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SEC Considers Updating the Accredited Investor Definition: a Discussion of Status, SEC Advisory Committee Recommendations, Comments and Proposed Legislation

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SEC Considers Updating the Accredited Investor Definition: a Discussion of Status, SEC Advisory Committee Recommendations, Comments and Proposed Legislation The SEC Considers Updating the Accredited Investor Definition: A Discussion of Status, SEC Advisory Committee Recommendations, Comments and Proposed Legislation NOVA D. HARB 904-798-2639 | [email protected] 50 North Laura Street Suite 3300 Jacksonville, FL 32202-3661 DAVID H. PANKEY 202-857-1716 | [email protected] 2001 K Street N.W. Suite 400 Washington, DC 20006-1040 DAVID L. RONN 713-353-6671 | [email protected] 600 Travis Street Suite 7500 Houston, TX 77002-2906 May 2015 Updated July 2015 www.mcguirewoods.com McGuireWoods news is intended to provide information of general interest to the public and is not intended to offer legal advice about specific situations or problems. McGuireWoods does not intend to create an attorney-client relationship by offering this information, and anyone’s review of the information shall not be deemed to create such a relationship. You should consult a lawyer if you have a legal matter requiring attention. TABLE OF CONTENTS Page EXECUTIVE SUMMARY ............................................................................................... 1 Possible Adjustment of Financial Thresholds........................................................ 1 Allow a Percentage of Income or Net Worth to Be Used in Qualifying Private Placements ....................................................................................................... 2 Add a New AI Category for Financial Sophistication ........................................... 2 Other Suggestions .................................................................................................. 2 Proposed Legislation .............................................................................................. 2 SEC STAFF REVIEW OF THE AI DEFINITION ........................................................... 3 SEC COMMENT LETTERS ............................................................................................. 3 THE SEC’S ADVISORY COMMITTEES ....................................................................... 3 THE AI FINANCIAL THRESHOLDS ............................................................................. 4 No Change to the Financial Thresholds ................................................................. 4 Adjust the Financial Thresholds for Inflation Going Forward .............................. 4 Add a Percentage of Income or Net Worth Test .................................................... 4 Add a New Financial Sophistication Component .................................................. 5 Professional Qualifications and Designations ........................................... 6 Professional Experience ............................................................................. 6 Investment Experience ............................................................................... 7 Investments Owned ........................................................................ 7 Angel Investors .............................................................................. 7 Passing a Test ............................................................................................. 7 Acting through a Registered Investment Advisor or Broker-Dealer ......... 8 PROPOSED LEGISLATION ............................................................................................ 8 Proposed Test to Provide AI Status ........................................................... 8 Proposed AI Status for Designated Professionals ...................................... 8 Use of Designated Professionals to Make Investment Decisions .............. 9 Self-Certification........................................................................................ 9 June 16 Legislative Hearing....................................................................... 9 Testimony at the June 16 Hearing Concerning the Proposed AI Status Test ................................................................................. 9 Testimony at the June 16 Hearing Concerning Proposed AI Status for Designated Professionals ............................................... 9 SEC Considers Updating the Accredited Investor Definition | Page i TABLE OF CONTENTS (continued) Page Testimony at the June 16 Hearing Concerning Proposed AI Status for People Who Retain Designated Professionals to Make Investment Decisions ......................................................... 10 Testimony of the June 16 Hearing Concerning Self- Certification ................................................................................. 10 Revisions to Proposed Legislation Likely ............................................... 10 SEC Considers Updating the Accredited Investor Definition | Page ii Executive Summary The accredited investor (AI) definition is an extremely important component of the private placement market. A significant amount of capital is raised using Regulation D, and accredited investors participated in 89 percent of reported Regulation D offerings from January 2009 through December 2012. (In other words, only 11 percent of reported Regulation D offerings during this period involved non-accredited investors.) The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) requires that the Securities and Exchange Commission (SEC) review the AI definition for natural persons beginning in 2014 and every four years thereafter. The SEC has received a significant number of comment letters concerning the AI definition for natural persons and two SEC advisory committees have made recommendations to the SEC on this issue. Also, legislation concerning the AI definition has been introduced in the U.S. Congress. Currently an individual is an AI if that person: • earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year; or • has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence, as calculated in accordance with the rule). See Regulation D, Rule 501(a). A lot of people, including an extremely large number of people associated with angel investor groups, have recommended that the AI definition remain as is, in other words, that the current AI financial thresholds remain in place. The vast majority of the comment letters received by the SEC take this view. The $200,000 income and $1 million net worth tests for individuals were established in 1982. The $300,000 income test that includes spousal income was added in 1988. Effective in 2012, the value of a person’s primary residence was eliminated from the net worth calculation. In other words, the basic AI qualification test for individuals has been in place since 1982. This fact has resulted in discussion as to whether the income and net worth thresholds for individual AIs should be changed. Possible Adjustment of Financial Thresholds Some of the discussion has focused on whether these financial thresholds should be raised. If these financial thresholds were adjusted for inflation, the income threshold would increase to just under $500,000 ($740,000 for a married couple), and the net worth criteria would increase from $1 million to almost $2.5 million. While the data is not entirely clear as to the extent of the impact, it is probable that an increase in the financial thresholds of this magnitude would have a material adverse impact on the private placement market. Very few people are advocating that the income and net worth thresholds be adjusted for inflation since 1982.i Accordingly, it is very unlikely that the SEC will simply increase the AI financial thresholds to adjust for inflation since 1982. SEC Considers Updating the Accredited Investor Definition | Page 1 However, a few commenters have recommended that these thresholds be adjusted for inflation on a going-forward basis, and the SEC’s Advisory Committee on Small and Emerging Companies (Small Companies Committee) has recommended this change. Allow a Percentage of Income or Net Worth to Be Used in Qualifying Private Placements The SEC’s Investor Advisory Committee (Investor Committee) has endorsed a new approach to the financial thresholds in the AI definition based on a percentage of income or net worth. This approach would be similar to the investment limitations in the SEC’s proposed crowdfunding rule. Add a New AI Category for Financial Sophistication The Investor Committee and the Small Companies Committee (together, the Advisory Committees), as well as a large number of angel investors, have recommended that the AI definition be expanded to include a new category of AI based upon “sophistication.” By “sophistication,” these commenters mean that a person could qualify as an AI without regard to the financial thresholds if that person had knowledge or experience that indicated financial literacy. The various ways that have been advanced to implement this concept are explained in more detail below. The SEC staff has stated publicly that it is considering this concept. Because of the rather broad support for the addition of financial sophistication as a factor that results in AI status, there is a realistic chance that the SEC staff will recommend that the SEC consider this kind of change. The more difficult part will be how to structure the new AI standard in a practical sense. Other Suggestions Investor protection advocates and others have recommended a variety of other changes to the AI definition. These potential changes include revising the net worth calculation
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