RALEIGH – When we begin advising new clients about raising capital, we always ask them whether they know what an “Accredited Investor” is.
Most people who have experience raising capital know that term, because most exemptions from registration under securities laws either (i) require that you sell only to Accredited Investors, (ii) restrict the number of offers to people who are not Accredited Investors or (iii) exempt sales to Accredited Investors from volume restrictions of the exemption rules.
For almost 40 years, Accredited Investors have been the central focus of capital raising efforts, because securities laws impose severe restrictions on offers and sales to persons who are not Accredited Investors.
So, anytime the SEC even thinks about changing the definition of Accredited Investors, the capital raising world pays attention. In June 2019, the SEC began soliciting comments about proposed changes to the SEC’s Accredited Investor definition.
In that release, the SEC indicated that approximately 16 million households in the US qualified as Accredited Investors (which was about 13% of all U. S. households) under either the $1 million net worth test (excluding primary residence) or the annual income test ($200,000 individual annual income or $300,000 joint spousal annual income). An unknown number of financial institutions are also accredited investors under other tests.
In response to the SEC’s request for comments, some people advocated for broad changes that would greatly expand the number of Accredited Investors. Other people wanted to reduce the number of Accredited Investors, because inflation since the early 1980s has greatly expanded the number of households who satisfy the $1 million net assets test and the annual income tests.
On August 26, 2020, the SEC issued several changes to its Accredit Investor definition that:
- immediately increases the number of Accredited Investors by a small amount
- opens the door to later bigger increases in the number of Accredited Investors by adding a new principle to determine who is an Accredited Investor
Let’s discuss the immediate additions to the list of Accredited Investors first:
- all holders in good standing of the Series 7, Series 65, and Series 82 licenses (for broker-dealers and investment advisers) without regard to their net worth or annual income;
- “knowledgeable employees” of a private investment fund without regard to their net assets or annual income (but this only applies to investments in the investment fund that employs them);
- limited liability companies with $5 million in assets that was not formed for the specific purpose of investing in the securities offered (even if some of its owners are not accredited);
- 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);
- registered (either state or SEC) investment advisers, exempt reporting advisers, and rural business investment companies (RBICs);
- any entity, including Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries, that own “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; and
- “spousal equivalents” may pool their finances for the purpose of qualifying as Accredited Investors.
None of these specific changes are earth shattering. What is more important is that the SEC has accepted the general principle that “sophistication” can make someone an Accredited Investor without regard to their financial resources.
Why is that a BIG DEAL in the world of securities?
For almost 40 years, SEC Rule 506 has required that people be both “sophisticated” and satisfy the Accredited Investor definition. Now, the SEC is opening the door to making “sophistication” alone a door to being able to invest in private offerings.
So, here’s the issue the SEC is wrestling with.
The dollar limits for Accredited Investors have always been a clear measurable standard. “Sophistication” is a fairly vague concept. In its first foray into including sophistication as a standard for being “accredited,” the SEC is using objective standards in the form of broker-dealer and investment adviser licenses.
The new rule invites people to suggest additional certifications, designations or credentials that satisfy the following attributes set out in the new rule.
- a self-regulatory organization, industry body or accredited educational institution administers them
- they demonstrate the individual understands the areas of securities and investing;
- person can reasonably be expected to have sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of a prospective investment; and
- the public can access a date base or can otherwise verify who meets these standards.
The biggest proposed category the SEC decided not to add to the Accredited Investor definition consists of people who have specific industry knowledge. For example, under this proposed category, people who run software companies could invest in other software companies. This category has always made sense to me, but the SEC seems to favor financial experience over industry experience. The other problem is that there is no list of such persons that issuers or securities regulators could check.
However, the SEC’s new rule opens the door to someone creating an “accredited investor” test to permit anyone who wants to invest in private offerings to demonstrate their financial and investment knowledge.
Are you the enterprising entrepreneur that will create an accredited investor test the SEC will accept?
Your fellow entrepreneurs who want to raise capital will be eternally grateful to you.
Let us know if you need help.