SEC Opens Window of Opportunity for Sophisticated Investors Who Aren’t Quite “Rich Enough”
By Scott M. Lewis, Partner, Business Practice Group
The “safe harbor” federal exemption from securities registration, which is available to companies raising capital under the Securities Act of 1933 – and Rule 501 of Regulation D in particular – has elevated the status in the financial markets of “accredited investors.” For individual investors, the Securities and Exchange Commission has used essentially the same stale net worth and net income thresholds for the past 35 years, with no adjustment for inflation. For companies seeking access to the capital markets, an “all-accredited investor” offering reduces, and in some cases even can eliminate, the amount of financial data and other information that needs to be disclosed to prospective investors provided that certain other conditions to the exemption are met. Consequently, shrewd investors who are eminently capable of making an informed investment decision are deprived of an investment opportunity because the companies seeking capital don’t want the burdens and costs of complying with the extensive safe harbor disclosure requirements that apply to a “non-accredited offering.”
In considering changes to Rule 501, the SEC recently reiterated its philosophical basis for the exemption: “to ensure that all participating investors are financially sophisticated and able to fend for themselves or sustain the risk of loss, thus rendering unnecessary the protections that come from a registered offering.” Yet for individuals who may be sophisticated and discerning investors but who may not have been wealthy enough to qualify as “accredited investors” under the existing definition, the failure to so qualify may leave them peering through the window of opportunity and being greeted with a sign stating: “IF you were rich enough, we’d let you in.”
On August 26, 2020 the Securities and Exchange Commission amended its “accredited investor” definition to allow investors to qualify based on defined measures of professional knowledge, experience or certifications — including holding certain Financial Industry Regulatory Authority (FINRA) licenses — in addition to the existing tests for earned income (at least $200,000 each year for the last two years or $300,000 combined income if married) or net worth ($1 million excluding the value of primary residence). The new rules go into effect on October 25, 2020. By adopting a multi-faceted approach rooted in financial sophistication and education rather than a binary approach that equated wealth with sophistication, the SEC has elected to modernize the “accredited investor” test rather than simply raising the net worth and earned income thresholds. Raising the wealth and income thresholds might have disqualified currently active accredited investors, leading to too large a disruption. The expanded definition of accredited investor should lead to an expansion of investment opportunities and promote capital formation. In addition to redefining which individual investors will be deemed accredited, the amendments also expand the list of entities that may qualify, including by allowing any entity that meets an “investments test.”
The amendments to the accredited investor definition in Rule 501(a):
1. add a new category to the definition that permits natural persons to qualify as accredited investors based on certain professional certifications, designations or credentials, including the Series 7, Series 65, and Series 82 licenses as qualifying natural persons. (The Commission will reevaluate or add certifications, designations or credentials in the future);
2. include as accredited investors, with respect to investments in a private fund, natural persons who are “knowledgeable employees” of the fund but who otherwise would not qualify because they do not satisfy the financial threshold (net worth or earned income test);
3. clarify that limited liability companies with $5 million in assets may be accredited investors and add SEC- and state-registered investment advisers, exempt reporting advisers and rural business investment companies (RBICs);
4. add a new category for any entity, including governmental bodies, funds, and entities organized under the laws of foreign countries;
5. add “family offices” with at least $5 million in assets under management and their “family clients,” as each term is defined under the Investment Advisers Act; and
6. add the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors.
If you have any questions or would like to discuss how these amendments to the accredited investor definition might affect you or your business, please contact your Meyers Roman attorney.
This Legal Update is a summary only, prepared for general informational purposes, and is not an exhaustive description of the aforementioned matters or issues. Nothing in this Update is intended or is to constitute a legal opinion or legal advice by the authors or Meyers, Roman, Friedberg & Lewis.