The definition of “accredited investor” is at the heart of Rule 506 exemption, one of the most utilized exemptions in the Securities Act of 1933.[1] The rationale for Rule 506 exemption, explained in SEC v. Ralston Purina, is that financially sophisticated investors do not need the protections of disclosure under the Securities Act of 1933.[2] To provide bright-line standards, the U.S. Securities and Exchange Commission (“SEC”) relied exclusively on income and net worth to identify natural persons as accredited investors.[3] This rigid test inevitably excludes investors who are financially sophisticated but failed to meet the income and assets requirements set forth in Regulation D.[4]
In December 2015, an SEC staff report examined the development of the accredited investor definition and considered suggestions from the public on potential amendments of the definition.[5] In June 2019, a concept release was issued by the SEC requesting public comments on ways to refine the current framework of exemptions under the Securities Act of 1933.[6] In March 2020, the SEC proposed rules to amend the definition of accredited investor. [7] On August 26, 2020, the SEC adopted amendments to expand the scope of persons who may qualify as an “accredited investor.”[8] The amendments largely track the proposed rules[9] and are set to become effective on December 8, 2020.[10]
Under the amendment, two new categories of natural persons are added to the accredited investor definition: (1) those who are in possession of certain professional certifications, designations, or other credentials that demonstrate a background and understanding in the specific areas of securities; and (2) those who are “knowledgeable employees” of a private fund may qualify as accredited investors for investments in the fund.[11]
For the first category, the SEC has the flexibility to evaluate and adjust the category of professional certifications, designations, and credentials that may confer the accredited investor status under the amendment as well as reevaluate existing listing and make adjustments accordingly.[12] For example, those who believe certain programs or certificates may qualify an investor to be an accredited investor can request the SEC to consider including such programs or certificates as a qualifying credential. The SEC adopted a good standing requirement and did not require an individual practice in a field or that such individual practice for a minimum number of years.[13] The SEC acknowledges that the validity of a license or a certificate as a measurement for financial sophistication will be less credible if the license or certificate has been inactive for a prolonged period of time.[14] However, the SEC refused to add the requirement that the individual must practice in the relevant field, let alone the requirement of minimum practice years[15] because such requirements are counterintuitive with the goal of the expansion of the definition.[16]
Under the amendments, a “knowledgeable employee” shares the same definition as in Rule 3c-5(a)(4) of the Investment Company Act.[17] A fact-specific assessment is required to determine whether a particular employee falls within the knowledgeable employee definition for a private fund.[18] The SEC believes that knowledgeable employees are likely to be financially sophisticated, thus do not need the protection of disclosure requirements under the Securities Act of 1933.[19] Furthermore, this aligns the employee’s interest with the interest of the private fund because fund employees often want to invest in the funds that they assisted to select, likely, after extensive research, also, it shows clients that the employees are aligned with them financially which helps to increase clients’ confidence in the fund.[20]
The amendments also expand accredited investors to include: (1) limited liability companies that meet conditions currently applicable to corporations; (2) all SEC- and state-registered investment advisers; and (3) rural business investment companies (“RBICs”).[21] A catch-all provision has also been added to provide the SEC with flexibility in dealing with “new entities that may be created in the future.”[22]
Concerns have been raised by the public that such expansion may lead to more private financings, allowing issuers to circumvent the disclosure requirement which is the key device to address the information asymmetry.[23] On the other side, as part of the SEC’s effort to promote capital formation and expand investment opportunities, the expansion in the definition will give more individual investors opportunities to invest and take a share of the economic growth.[24] Time will tell how the expansion will impact a newly qualified accredited investor.
[1] See 17 C.F.R. § 230.506.
[2] See SEC v. Ralston Purina Co., 346 U.S. 119, 125 (1953).
[3] See 17 C.F.R. § 230.501.
[4] Jay Clayton, Statement by Chairman Clayton on Modernization of the Accredited Investor Definition, Harv. L. Sch. F. on Corp. Governance (Oct. 25, 2020), https://corpgov.law.harvard.edu/2020/08/27/statement-by-chairman-clayton-on-modernization-of-the-accredited-investor-definition/; Regulation D is a regulation issued by the SEC to provide safe harbors for private placement and small offerings
[5] Press Release, SEC, SEC Modernizes the Accredited Investor Definition (Aug. 26, 2020), https://www.sec.gov/news/press-release/2020-191 (A commission staff report issued in December 2015 “examined the background and history of the definition [of accredited investor]and considered comments and recommendations on amending the definition.”)
[6] Id. (“In the Concept Release, the Commission requested comments on possible approaches to amending the accredited investor definition, which is a central component of several exemptions from registration, including Rules 506(b) and 506(c) of Regulation D, and plays an important role in other federal and state securities law contexts.”)
[7] Id. (“the Commission proposed in December 2019 to amend the accredited investor definition”).
[8] See Press Release, SEC, Accredited Investor Definition, Exchange Act Release Nos. 33-10824; 34-89669 (Aug. 26, 2020), https://www.sec.gov/rules/final/2020/33-10824.pdf [hereinafter SEC Aug. 26, 2020 Press Release].
[9] See id.; see also Facilitating Capital Formation and Expanding Investment Opportunities by Improving. Access to Capital in Private Markets, Exchange Act Release Nos. 33-10763; 34-88321 (Mar. 4, 2020), https://www.sec.gov/rules/proposed/2020/33-10763.pdf.
[10] SEC Aug. 26, 2020 Press Release, supra note 8.
[11] See id. at 10.
[12] See id. at 24-27 (noting that “the proposed amendments included a mechanism by which the Commission would designate qualifying professional credentials by order and noted that the Commission “anticipate[d]that the Commission generally would provide public notice and an opportunity for public comment before issuance of such order” and this mechanism can “provide the Commission with flexibility to reevaluate previously designated certifications, designations, or credentials if they change over time, and also to designate other certifications, designations, or credentials if new certifications, designations, or credentials develop or are identified that are consistent with the specified criteria and that the Commission determines are appropriate.”).
[13] See id. at 28.
[14] See id.
[15] See id.
[16] See id.; see also Jay Clayton, supra note 4.
[17] SEC Aug. 26, 2020 Press Release, supra note 8, at 34.
[18] See id. at 38 (“whether any particular employee is one who participates in the investment activities of a fund is a determination that must be made on a case-by-case basis.”).
[19] See id. at 37-38.
[20] See id.
[21] See id. at 10-11.
[22] See id. at 49.
[23] See id. at 132.
[24] See id.; see also Jay Clayton, supra note 4.
