SEC Updates Accredited Investor Definition

On August 26, 2020, the SEC released new rules that update the definition of an accredited investor. This definition determines if, and how much, an individual can invest in nonpublicly traded or nonregistered investments such as hedge, private equity, or venture capital funds (collectively private funds). The changes to Rule 501 in Regulation D will allow an individual to qualify as an accredited investor based on professional certifications or knowledge in addition to the existing income and net worth tests. The rule also updates Rule 144A to expand the definition of a qualified institutional buyer (QIB) to add entities that may qualify as an accredited investor. The SEC intends for the changes to better align access to unregistered offerings to investors with the financial sophistication required to assess an investment opportunity without the added protections of SEC registration. The changes will be effective 60 days after publication in the Federal Register.

Background The rule does not change existing asset and wealth thresholds, but rather adds several new categories of both qualifying individual and entity investors that would be allowed to purchase unregistered securities. The current accredited investor definition has been relatively unchanged since it was established in 1982. At that time, 1.3 million individuals or fewer than 2 percent of U.S. households qualified. Because the asset and wealth thresholds are not tied to inflation, the number of accredited investors has risen to about 13 percent of the population or roughly 16 million individuals. Even though the SEC elected not to change the income and asset threshold, the number of eligible investors under these tests will continue to rise due to the lack of inflation indexation. Unregistered offerings conducted under Regulation D play a significant role in U.S. capital formation. In 2019, the estimated amount of capital—both equity and debt—raised in exempt offerings was $2.7 trillion (primarily under Regulation D Rule 506(b) and (c)), compared to $1.2 trillion raised in registered offerings.

Individual Investors Changes The SEC believes the traditional wealth-based criteria should not be the only means for establishing financial sophistication to qualify as an accredited investor. The new rules add two new, nonmonetary categories: . Individuals holding certain educational or professional certifications the SEC has designated as qualifying an individual for accredited investor status . Knowledgeable employees of a private fund solely with respect to investment in such private fund

Professional Certifications The SEC has designated that a holder in good standing of the following licenses would qualify as an accredited investor regardless of their net worth or income: . Series 7, Licensed General Securities Representative . Series 65, Licensed Investment Adviser . Series 82, Licensed Private Securities Offerings Representative The rule notes that there are more than 700,000 people who hold those designations, but the SEC has no data on how many of these were not previously qualified. The SEC can identify additional certifications, designations, or credentials in the future using the following criteria: . Whether the subject certification/designation arises out of an examination(s) administered by a self- regulatory organization or an accredited educational institution

SEC Updates Accredited Investor Definition

. Whether the examination giving rise to the subject certification/designation is designed to reliably and validly demonstrate an individual’s comprehension and sophistication in the areas of securities and investing . Whether persons obtaining the subject certification/designation 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 . Whether persons holding the certification/designation are publicly identified by the issuing body

Knowledgeable Employees The new rule adds a knowledgeable employee of a private fund as an accredited investor for investment in only that fund without having to meet the income or net worth test. Rule 3c-5 allows knowledgeable employees to invest in their company’s private fund without having to be a qualified purchaser. The rule also exempts these knowledgeable employees from the 100-investor limit under the Section 3(c)(1) exemption from the Investment Company Act. Currently, the knowledgeable employee must be an accredited investor. Rule 3c-5(a)(4) of the Investment Company Act defines a knowledgeable employee with respect to a private fund as: . An executive officer, director, trustee, general partner, advisory board member, or person serving in a similar capacity, of the private fund or an affiliated management person of the private fund . An employee of the private fund or an affiliated management person of the private fund (not performing solely clerical, secretarial, or administrative functions) who, in connection with his or her regular functions or duties, participates in the fund’s investment activities if the employee has been performing such functions (or substantially similar functions for another company) for at least 12 months The rule also attributes a knowledgeable employee’s accredited investor status to a spousal equivalent for joint investments in a private fund. Under Rule 501(a)(8), a private fund with less than $5 million of assets can qualify as an accredited investor if all the fund’s equity owners are accredited investors. The addition of knowledgeable employees as accredited investors also will allow these employees to invest in a small private fund without the fund losing accredited investor status.

Spousal Equivalents The final rule expands the accredited investor definition to include joint income and joint net worth from “spousal equivalents” and does not require assets to be held jointly in calculating wealth. A spousal equivalent includes a cohabitant occupying a relationship generally equivalent to that of a spouse. This change provides a consistent regulatory treatment among traditional marriages, same-sex marriages, civil unions, and domestic partnerships.

Eligible Entity Changes Under current guidance, only certain entity types can qualify as an accredited investor regardless of the amount of assets/investments. The SEC is adding several categories of entities to the accredited investor definition: . SEC and state-registered investment advisors (RIA). The SEC estimates there are approximately 13,400 SEC-registered RIAs and 17,500 state-registered RIAs; however, many may already qualify as accredited investors under the $5 million asset test. . Rural business investment companies (RBIC). RBICs are intended to promote economic development and the creation of wealth and job opportunities in rural areas, similarly to a small business investment company (SBIC), which is intended to increase access to capital for growth stage businesses. SBICs already qualify as an accredited investor and with the new rule, RBICs will have the same investment opportunities. 2 SEC Updates Accredited Investor Definition

. Any limited liability company (LLC) with $5 million in assets that was not formed for the purpose of acquiring the subject offered securities. LLCs were not widely used when the SEC created the accredited investor definition. This addition formalizes long-standing SEC staff positions and is not expected to significantly change the pool of accredited investors. . Any entity that is either directly owned by individuals who qualify as accredited investors, or indirectly owned by another entity comprised of equity owners that are individuals who qualify as accredited investors. Currently under Rule 501(a)(8), an entity qualifies as an accredited investor if all of an entity’s equity owners are accredited investors. This category was added because in some instances an entity’s equity owner is another entity and not a natural person. This change will allow a “look through” various forms of equity ownership so that it will not matter if ownership is direct or indirect. . Family office or family client. Family offices are created by wealthy families to manage their assets, plan for their families’ financial future, and provide other services. Family offices generally meet the definition of an investment adviser; however, a 2011 family office rule excluded single family offices from the Advisers Act regulations if the family office has no clients other than family clients (family members, former family members, key family office employees and their charitable organizations, trusts, etc.) under certain conditions. In some cases, under different SEC regulations, a family client may not meet the accredited investor definition but could meet the qualified purchaser definition, which has a higher financial threshold. Under the final rule, a family office or a family client would qualify as an accredited investor if the following criteria are met: • At least $5 million in assets under management • Not formed for the specific purpose of acquiring the securities offered • Managed by a person knowledgeable and experienced in financial and business matters such that the family office can evaluate the merits and risks of the prospective investment

A person who receives assets upon the death or involuntary transfer from a family member or key employee will qualify as a family client under the accredited investor definition for one year. . Any entity owning investments in excess of $5 million which was not formed for the purpose of acquiring the subject offered securities. This new category is intended to capture all existing entity forms not already included in Rule 501(a), as well as newly created entity types in the future. Indian tribes and governmental entities will now be eligible for accredited investor status. Eligible investments for the size test include securities, real estate, commodity interests, physical commodities, nonsecurity financial contracts held for investment purposes, and cash and cash equivalents.

QIBs Certain private placements of stocks and bonds are available only to QIBs to limit regulatory restrictions and public filing requirements. A QIB is a purchaser of securities that is deemed financially sophisticated and is in need of less protection from issuers than most public investors. Under Rule 144A, except for registered dealers, a QIB must manage at least $100 million in securities from unaffiliated issuers. A bank or savings and loan thrift can qualify as a QIB if it has a net worth of at least $25 million. A registered dealer acting for its own account can qualify as a QIB if it owns and invests on a discretionary basis at least $10 million of securities of unaffiliated issuers. Eligible QIB entities include investment and insurance companies, employee benefit plans, and entities completely owned by accredited investors. Under current guidance, any entity not specifically listed cannot be a QIB. The final rule amends Rule 144A to add RBICs and LLCs to the QIB definition when they meet the $100 million threshold to align with Rule 501 changes noted above. Rule 144A also is amended to include a QIB catchall category so that any entity that qualifies as an accredited investor also qualifies for QIB status when it meets the $100 million threshold, even if not specifically listed. This will include Indian tribes, governmental bodies, sovereign wealth funds, and bank-maintained collective investment trusts.

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Conclusion These changes will substantially increase the potential pool of investors in exempt securities offerings, including Rule 506(b) and 506(c) offerings as well as interstate crowdfunding offerings. The changes to the QIB definition will allow Indian tribes, labor unions, and 529 educational savings plans, among others, to invest in private funds. Visit BKD’s Public Company Reporting Resource Center to learn more. If you have questions about these changes, contact your BKD Trusted Advisor™ today.

Contributors John Griffin Partner 972.702.8262 [email protected]

Anne Coughlan Director 317.383.4000 [email protected]

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