On December 18, 2019, the SEC proposed amendments to the definition of “accredited investor” in the SEC’s rules and the definition of “qualified institutional buyer” (QIB) in Rule 144A under the Securities Act of 1933 (Securities Act).1 The amendments to the definition of “accredited investor” would add new categories of individuals and entities and make certain other revisions to the existing definition. The amendments to the QIB definition would add further entities to the existing list of entities that are QIBs. Comments on the proposal must be submitted not later than March 15, 2020.
As we discuss in more detail below, these amendments could, if adopted, have impacts beyond simply expanding the list of eligible accredited investors and QIBs. In particular, we believe that the amendments could encourage more private funds to rely upon Section 3(c)(7) of the Investment Company Act of 1940 (1940 Act) instead of Section 3(c)(1) of the 1940 Act. In addition, we believe that the amendments would facilitate due diligence by investment funds and advisers when they onboard new clients, as more clients should qualify as accredited investors and QIBs.
Proposed Amendments to the Accredited Investor Definition
The SEC would add two additional categories of individuals to the definition of accredited investors. Each category would focus on an individual’s professional knowledge or experience rather than the individual’s net worth or income.
Professional Certifications and Designations and Other Credentials
As proposed, the SEC would recognize individuals holding a Series 7 (licensed general securities representative), Series 65 (licensed investment adviser representative) or Series 82 (licensed private securities offerings representative), as accredited investors. The Proposing Release states that the amendments would enable individuals holding certain identified certifications, designations or credentials to qualify as accredited investors even if their net worth or income fails to meet the standards set forth in the accredited investor definition.2
Knowledgeable Employees of Private Funds
Rule 3c-5 under the 1940 Act defines a knowledgeable employee of a private fund to include an employee of the private fund or an affiliated management person of the private fund who, in connection with his or her regular functions or duties, participates in the investment activities of that private fund or other private funds or investment companies managed by the private fund’s affiliated management person. The SEC proposes to amend the definition of accredited investor so that a knowledgeable employee of a private fund would also be deemed to be an accredited investor.
The following chart summarizes the conditions for relying upon Sections 3(c)(1) or 3(c)(7) of the 1940 Act, as well as the current carve-outs for knowledgeable employees:
|Section 3(c)(1)||Section 3(c)(7)|
|100 person beneficial owner limit.||Beneficial owner must be qualified purchaser |
if not a knowledgeable employee.
|Knowledgeable employees aren’t counted|
toward 100 person limit.
|Knowledgeable employees may be |
beneficial owners even
if they aren’t qualified purchasers.
|No public offering.||No public offering.|
The Proposing Release notes that, while knowledgeable employees do not face restrictions under the 1940 Act from investing in a 3(c)(7) fund, a knowledgeable employee that is not also an accredited investor may be restricted from investing in a 3(c)(7) fund that is limited to accredited investors. The SEC is proposing to amend the definition of accredited investor to encompass knowledgeable employees of a private fund. The definition would match the current Rule 3c-5 definition of “knowledgeable employee”. The SEC states that it believes that knowledgeable employees, through their knowledge and active participation of the investment activities of the private fund, are likely to be financially sophisticated and capable of fending for themselves in evaluating investments in such private funds. The SEC also notes that the inclusion of knowledgeable employees in the definition of “accredited investor” would also allow knowledgeable employees to invest in a private fund without the fund itself losing accredited investor status when the funds have assets of $5 million or less.3
We believe that if this is adopted, funds that may have previously chosen to rely upon Section 3(c)(1) may now choose to rely upon Section 3(c)(7). In particular, a sponsor that currently wishes to include non-accredited investor knowledgeable employees among its fund owners cannot engage in general solicitations or general advertising and sales. Given that restriction, a sponsor may find it necessary to accept subscriptions from accredited investors who are not also qualified purchasers, which would be permissible under Section 3(c)(1). By contrast, if the amendment is adopted, a sponsor’s knowledgeable employees would be accredited investors, which would enable the sponsor to engage in general solicitations or general advertising and sales if it so chose. We believe that this added flexibility, together with the absence of beneficial ownership limitations under Section 3(c)(7), could redirect more funds towards Section 3(c)(7).
Joint Net Worth – New Proposed Note to Rule 501(a)(5); Spousal Equivalents
The SEC proposes to add a note to clarify that when calculating joint net worth for purposes of Rule 501(a)(5), it does not matter whether assets are owned jointly by an individual and his/her spouse (or spousal equivalent (discussed below)) (collectively, SSEs) or separately when calculating the net worth of an individual and his/her SSE, and investor relying upon the joint net worth test need not purchase a security jointly with his/her SSE.
In addition, the SEC is proposing to to allow individuals to include joint income from spousal equivalents when calculating joint income under Rule 501(a)(6), and to include spousal equivalents when determining net worth under Rule 501(a)(5). A “spousal equivalent” would be defined as a cohabitant occupying a relationship generally equivalent to that of a spouse. The SEC notes that this definition is used elsewhere in SEC rules.
Registered Investment Advisers.
The SEC proposes to include SEC- and state-registered investment advisers as accredited investors. The Proposing Release notes that registered investment advisers are generally considered to be institutional investors under state securities laws, and appear to have the requisite financial sophistication needed to conduct meaningful investment analysis. The SEC is specifically soliciting comment on whether exempt reporting advisers4 should also be permitted to qualify as accredited investors, and, if so, under what conditions.
Rural Business Investment Companies.
Rural Business Investment Companies (RBICs) are intended to promote economic development and the creation of wealth and job opportunities in rural areas and among individuals living in rural areas. The SEC states that RBICs’ purpose is similar to the purpose of SBICs, which are intended to increase access to capital for growth stage businesses. The Proposing Release notes that SBICs are already accredited investors under Rule 501(a)(1) and therefore, the SEC proposes to include RBICs as accredited investors.
Limited Liability Companies.
Rule 501(a)(3) currently sets forth a laundry list of entities that qualify for accredited investor status if they have more than $5 million in total assets, including organizations described in Internal Revenue Code section 501(c)(3), corporations, Massachusetts or similar business trusts and partnerships. However, limited liability companies are not included as they were still in their infancy when the laundry list was last revised in 1989. The SEC is proposing to add limited liability companies to the list. The amendment would codify existing SEC staff guidance.
Other Entities Meeting an Investments-Owned Test.
The Proposing Release notes that entities such as Indian tribes, labor unions, governmental bodies and funds and entities organized under the laws of a foreign country are excluded from Rule 501(a)(3)’s laundry list. It also notes that it is possible for a new type of entity to gain acceptance before the SEC revises its accredited investor definition to accommodate the entity. Consequently, the SEC is proposing a new category of accredited investor that would encompass any entity not otherwise identified as an accredited investor (“Other Entity”) that owns more than $5 million in investments that is not formed for the specific purpose of acquiring the securities being offered. The SEC states that investments, which would mirror the definition currently in Rule 2a51-1(b) under the 1940 Act – securities, real estate, commodity interests, physical commodities, non-security financial contracts held for investment purposes; and cash and cash equivalents – is a better proxy for financial sophistication and experience than assets.
Family Offices and Family Clients.
Currently, it is possible for a client of a family office not to meet the definition of accredited investor even though it can meet the definition of “qualified purchaser” under the 1940 Act, notwithstanding the fact that the qualified purchaser definition has a higher financial threshold. For example, a trust with less than $5 million in total assets would not be an accredited investor, but may nevertheless be a qualified purchaser if established and managed by a person who separately meets the definition of qualified purchaser. In response to commenters who addressed this anomaly, the SEC is proposing to amend the accredited investor definition to include family offices and family clients under certain conditions. For a family office to be an accredited investor:
- it must have at least $5 million in assets under management;
- the purchase must be directed by a person who has such knowledge and experience in financial and business matters that the family office is capable of evaluating the merits and risks of the prospective investment; and
- it cannot have been formed for the specific purpose of acquiring the securities offered.
For a family client to be an accredited investor, it must be a family client of a family office that meets all of the above conditions.
Proposed Amendments to the QIB Definition
The SEC is proposing to add RBICs and LLCs to the list of entities that are eligible to become QIBs. The SEC also proposes to add an Other Entity as a QIB if it owns and invests on a discretionary basis at least $100 million in securities of issuers not affiliated with the Other Entity. This new category is intended to mirror the Other Entity proposed amendment to the accredited investor definition.
The SEC has adopted various tests over the years to determine whether an investor is sufficiently financially sophisticated not to need the protection of one or more of the federal securities laws. However, these tests have not always been consistent or intuitive and, consequently, the SEC has been urged to harmonize these definitions to the extent possible.5 The SEC also has recognized the need to update the definition of “accredited investor” to respond to developments in the capital markets. The proposed amendments, if adopted, would facilitate the ability of market participants to determine whether an individual or an entity is an accredited investor and/or a QIB, and will facilitate the ability of private fund sponsors to rely upon Section 3(c)(7). If you would like to submit a comment letter, please contact the author of this Legal Insight or one of the Practus attorneys with whom you work .
1Amending the “Accredited Investor” Definition, Securities Act Rel. No. 10734 (Dec. 18, 2019), 85 FR 2574 (Jan. 15, 2020) (“Proposing Release”).
2 The SEC stated that credentials and designations should directly relate to securities and investing. Id., 85 FR at 2582. Note, of course, that an investor might otherwise be accredited under the net worth or income standards, and simply choose to claim accredited investor status based on one of the enumerated designations or credentials.
3 Under Rule 501(a)(8), private funds with assets of $5 million or less may qualify as accredited investors if all of the fund’s equity owners are accredited investors. Id., 85 FR at 2585 and n.119.
4 An exempt reporting adviser is an investment adviser that qualifies for the exemption from registration under Section 203(l) of the Advisers Act because it is an adviser solely to one or more venture capital funds, or under Rule 203(m)-1 of the Advisers Act because it is an adviser solely to private funds and has assets under management in the United States of less than $150 million. Id., 85 FR at 2586 n. 132.
5 See id., 85 FR at 2597 n. 238.