The Securities and Exchange Commission’s (SEC) recent expansion of the definition of “accredited investor” in the final rule (Final Rule) issued on August 26, 2020, allows people with professional knowledge, experience or certifications to qualify as accredited investors, which is a highly welcome step that is creating quite a buzz!! The Final Rule is particularly beneficial to private offerings that are restricted to accredited investors such as Rules 506(b) or 506(c) of Regulation D of the Securities Act of 1933, as amended (Securities Act), on which countless private companies and private funds rely to raise funds year after year.
Indeed, according to the SEC, unregistered offerings conducted under Regulation D, particularly those under Rule 506(b), play a profoundly significant role in capital formation in the United States. In 2018, the estimated amount of capital including both equity and debt reported as being raised in Rule 506 offerings was $1.7 trillion, compared to $1.4 trillion raised in registered offerings. Of the $1.7 trillion, $1.5 trillion was raised by pooled investment funds, and $228 billion was raised by non-fund issuers. Accredited investors are critical to providing capital for the private offering market.
Enjoying the Gift: Making Use of the Broadened Category of Potential Investors. The Final Rule effectively identifies additional potential individual and institutional investors that have sufficient knowledge and expertise to participate in investment opportunities. All company issuers and private funds (Issuers) can benefit from the expanded category of investors including, in particular, smaller and early-stage businesses, business in geographic areas with lower concentrations of accredited investors, or founders without an affluent network of friends and family from whom sorely needed seed and growth capital is sought.
Historically, smaller businesses rely heavily on local sources of capital, particularly at the seed and initial growth stages, which means that the narrower definition of accredited investors stifles many fundraising opportunities. Moreover, there is significant data to support the position that wealth-based factors on qualification as accredited investor has a disproportionate adverse effect on minority- and women-owned businesses and other underrepresented.
The new expanded pool of potential accredited investors under the Final Rule from whom Issuers can seek to raise funds under Rules 506(b) and 506(c) includes:
Individual Persons – The Final Rule creates an alternative route for persons without the necessary income to invest in private funds based on the belief that those with sufficient licensing and knowledge can adequately assess risks, including:
- Knowledgeable employees of the private fund offering securities (i.e., high-level executives, heads of principal business units, or qualifying investment personnel)
- Holders of Series 7, 65, or 82 financial licenses
Additionally, the Final Rules will add the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors. “Spousal equivalents” means a cohabitant occupying a relationship generally equivalent to that of a spouse, which is appropriately broad to allow cohabitants to satisfy the accredited investor requirements.
Entities — The Final Rule will add the following entities that qualify as accredited investors upon the effective date, even if certain of the owners of the family assets might not qualify, including:
- Family offices with $5 million in assets not specifically formed for the specific purpose of acquiring the securities offered and whose investment is directed by a person with financial and business knowledge and experience
- Family clients of such qualified family offices
- Limited liability companies with more than $5 million in assets not specifically formed for the specific purpose of acquiring the securities offered
- SEC- and state-registered investment advisers as well as venture capital or mid-sized private fund exempt reporting advisers under the Investment Advisers Act of 1940
- Any entity owning more than $5 million in investments not specifically formed for the specific purpose of acquiring the securities offered.
Qualified Institutional Buyers – The Final Rule amends the “qualified institutional buyer” definition in Rule 144A under the Securities Act to expand the list of entities that qualify as qualified institutional buyers, including (i) Limited liability companies; (ii) Rural business investment companies (RBICs); and (iii) Entities not covered under the current accredited investor rule (such as sovereign funds and non-U.S. plans).
What Now? The Final Rule will become effective sixty (60) days following its publication in the Federal Register, which has yet to occur as of the date hereof. It is anticipated that the effective date will be sometime in late-November 2020. Until then, here are a few suggested steps to take:
1. Update Accredited Investor Questionnaires and PPMs — In anticipation of the effective date, Issuers should consult with securities counsel to update their accredited investor questionnaires and private placement memorandum (PPM), as necessary, to incorporate the expanded definitions of accredited investors under the Final Rules. If not launching the offering until mid- to late November, the accredited investor questionnaire and PPM could rely alone on the expanded definitions of accredited investors under the Final Rules only. If in the market now or launching soon, the accredited investor questionnaire and PPM could rely on existing rules for investors investing before the effective of the Final Rules and the expanded definitions of accredited investors who invest once the Final Rules govern the fundraising
2. Expand Investor Verification Processes for Offerings Under Rule 506(c) — Issuers raising money in reliance on Rule 506(c), which permits the company issuers and private funds to raise funds through the use of general solicitation need to be prepared to verify investor qualifications, of these new categories of prospective accredited investors. If using a third-party firm to verify accredited investors, we recommend making sure they are prepared to respond to the new categories.
3. Broaden Fundraising Strategy – Issuers should consider how the expanded accredited investor categories might expand their pool of potential accredited investors under the Final Rule from whom Issuers can raise funds and thus revise and broaden their investment strategy.
The Final Rule will likely require such managers to update their private placement memoranda, subscription documents, information brochures, and disclosure documents (among other forms of documentation) to account for the amendments to the definition of accredited investor. Additionally, the Final Rule will likely require updates to form representations or certifications related to the resale of securities in reliance on Rule 144A to account for the amendments to the definition of a QIB. Moreover, funds and investment advisers typically have policies and procedures related to compliance with the exemptions under the Securities Act for private offerings, which also may need to be updated to account for these definitional changes.
Separately, Rule 506(c) under the Securities Act requires issuers engaging in a general solicitation to take “reasonable steps” to verify that each investor is an accredited investor. Rule 506(c) further states that issuers will be deemed to meet this standard if, for investors claiming to be accredited based on factors other than income or wealth, the issuer obtains a written confirmation from certain persons (including a licensed attorney) that the certifying person has taken reasonable steps to verify that the investor satisfies the relevant criteria. Because the Final Rule expands the number of ways to qualify as an accredited investor outside of income or wealth (e.g., by qualifying as a family office, family client or “spousal equivalent,” among other things), the Final Rule may require a greater number of investors to obtain such a written confirmation.
The Final Rule will also allow funds and investment advisers to manage capital and take investments from a wider range of persons without forfeiting exemptions for private offerings from the otherwise applicable disclosure requirements (e.g., under Rule 506(b), offers and sales to non-accredited investors may only be made through disclosure documents that contain specific and detailed disclosures and financial information not otherwise found in a more traditional private placement memorandum). Additionally, because certain regulations by the Commodity Futures Trading Commission provide exemptions from the requirement to register as a commodity pool operator (CPO) to funds that limit their limited partners to accredited investors and satisfy certain other conditions, the Final Rule may expand the scope of market participants that can invest in commodity pools without the operator needing to register as a CPO.
The Final Rule is available here: https://www.sec.gov/rules/final/2020/33-10824.pdf.