On August 26, 2020, the SEC expanded the definition of “accredited investor,” which is one of the primary tests for determining who is eligible to participate in private capital markets. The SEC’s final rule can be found HERE.
According to Chairman Jay Clayton of the SEC, “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.” The SEC also expanded and updated the list of organizations that may qualify to participate in certain private offerings.
In its press release, the SEC contended that the amendments update and improve the accredited investor definition. The SEC’s position is that the new definition will more effectively identify institutional and individual investors possessing the knowledge and expertise to participate in private capital markets.
Implications of change in accredited investor definition
The definition of an accredited investor is found in Rule 501(a) of the Securities Act. The net worth and income components of the definition define accredited investor as:
- Any natural person whose individual or joint net worth with a spouse, at the time of purchase, exceeds $1 million;
- Any natural person who had an individual income in excess of $200,000 in each of the two most recent years, or had joint income with that person’s spouse that exceeded $300,000 in each of those two most recent years, and has a reasonable expectation of reaching the same income level in the current year.
The individual and joint net worth figures exclude the value of the investor’s primary residence.
Because of the amendments, the definition of accredited investor now includes natural persons with specified professional certifications, designations, and credentials, including Series 7, Series 65, and Securities 82 licenses. The accredited investor definition was also broadened to include knowledgeable employees of a private fund, so they are permitted to invest in it.
In addition, the SEC incorporated the term, “spousal equivalent,” in the definition. Spousal equivalents are now permitted to pool their finances in order to qualify as accredited investors. A spousal equivalent is defined as a cohabitant who has a relationship, which is generally the equivalent to that of a spouse.
Other changes triggered by the amendments to the definition of accredited investor
Along with the above changes, limited liability companies (LLCs) with $5 million in assets may qualify as accredited investors. These LLCs must not have been formed for the specific purpose of investing in the securities offered.
SEC and state-registered investment advisers, exempt reporting advisers, and rural business investment companies (RBICs), are now included in the list of entities that may qualify to be accredited investors. There is no requirement that these entities have a minimum level of assets.
The amendments make a number of other changes, including the creation of a new category for entities such as Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries. Family offices with at least $5 million in assets under management and their family clients are now accredited investors.
On top of all those changes, the amendments expand the Rule 144A definition of “qualified institutional buyer” to include LLCs and RIBC programs, as long as they satisfy the $100 million in securities owned and invested threshold.
The SEC has the flexibility to reevaluate or add certifications, designations, or credentials in the future. The public can request that the SEC consider additional certifications, designations, or credentials that will qualify natural persons to be treated as accredited investors.
The SEC observed that the amendments are part of its “ongoing effort to simplify, harmonize, and improve the exempt offering framework.” The SEC asserted that the amendments will expand investment opportunities while maintaining appropriate investor protections and promoting capital formation. Not all consumer advocates agree that the investor protections are adequate. The amendments will become effective sixty days after they are published in the Federal Register.
Important Note: The term “accredited investor” should not be confused with “qualified client.” The definition of qualified client is much different. An investment adviser may not enter into, renew, or extend an advisory contract providing for performance-based compensation unless the agreement is with a qualified client. Currently, a qualified client is defined as:
- A natural person who, or a company that, immediately after entering into the contract has at least $1,000,000 under the management of the investment adviser;
- A natural person who, or a company that, the investment adviser entering into the contract (and any person acting on his behalf) reasonably believes, immediately prior to entering into the contract, either:
- Has a net worth (together, in the case of a natural person, with assets held jointly with a spouse) of more than $2,100,000. For purposes of calculating a natural person’s net worth:(1) The person’s primary residence must not be included as an asset; (2) Indebtedness secured by the person’s primary residence, up to the estimated fair market value of the primary residence at the time the investment advisory contract is entered into may not be included as a liability (except that if the amount of such indebtedness outstanding at the time of calculation exceeds the amount outstanding 60 days before such time, other than as a result of the acquisition of the primary residence, the amount of such excess must be included as a liability); and (3) Indebtedness that is secured by the person’s primary residence in excess of the estimated fair market value of the residence must be included as a liability; or
- Is a qualified purchaser as defined in Section 2(a)(51)(A) of the Investment Company Act of 1940 at the time the contract is entered into; or
- A natural person who immediately prior to entering into the contract is:
- An executive officer, director, trustee, general partner, or person serving in a similar capacity, of the investment adviser; or
- An employee of the investment adviser (other than an employee performing solely clerical, secretarial or administrative functions with regard to the investment adviser) who, in connection with his or her regular functions or duties, participates in the investment activities of such investment adviser, provided that such employee has been performing such functions and duties for or on behalf of the investment adviser, or substantially similar functions or duties for or on behalf of another company for at least 12 months.
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