedings.
Other Entities Covered
In addition to the change involving natural persons, the SEC also expanded the definition of “accredited investor” with respect to several types of legal entities.
Before the change, the definition included a laundry list of entities that were deemed accredited, including national banks, trusts holding more than $5 million, corporations holding more than $5 million, and partnerships in which each partner was itself an accredited investor. In the rule change, the SEC added the following types of entities to the list of accredited investors:
- Limited liability companies with $5 million in assets;
- SEC- and state-registered investment advisers, exempt reporting advisers, and rural business investment companies (RBICs);
- Other specified entities, 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, in excess of $5 million and that were not formed for the specific purpose of investing in the securities offered; and
- Family offices with at least $5 million in assets under management and their “family clients,” as defined under the Investment Advisers Act.
The SEC further modified the definition of accredited investor by changing the income test and the net worth test to make it possible for investors and their “spousal equivalent” to pool their income and net worth.
Previously, the definition allowed investors and their “spouse” to pool their income and net worth to exceed the minimum income and net worth tests. Under the new rules, investors will be able to pool their income and net worth with a “cohabitant occupying a relationship generally equivalent to that of a spouse.”
Knowledgeable Employees of a Private Fund
With respect to investments in private funds, the SEC also expanded the list of permitted investors to include natural persons who are “knowledgeable employees” of the private fund.
The new rules adopts the definition of “knowledgeable employees” from Rule 3c-5(a)(4) under the Investment Company Act which consists of:
- an executive officer, director, trustee, general partner, advisory board member, or person serving in a similar capacity, of the private fund or an affiliated management person (as defined in Rule 3c-5(a)(1)) of the private fund; and
- an employee of the private fund or an affiliated management person of the private fund (other than an employee performing solely clerical, secretarial or administrative functions with regard to such company or its investments) who, in connection with his or her regular functions or duties, participates in the investment activities of such private fund, other private funds, or investment companies the investment activities of which are managed by such affiliated management person of the private fund, provided that such employee has been performing such functions and duties for or on behalf of the private fund or the affiliated management person of the private fund, or substantially similar functions or duties for or on behalf of another company for at least 12 months.
Importantly, this concept only applies to investments in private funds, defined as pooled investment vehicles that would be subject to regulation under the Investment Company Act if not exempt under either Rule 3(c)(1) or Rule 3(c)(7). The “knowledgeable employee” concept does not apply to other private companies and start-ups looking to raise capital if those private companies are not pooled investment vehicles.