For too many years at the SEC, investments by non-accredited investors in unregistered offerings have been on par with any one of the seven Deadly Sins. But now, there may finally be room in heaven for “financially sophisticated” but previously non-accredited investors to try their luck in today’s private capital markets.
The Proposed Amended Definition
On December 18, 2019, the SEC published proposals to expand the definition of “accredited investor” in Rule 501(a) of Regulation D under the Securities Act to permit additional investors to participate in various private offerings and at potentially higher amounts. The accredited investor definition is a central concept in deciding who may invest in a traditional private placement under Rule 506(b) and a generally-solicited private placement under Rule 506(c) for both private companies and publicly-traded companies, as well as private equity funds, venture capital funds and hedge funds. The definition is also used in determining investment amount limits in other exempt offerings including an offering made under Tier 2 of Regulation A and Regulation Crowdfunding.
The SEC’s proposal would amend the accredited investor definition by:
- adding new categories in the definition that would permit natural persons to qualify as accredited investors based on certain professional certifications or designations or other credentials arising out of an examination administered by a self-regulatory or other industry body such as FINRA or issued by an accredited educational institution, or in connection with investments in a private fund, as a “knowledgeable employee” of the private fund;
- adding certain entity types to the current list of entities that may qualify as accredited investors and a new category for any entity with “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered;
- adding family offices with at least $5 million in assets under management and their family clients to the definition; and
- adding the term “spousal equivalent” to the definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors.
The proposed amendments to the accredited investor definition, however, do not include changes to the current income and net worth thresholds to identify individuals as accredited investors.
The SEC has also proposed to expand the list of entities that are eligible to qualify as “qualified institutional buyers” under Rule 144A and add a “catch-all” category that would permit institutional accredited investors under Rule 501(a), of an entity type not already included in the qualified institutional buyer definition, to qualify as qualified institutional buyers when they satisfy the $100 million threshold.
Benefits of the Amended Definition in Various Offerings
Regulation D Private Placements. According to the SEC, the proposed amendments would benefit issuers that conduct private offerings under Rule 506(b) (which has no limit on the number of purchasers who are accredited investors and limits the number of non-accredited investors to 35 per offering) and Rule 506(c) (under which purchasers are exclusively accredited investors) by expanding the pool of accredited investors, improving the ability of issuers to raise capital in the exempt markets and reducing the competition between issuers for investors, thereby likely resulting in overall increased capital raising in the private offering market. The SEC further indicated that by selectively eliminating restrictions on these sophisticated and informed investors who do not need the protections provided by registration under the Securities Act, there would be little downside to enacting the amendments.
In addition, the amendments to the accredited investor definition could increase capital raising under Rule 504 of Regulation D. Under Rule 504 of Regulation D, issuers are permitted to use general solicitation or general advertising to offer and sell securities when (i) offers and sales are made pursuant to state law exemptions from registration that permit general solicitation and general advertising and (ii) sales are made only to accredited investors.
Generally, it is expected that these proposed amendments would be most valuable to firms that face greater uncertainty about investor interest in their prospective Regulation D offerings, particularly issuers that are smaller, in early stages of development or in geographic areas that currently have lower concentrations of accredited investors. Accordingly, large and well-established public issuers are less likely to benefit from these amendments.
Amendments to the accredited investor definition also impact several other capital formation structures and related trading liquidity and public reporting matters.
Regulation A. As accredited investors are not subject to investment limits under Tier 2 of Regulation A, expanding the pool of accredited investors could enable issuers that are conducting offerings under Tier 2 of Regulation A to raise capital faster and at a lower cost.
Rule 144A. Expanding the definition of qualified institutional buyer under Rule 144A may increase the number of potential buyers of Rule 144A securities from financial intermediaries, thereby facilitating capital formation in this market by issuers conducting Rule 144A exempt offerings.
In addition to the effects on the ability to raise capital, the proposed amendments may have a positive effect on the liquidity of securities issued in unregistered offerings. Since the proposed amendments to the qualified institutional buyer definition would expand the pool of potential purchasers in resale transactions, it could facilitate greater resale of Rule 144A securities by holders of such securities. This could increase demand for Rule 144A securities and have an impact on the price and liquidity of these securities when offered and sold by the issuer in Rule 144A offerings and in subsequent resale transactions.
Regulation Crowdfunding. An expanded accredited investor definition could impact resales under Rule 501 of Regulation Crowdfunding during the one-year resale restriction period, thus potentially affecting the liquidity discount for such securities. Securities purchased in a crowdfunding transaction generally cannot be resold for a period of one year, unless they are transferred to an accredited investor. An expanded pool of accredited investors as a result of the proposed amendments could make it easier for holders of such securities to find a buyer, potentially leading to a lower liquidity discount.
Verification of Accredited Status. Another potential benefit to issuers interested in raising capital through Rule 506(c) offerings is that the proposed amendments would provide them with additional ways to verify an investor’s status as an accredited investor. Issuers conducting offerings under Rule 506(c) are required to take reasonable steps to verify the accredited investor status of all purchasers in the offering. Compliance with this verification requirement has been cited as a potential impediment to the use of Rule 506(c) to raise capital despite the ability to use general solicitation when conducting these types of offerings. To the extent that issuers face challenges complying with this requirement, the proposed amendments would provide them with additional avenues to meet this requirement, such as through professional certifications.
Testing the Waters. The proposed amendments would increase the number of potential investors with whom issuers undertaking a registered offering may be able to communicate under Section 5(d) of the Securities Act and Securities Act Rule 163B (the “testing the waters” provisions). By increasing the pool of potential institutional accredited investors and qualified institutional buyers, the proposed amendments would allow certain issuers to gather valuable information about investor interest before a potential registered offering. This could result in a more efficient and potentially lower-cost, lower-risk capital raising process for such issuers.
Non-Reporting Status. Under Section 12(g) of the Exchange Act, an issuer (other than a bank) is required to register a class of equity securities under the Exchange Act if, on the last day of its fiscal year, it has more than $10 million in total assets and the securities are “held of record” by either 2,000 or more persons, or 500 or more persons who are not accredited investors. To the extent that the proposed amendments increase the pool of accredited investors, issuers may be able to raise the capital that they need by selling securities to fewer non-accredited investors, which could enable these issuers to avoid becoming an Exchange Act reporting company for a longer period.
Private Fund Employees. Finally, a proposed amendment to the accredited investor definition would allow knowledgeable employees of private funds to qualify as accredited investors for purposes of investing in offerings without the funds themselves losing accredited investor status when the funds have assets of $5 million or less. This proposed amendment would potentially allow these private funds the ability to offer knowledgeable employees performance incentives, such as investing in the fund.
The SEC requests public comments to the accredited investor definition amendments and, importantly, in response to specific questions posed by the SEC such as which professional certifications or academic degrees should count in determining accredited investor status.The proposed amendments will be subject to a 60-day public comment period following publication of the release in the Federal Register. To submit comments, one can use the SEC’s Internet submission form or send an email to rule-comments@sec.gov.
PartnerArmed with more than three decades of capital market experience, Spencer represents smaller publicly traded companies, and often underwriters and investment funds, in public and private securities offerings. He focuses ...