SEC expands scope of “accredited investors” and “qualified institutional buyers”

Introduction

On 26 August 2020, the U.S. Securities and Exchange Commission (the “SEC”) loosened the definitions of “accredited investor” and “qualified institutional buyer” in the SEC’s rules. The changes were motivated by the need to more effectively identify institutional and individual investors that have the knowledge and expertise to participate in private markets. Knowledge and expertise of an investor were never considered before by the SEC in determining whether an investor is an “accredited investor”.

The amendments dovetail with the Department of Labor’s recent announcement in June to allow ordinary investors access to investments beyond the ordinary stocks and bonds.

The amendments will become effective 60 days after the publication in the Federal Register.

Amendments to the “accredited investor” definition

“Accredited investors” are an exclusive group of investors that can invest in specific opportunities, such as investments in private companies and offerings by certain hedge funds, private equity funds and venture capital funds. The definition also plays an important role in exemptions from registration requirements for private placements and other federal and state securities law exemptions.

The following is a summary of the key changes to the definition of “accredited investors”:

• Natural persons holding professional certifications and designations or other credentials: Previously, in determining whether an individual investor is an “accredited investor”, the SEC will only consider whether the investor satisfies the income or net worth tests set out in the definition; financial sophistication of the investor would not be a relevant consideration.

The current amendment provides that natural persons holding professional certifications, designations or credentials or other credentials issued by an accredited educational institution, which the SEC may designate from time to time by order, can be qualified as accredited investors. For example, as of 26 August 2020, the SEC designated holders in good standing of the Series 7 (General Securities Representative), Series 65 (Licenced Investment Adviser Representative) and Series 82 (Private Securities Offerings Representative) licences as natural persons that qualify as accredited investors.

• Natural persons as knowledgeable employees of private funds: In line with the above requirements in relation to knowledge and expertise of the investor, the SEC included natural persons who are “knowledgeable employees” of the private-fund issuer, such as trustees, board members, or persons serving in a similar capacity, as a new category of accredited investors.

Note that the directors, executive officers, or general partners of the issuer (or directors, executive officers, or general partners of a general partner of the issuer) are already “accredited investors” before these amendments were adopted.

• Natural persons to pool finances from spousal equivalents to qualify as accredited investors: Consistent with the approach taken in other SEC rules, the SEC allows the spousal equivalent of a person (i.e. a cohabitant occupying a relationship generally equivalent to that of a spouse) and that person to pool their finances when calculating the joint income and joint net worth of that person. The SEC also noted that the securities being purchased by a person relying on the joint net worth test need not be purchased jointly.
• Entities as SEC- and state-registered investment advisers and exempt reporting advisers: The SEC added (1) investment advisers registered under the Investment Advisers Act of 1940 (the “Investment Advisers Act”), (2) investment advisers registered under the laws of the various states and (3) exempt reporting advisers to the list of entities that may qualify as accredited investors. This addition is sensible, as registered investment advisers would likely have the investment acumen to make investments in the private placement market.
• Entities as rural business investment companies (RBICs): The SEC added RBICs, i.e. a company that is approved by the U.S. Secretary of Agriculture (the “Secretary”) and has entered into a participation agreement with the Secretary, to the list of entities that may qualify as accredited investors.

By doing so, the SEC levels the playing field for RBICs, as small business investment companies, which serve a purpose similar to RBICs’ (i.e. to promote economic development in certain areas or businesses), have been included in the “accredited investor” definition.

• Limited liability companies (LLCs): The SEC clarified that LLCs satisfying the requirements under Rule 501(a)(3) (i.e. having total assets in excess of USD5 million and were not formed for the specific purpose of acquiring the securities being offered) are eligible to be accredited investors.

The SEC also clarified that managers (whether as member managers or third-party managers) of LLCs do fall within the scope of “executive officers” under Rule 501(f) under the Securities Act and may therefore qualify as accredited investors.

Before the current amendment, the longstanding staff position of the SEC has been that LLCs may qualify as accredited investors provided that they satisfy the other requirements of the definition. The SEC’s codification of such position helps to bring the SEC’s rules up-to-date and avoids any confusion as to the status of LLCs.

• Other entities meeting an investments-owned test: The SEC added that any type of entity (1) that owns “investments” in excess of USD5 million and (2) that is not formed for the specific purpose of acquiring the securities being offered can be an accredited investor (the “Investments-owned Test”).

As noted by the SEC, this category is intended to capture all entity types not already included in the definition as well as those entity types that may be created in the future. As such, entities such as Indian tribes, labour unions, governmental bodies and funds and entities organised under the laws of a foreign country can qualify as accredited investors, provided that the Investments-owned Test is passed.

Additionally, the SEC included this category of newly added accredited investors to the list of entities that would receive test-the-waters communications from issuers to gauge their interest in a contemplated offering with the hope of increasing the use of such mechanism.

To ensure consistency, the SEC also added these entities as a category of institutional accredited investors that can be exempted from broker-dealers’ disclosure requirements prior to effecting a transaction in a “penny stock”.

• Certain family offices and family clients: Family offices that (1) have at least USD5 million in assets under management, (2) are not formed for the specific purpose of acquiring the securities offered and (3) which prospective investment is directed by a person who has such knowledge and experience in financial and business matters that such family office is capable of evaluating the merits and risks of the prospective investment, are now included as a new category of “accredited investors”. This amendment does not apply to multi-family offices.

Family clients of a family office that (1) meet the three requirements above and (2) whose prospective investment in the issuer is directed by such family office, are also included in the new category.

Similar to the entities that meet the Investments-owned Test, the SEC included these newly added accredited investors to (1) the list of entities that would receive test-the-waters communications from issuers and (2) if such investors are institutional, the list of exempted investors from broker-dealers’ disclosure requirements prior to effecting a transaction in a “penny stock”.

• Entity which owners are all accredited investors: The SEC clarified that in determining the “accredited investor” status under Rule 501(a)(8) (i.e. an entity qualifies as an accredited investor if all of the equity owners of that entity are accredited investors), one may look through various forms of equity ownership to natural persons. If those natural persons are themselves accredited investors, and if all other equity owners of the entity are accredited investors, the entity would be an accredited investor.

Amendments to the “qualified institutional buyer” definition

Consistent with the above amendments to the definition of “accredited investor”, the SEC expanded the “qualified institutional buyer” definition in Rule 144A (which generally refers to a list of entities that each owns and invests a minimum of USD100 million in securities) to add three new categories:

• RBICs that satisfy the USD100 million threshold above;
• LLCs that satisfy the USD100 million threshold above; and
• entities that qualify for accredited investor status that (1) are not already included in Rule 144A, (2) are not RBICs or LLCs and (3) satisfy the USD100 million threshold above.

Conclusion

Through the above amendments, the SEC places a new emphasis on financial sophistication as a factor which determines an investor’s ability to invest as an accredited investor. This, instead of an investor’s wealth, is viewed by many as a more apt measurement of an investor’s ability to withstand the risk of loss. Although we share the SEC’s view that the amendments would not result in a significant increase in the number of newly eligible individual accredited investors and “the amount of capital invested by such newly eligible individual investors [would] have minimal effects on the private offering market generally”, these amendments are nonetheless a welcome change in the industry as it demonstrates the willingness of the SEC to modernise the Securities Act to keep up with changes in the market.

Furthermore, fund managers and administrators are also advised to keep themselves abreast with the revised definitions of “accredited investors” and “qualified institutional buyers” in order to ascertain the status of their U.S. investors with respect to these investors’ investments in their funds.

If you are interested in any of the above legal issues and want to discuss further, please contact our Luke Gannon, Head of Funds and Investment Management (Asia).

About our funds and investment management group

Our group in Asia represents a wide range of clients in the financial services sector including fund sponsors, fund managers, investment advisers, securities brokers, investment banks, investors, trustees, administrators, custodians and other players. We help clients design and establish a wide variety of funds including alternative assets funds such as hedge funds, virtual assets and digital assets funds, private equity, venture capital, real estate and infrastructure funds. We also advise clients on SFO regulation and SFC related matters such as advising on licencing requirements, registrations, licence applications and alterations, and general SFC regulatory and compliance requirements.