SEC Modernizes the Accredited Investor Definition

Published: Dec 11, 2020
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On August 26, 2020, the U.S. Securities and Exchange Commission (SEC) adopted amendments to expand the “accredited investor” definition, which had been largely unchanged since 1982. The accredited investor definition is one of the principal tests for determining who is eligible to participate in private offerings. Previously, the accredited investor definition was primarily an income and net worth test. While retaining the existing income and net worth criteria, the SEC notes that the amendments are likely to expand the pool of potential institutional and individual investors who might now meet the accredited investor definition by virtue of newly introduced measures of financial sophistication. In announcing the amendments, the SEC noted, “these amendments are part of the Commission’s ongoing effort to simplify, harmonize, and improve the exempt offering framework, thereby expanding investment opportunities while maintaining appropriate investor protections and promoting capital formation.”

Prior to the amendments, the accredited investor requirements for natural persons and entities were generally as follows:

Natural persons:

Natural person having income of more than $200,000 in each of the last two years (or more than $300,000 together with spouse in each of those years) and reasonably expect the same for this year.
Natural person having a net worth over $1 million, either alone or together with spouse, excluding the value of primary residence.
Any director, executive officer, or general partner of the issuer of the securities being offered or sold.

Entities:

Bank, savings and loan association, broker or dealer, insurance company, registered investment company, business development company, small business investment company or private business development company.
Employee benefit plan having total assets in excess of $5 million, employee benefit plan wherein the investment decision is made by a bank, savings and loan association, insurance company, or registered investment advisor, or a self-directed plan, wherein investment decisions are made solely by persons that are accredited investors.
Any organization described in IRC Sec. 501(c)(3), corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5 million.
Any trust, with total assets in excess of $5 million, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person as described in Rule 506(b)(2)(ii).
Entity qualifies as an accredited investor if all of the equity owners of that entity are accredited investors.

The amendments to the accredited investor definition:

Natural persons:

Add the term “spousal equivalents” so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors.
Add a new category that permits natural persons to qualify as accredited investors based on holding certain professional certifications, designations or credentials.
Include as accredited investors, with respect to investments in a private fund, natural persons who are “knowledgeable employees” of the fund.

Entities:

Clarify that limited liability companies with total assets in excess of $5 million may be accredited investors and add SEC- and state-registered investment advisors, exempt reporting advisors, and rural business investment companies to the list of entities that may qualify.
Add a new category for any entity, including Indian tribes, governmental bodies, funds and entities organized under the laws of foreign countries that own certain investments in excess of $5 million and not formed for the specific purpose of investing in the securities offered.
Add “family offices” with at least $5 million in assets under management and their “family clients.”

The original accredited investor definition relied on income and net worth thresholds as a proxy for investor sophistication. As markets and market participants have evolved over the years, and in response to both public comments and recommendations from various advisory committees, the SEC will now allow individuals to qualify as accredited investors based on certain professional certifications, designations or credentials.

“While certain new categories of accredited investors will be a welcome change for private offerings in general, for private equity fund offerings, the new categories may not actually increase the potential pool of otherwise eligible fund investors,” said Genna Garver, a Partner at law firm Troutman Pepper. “Many private equity funds have additional eligibility requirements, such as minimum investment amounts, residency, and tax status requirements. For regulatory purposes, private equity funds managed by registered investment advisors typically require investors to be ‘qualified clients’ and some private equity funds limit participation to investors who are ‘qualified purchasers.’ Both the qualified client and qualified purchaser standards are generally harder to satisfy than the accredited investor standard, narrowing the pool of prospective investors.”

Similar views were noted by Richard Heller, a Partner with legal firm Thompson Hine, who commented, “Overall, the recent changes will expand access to PE markets. However, for funds that rely upon the 3(c)(1) exemption from registration under the Investment Company Act, fund sponsors will have to consider the impact of minimum investment amounts. Individual investors that qualify solely as an accredited investor on the basis of a professional certification may not have the requisite investment minimum for most private funds. Fund sponsors typically reserve the right to lower an investment minimum on a case-by-case basis but investment minimums may be a speed bump in new growth.”

These amendments become effective 60 days after publication in the Federal Register (i.e., from October 25, 2020).