The accredited investor exemption has been widely and frequently used in private capital raising activities for many years. The exemption is one of the easiest to establish and least expensive for a company to utilize. It has therefore remained popular since the definition and the associated regulation was adopted in 1982.

Notwithstanding its popularity, investors and other market participants have long expressed interest in updating the accredited investor definition to increase the number of individuals and entities that would qualify for the exemption and thereby be able to participate in private securities offerings. Fortunately, in December 2019, the Securities and Exchange Commission (SEC) proposed amendments to Regulation D to update and modernize the definition of accredited investor. The proposed amendments would expand those classes of individuals and entities who could qualify under the exemption. This article discusses the amendments and their potential impact on privacy securities offerings.

Background

Currently, Rule 501(a) of Regulation D provides that accredited investors include natural persons and entities that comes within, or that the issuer reasonably believes comes within, any of eight enumerated categories at the time of the sale of the securities. Natural persons may qualify as accredited investors based on the following criteria: individuals who have a net worth exceeding $1 million (excluding the value of the individual's primary residence), either alone or with their spouses; individuals who had an income in excess of $200,000 in each of the two most recent years, or joint income with the individual's spouse in excess of $300,000 in each of those years, and have a reasonable expectation of reaching the same income level in the current year; and directors, executive officers, and general partners of the issuer or of a general partner of the issuer. Some entities may qualify as accredited investors based on their status alone. Other entities may qualify as accredited investors based on a combination of their status and the amount of their total assets.

The standard set forth in the accredited investor definition has remained unchanged since its adoption in 1982. However, in early 2019, the SEC voted to propose amendments to the definition. The SEC thereafter issued a concept release in June 2019 soliciting public comment on how to "simplify, harmonize, and improve" the exempt offering framework under the Securities Act of 1933 (the Securities Act). On Dec. 18, 2019, the SEC ultimately proposed amendments to the definition of "accredited investor" in Rule 501 of Regulation D, which amendments addressed feedback received as part of the comment process.

The Proposed Amendments

The proposed amendments to the definition of "accredited investor" included both changes to the categories of natural persons and entities who qualify as accredited investors under Rule 501 of Regulation D.

New Categories of Natural Persons Who Qualify as Accredited Investors

The proposed amendments would add the following two new categories to the accredited investor definition for natural persons:

• Persons holding certain professional certifications or designations or other credentials that demonstrate an understanding of securities and investing: Under this category, individuals that are licensed as general securities representatives (Series 7), investment adviser representatives (Series 65), or private securities offerings representatives (Series 82) would be qualified as accredited investors.
• Knowledgeable employees of private funds: The proposed amendments would also include a new category of "knowledgeable employees," as already defined in Rule 3c-5(a)(4) of the Investment Company Act of 1940, to the definition of accredited investors. Accordingly, knowledgeable employees would include executive officers, directors, general partners, trustees, advisory board members, or persons serving in a similar capacity, of a private fund or an affiliated person of the fund that oversees the fund's investments, and employees of the private fund or the affiliated person of the fund (other than employees performing solely clerical, secretarial, or administrative functions) who, in connection with the employees' regular functions or duties, have participated in the investment activities of such private fund for at least 12 months.

New Categories of Entities Who Qualify as Accredited Investors

The proposed amendments would add the following new categories in the accredited investor definition for entities:

• Investment advisers registered under Section 203 of the Investment Advisers Act of 1940 and under the laws of the various states.
• Rural business investment companies (RBICs) as defined in Section 384A of the Consolidated Farm and Rural Development Act.
• Limited liability companies owning total assets in excess of $5 million and not formed for the specific purpose of acquiring the securities being offered.
• Any family office with at least $5 million in assets under management and its family clients, each as defined in the family office rule. In addition, in order to qualify as an accredited investor, the proposed amendments would require that the purchase by a family office is directed by a person who has such knowledge and experience in financial and business matters that such family office is capable of evaluating the merits and risks of the prospective investment. The proposed amendments would further require that the family office not be formed for the specific purpose of acquiring the securities offered.
• Any entity, including Indian tribes, labor unions, governmental bodies and funds, as well as foreign entities, owning investments in excess of $5 million, that was not formed for the specific purpose of acquiring the securities being offered. This category would serve as a "catch-all" category for other entities to qualify.

Spousal Equivalents to Pool Finances for the Purposes of Qualifying as Accredited Investors

The proposed amendments would allow natural persons to include joint income from spousal equivalents when calculating joint income under Rule 501(a)(6), and to include spousal equivalents when determining net worth under Rule 501(a)(5). According to the proposed amendments, spousal equivalent includes a cohabitant occupying a relationship generally equivalent to that of a spouse.

Conforming Changes to Rule 163B and Rule 144A

The proposed amendment also expands the safe harbor under Rule 144A for qualified institutional buyers (QIBs). To avoid inconsistencies between the entity types that are eligible for accredited investor status and QIB status, the proposed amendments would make conforming changes to the definition of QIBs in Rule 144A(a) to include limited liability companies and RBICs. The amendment would also expand the categories of entities that constitute QIBs by providing that entities that are institutional accredited investors would qualify as QIBs if they own and invest at least $100 million in securities. This new category in the QIB definition would encompass the proposed new catch-all category in the accredited investor definition.

Implications for Private Offerings

The definition of accredited investor is a central component of several exemptions from registration, such as Rules 506(b) and 506(c) of Regulation D, and plays an important role in other federal and state securities law contexts. 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 certain hedge funds, private equity funds, and venture capital funds. From a company's perspective, expanding those eligible to participate in private offerings should increase the company's opportunities for financing, especially at earlier stages. Companies will now be able to pursue investments from several large categories of investors that previously had a limited ability to participate in a private offering. Given the extensive reliance on Regulation D for capital raising, it will be interesting to see how significantly the changes impact the market for private securities offerings.

Peter A. Jaslow is a partner in Ballard Spahr's business and finance department. He advises clients regarding securities matters, including corporate governance, disclosure and compliance matters. In particular, he represents companies in public and private offerings and other capital-raising transactions, merger and acquisition transactions and a variety of commercial technology transactions. He can be reached at [email protected] or 215-864-8737.

Joanna Jiang is an associate at the firm. She counsels publicly traded and privately held companies on mergers and acquisitions, securities offerings, regulatory compliance, corporate governance, corporate formation, contract review, and other business and financing matters. She can be reached at [email protected] or 202-661-7644.