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Accredited Investors In August 2020 the U.S. Securities and Exchange Commission (SEC) expanded the definition of "accredited investor". See SEC Staff Report on the Review of the Definition of "Accredited Investor" and adopted amendments to the definition of “accredited investor” in Regulation D under the Securities Act of 1933, as amended (Securities Act). The “accredited investor” definition is one of the principal tests for determining who is eligible to participate in private offerings, which are typically conducted by privately held companies and used to raise for funds. Until the SEC’s recent action, the test for individuals to qualify as accredited investors remained largely unchanged for over 40 years. The final rules modernize the “accredited investor” definition by adding new categories of qualifying individuals and entities that have demonstrated knowledge, expertise and financial sophistication, which are in addition to the current categories based on income and net worth. The adopted amendments are part of the SEC’s stated objective to open up private markets to a wider range of investors. The amendments will become effective 60 days after publication in the Federal Register, which is expected to be in November 2020.
Importance of Accredited Investor & Current Standard The “accredited investor” definition is a central component of Regulation D. It is intended to encompass those persons whose financial sophistication and ability to sustain the risk of loss of investment or ability to fend for themselves render the protections of the Securities Act’s registration process unnecessary. Qualifying as an accredited investor is significant because accredited investors may, under SEC rules, participate in investment opportunities that are generally not available to non-accredited investors, such as investments in private companies and offerings by hedge funds, private equity funds and venture capital funds. The “accredited investor” definition forms the basis for determining the class of investors permitted to invest in private offerings relying on the exemption in Rule 506(b) of Regulation D under the Securities Act. Rule 506(b) provides an exemption from registration for offerings of an unlimited dollar amount of securities to accredited investors and up to 35 additional non-accredited investors. Rule 506(b) offerings comprise the vast majority of exempt private offerings conducted in the United States. Therefore, the ability of an individual or entity to meet the accredited investor definition is vitally important to the capacity of thousands of private companies and investment funds to raise the necessary capital for operations and expansion, especially small start-up and venture capital companies which often have a more difficult time accessing capital compared to larger more established companies.
The definition of “accredited investor” is set forth in Rule 501(a) of Regulation D and includes any person who comes within or whom the issuer reasonably believes comes within certain enumerated categories at the time of the sale of securities to that person. Before the SEC’s recent amendments, the accredited investor criteria for natural person investors (other than officers, directors, and partners of the issuer) were focused exclusively on financial metrics – specifically a net worth threshold of at least $1 million, or an individual income threshold of more than $200,000 (or $300,000 jointly with the person’s spouse) in each of the last two years. However, the amendments now permit individuals to meet the accredited investor definition not only based on their income or net worth, but also based on measures of financial sophistication, which is intended to expand the number of individuals who will be able to invest in private offerings. The adopted amendments also would expand the list of entities that may qualify as accredited investors by, among other things, allowing any entity that meets an investments ownership test to qualify.
Amendments to "Accredited Investor"Under the amendments, the SEC adopted the following changes to the “accredited investor” definition in Rule 501(a) of Regulation D:
Add a new category to the definition that permits natural persons to qualify as accredited investors based on certain professional certifications, designations, or credentials or other credentials issued by an accredited educational institution, which the SEC may designate from time to time by order. In conjunction with the adoption of the amendments, the SEC designated by order holders in good standing of the Financial Industry Regulatory Authority, Inc. (FINRA) General Securities Representative (Series 7), Investment Adviser Representative (Series 65), and Private Securities Offerings Representative (Series 82) licenses as qualifying natural persons. This approach provides the SEC with flexibility to reevaluate or add certifications, designations, or credentials in the future.
Include as accredited investors, with respect to investments in a private investment fund (such as a private equity fund, venture capital fund, or hedge fund), natural persons who are “knowledgeable employees” of the fund.
Clarify that limited liability companies with $5 million in assets may be accredited investors and add SEC- and state-registered investment advisers, exempt reporting advisers, and rural business investment companies (RBICs) to the list of entities that may qualify.
Add a new category of accredited investor for 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 of 1940, in excess of $5 million and that was 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,” as each term is defined under the Investment Advisers Act of 1940.
Add the term “spousal equivalent,” so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors.
Publicly Advertised Fund & Accredited Investor Rule 506(c) Verification Procedures If you are operating under Rule 506(c) of Regulation D (i.e., applicable to advertised U.S. hedge funds) you must request that your investors provide you with a CPA confirmed, licensed attorney confirmed, or SEC registered broker-dealer confirmed accredited investor status statement. Planning Tip: A third party confirmation of an investor's status is a good practice to observe for Rule 506(b) hedge funds in any event. Of course, contact the actual party documenting the confirmation directly to verify that the third party is accredited to avoid fabricated statements). A U.S. hedge fund that does not advertise may have up to 35 non-accredited investors. For more information, read the SEC Staff Report on Accredited Investor Definition Issued December 18, 2015 and see above referenced links on this page. The definition will continue to evolve over time. Learn More About U.S. Hedge Fund Advertising
Planning Tips for Income Test Though joint spousal income can be used to establish accredited investor status, your investors cannot use separate income for one year and joint income for the next year and future years to meet the test. If the prospective investor has a consistent pattern of income that exceeds $200,000, or $300,000 joint income, the investor's representation is acceptable if you are operating a Rule 506(b) hedge fund (i.e., an unadvertised U.S. hedge fund). Contact Us for Help
Planning Tips for the Net Worth Test The Dodd-Frank Act requires that the value of a person’s primary residence be excluded from the net worth calculation used to determine the person’s accredited investor status. When in doubt of a proposed investor's net worth, the best bet is to request third party confirmation of prospective investor's financial statement of net worth. For more information, read the SEC Staff Report on Accredited Investor Definition Issued December 18, 2015. The definition will continue to evolve over time. Contact Us for Help
Subscription Agreement Description of Accredited Investor The language below is taken from a standard Subscription Agreement used in hedge fund offering documents.
1. Any bank as defined in section 3(a)(2) of the [Securities] Act, or any savings and loan association or other institution as defined in section 3(a)(5)(A) of the Act whether acting in its individual or fiduciary capacity; any broker or dealer registered pursuant to section 15 of the Securities Exchange Act of 1934; any insurance company as defined in section 2(a)(13) of the Act; any investment company registered under the Investment Company Act of 1940 or a business development company as defined in section 2(a)(48) of that Act; any Small Business Investment Company licensed by the U.S. Small Business Administration under section 301(c) or (d) of the Small Business Investment Act of 1958; any plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5,000,000; any employee benefit plan within the meaning of the Employee Retirement Income Security Act of 1974 if the investment decision is made by a plan fiduciary, as defined in section 3(21) of such act, which is either a bank, savings and loan association, insurance company, or registered investment adviser, or if the employee benefit plan has total assets in excess of $5,000,000 or, if a self-directed plan, with investment decisions made solely by persons that are accredited investors;
2. Any private business development company as defined in section 202(a)(22) of the Investment Advisers Act of 1940;
3. Any organization described in section 501(c)(3) of the Internal Revenue Code, 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 $5,000,000;
4. Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer;
5. Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his purchase exceeds $1,000,000;
6. Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;
7. Any trust, with total assets in excess of $5,000,000, 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) and
8. Any entity in which all of the equity owners are accredited investors.
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