SEC Amends Accredited Investor Definitions

On August 26, 2020, the Securities and Exchange Commission (“SEC”) officially updated the definition of “accredited investors” under the Securities Act of 1933 (“Securities Act”). (Press Release, SEC Modernizes the Accredited Investor Definition). The amendments greatly expand the threshold of determining whether an investor is accredited in Rule 215 and Rule 501(a) of the Securities Act, signaling a significant overhaul of the growing market for exempt offerings.

“Accredited Investors” are a crucial piece in the market of exempt offerings; Rules 506(b) and 506(c) provide “safe harbors” for issuers providing exempt offerings under Section 4(a)(2) of the Securities Act to accredited investors. Issuers are able to raise an unlimited amount of capital through such offerings so long as the investors are “accredited.” On an individual basis, Rule 501(a) has defined “accredited investors” as those with a net worth above $1,000,000 (excluding the value of a personal residence) or have an expected annual income of more than $200,000 (or $300,000 jointly, with a spousal equivalent). (17 C.F.R. §230.501(a)). These parameters are intended to ensure that those involved in investing in exempt offerings are able to fend for themselves should their investments prove insolvent.

The SEC’s updated rules appear to cast a much wider net on who may qualify as an “accredited investor.” Perhaps most notably, the SEC now includes individuals with certain professional designations or credentials within the definition. These would include licensed general securities representatives (Series 7), licensed investment advisers (Series 65), and licensed private securities offerings representatives (Series 82). (SEC Release Nos. 33-10824; 34-89669, Final Rule: Amending the “Accredited Investor” Definition). Further, the SEC has also added Investment Advisers – both those registered with the SEC or States, and those exempt from registration – as entities to fall within the definition of “accredited investors,” as well as “knowledgeable employees” of private funds. (Id.). Lastly, the SEC has also included a “catch-all” category of accredited investors that encompasses any entity with more than $5 million in investments. (Id.). The SEC notes that this category is intended to include, among other things, Native American Tribes, governmental bodies, and limited liability companies. (Id.).

The traditional rules governing the definition of accredited investors by way of financial proxy ($1,000,000 net worth or $200,000 annual income) is both under-inclusive and over-inclusive; those who are wealthy enough may not have investment knowledge, and those with significant investment knowledge may not be wealthy enough to be an accredited investor. Further, by including those who do not meet the net worth standards, the SEC is allowing those individuals to take on the risk of private transactions without necessarily being able to bear potential losses. In fact, these seemingly arbitrary numbers have come under criticism. SEC Commissioner Allison Herren Lee noted that individuals fitting in the “accredited investor” umbrella can do so simply with a few decades of saving, and further recognizes that those individuals may have spent only a lifetime of saving, not a lifetime of investing. (SEC Commissioner Allison Herren Lee, Statement on the Proposed Expansion of the Accredited Investor Definition). So, while the updated rules seem to address the under-inclusivity of the former rules; meaning those with investment knowledge but without significant wealth, the proposed rules do not address the over-inclusivity, as Commissioner Lee notes, “there are no limits on the amount that can be gambled and lost.” (Id.).

Commissioners Lee and Crenshaw were also critics of the SEC’s determination to not adjust the wealth thresholds for inflation. (Commissioners Alison Herren Lee and Caroline Crenshaw, Joint Statement on the Failure to Modernize the Accredited Investor Definition). The Commissioners noted that such a failure has resulted in a 550% increase in the number of qualifying households since 1983. (Id.). The SEC’s release aims to justify this non-action by citing the potential for market disruption should numerous investors already participating in exempt offerings no longer being able to meet the requirements needed to participate. (SEC Release Nos. 33-10824; 34-89669, Final Rule: Amending the “Accredited Investor” Definition). The release also cites the changes in technology and access to information that have occurred since 1982, when the original wealth thresholds were put in place. (Id.). Commissioners Lee and Crenshaw, however, noted that the power of the internet and a personal computer cannot rectify the naturally opaque market for exempt offerings, where issuers do not need to make disclosures available to the internet. (Commissioners Alison Herren Lee and Caroline Crenshaw, Joint Statement on the Failure to Modernize the Accredited Investor Definition).

Regardless, the updated definitions are nothing short of a major change; the increase in the number of accredited investors that will soon be able to participate in the market for exempt offerings is practically immeasurable, and the effects of what will be a huge growth in market participants cannot be quantitatively measured for some time.

While the revised rule has an obvious impact on investors, this change will also affect registered investment adviser (RIA) firms as well. For many RIAs, the new guidance probably will not change much. Under the new definition, RIAs themselves are now considered accredited investors, but RIA clients are not likely to be affected by the changes. Notably, although it was considered, the SEC did not expand the definition to include discretionary clients of fiduciary investment advisors.

One important note is that while the updated definition allows additional investors to become accredited investors, it does not mandate that RIAs change their current policies. For those that are new accredited investors, there is still the question of whether the types of private placements available to accredited investors would be an appropriate portfolio addition. Financial sophistication and the ability to understand the investment opportunity are just one part of the equation. Private placements often have long holding periods, low liquidity, and relatively high probability of capital loss. While these features may be accompanied by higher expected returns, the high risk and low liquidity often make these investments inappropriate for investors who do not have the assets to endure substantial losses. Also, despite the SEC now allowing it, there is still the practical limitation of investment minimums that will likely limit the ability of those newly endowed with accredited investor status to participate in private placements.

It is for these reasons that many RIAs view the SEC’s action with caution and believe that the SEC may be trying to address something at the lower end of the market without fully understanding the potential to opening investors to potential fraud and not being capable of properly evaluating private placements.

Though there may not necessarily be a flood of investors requesting to be put into private placements, anytime access to lucrative products is broadened, there will invariably be new individuals who will inquire about their details. RIAs, especially smaller shops who generally have less expertise with these types of products, will need to ramp up investment in compliance, whether that is training internal staff on how to review private placement documents (private placement memorandums, subscription documents, etc.), or relying on third-party compliance providers.

The larger impact the rule may have on financial services firms concerns personal securities reporting. As noted above, registered employees can now invest in private placements without having to meet the accredited investor financial thresholds. The SEC estimates that just over 700,000 individuals hold the professional certifications and licenses listed above.

Under Section 204A of the Investment Advisers Act, most employees (those defined as access persons) are required to report their personal securities holdings to the Compliance Department. Rule 204A also requires employees to obtain pre-approval for initial public offerings and limited offerings, which includes securities exempt from registration under the Securities Act.

The first step firms should take is to review their own policies regarding private placements and determine if changes are warranted. The next step is to provide education to the firm’s employees so that when registered employees receive requests from clients and/or submit requests to invest in private placements themselves, they will be better informed about the risks and rewards these investments offer. RIAs should also have a formalized system in place for employees to report personal securities accounts and to submit requests for the compliance department to review investments in private placements.

In summary, RIAs will need to prepare for both investors and registered employees requesting access to private placements and develop proper policies and procedures to address the issue. By being prepared, RIAs can avoid many of the pitfalls that arise from selection of these types of investments – as Ben Franklin stated, “an ounce of prevention is worth a pound of cure.”