New Rules Effective on Dec 8 Open Private Markets to More Investors: SEC Expands “Accredited Investor” and” Qualified Institutional Buyer” Definitions

Traditionally, most people have been unable to invest in the private placement market because alternative investments have generally been reserved for those considered by regulators to be wealthy enough to bear the risks. Such qualified entities and individuals, known as accredited investors, feed much-needed capital into the private placement market by participating in publicly solicited offerings such as Rule 506(c). Now, after 35 years of largely unchanged rules that qualify the investors in many private placement offerings, the U.S. Securities and Exchange Commission (SEC) has expanded the definitions of “accredited investor” and “qualified institutional buyer.” Adopted on August 26, 2020 and taking effect December 8th, 2020, the final rules add new investor categories that reflect the "financial sophistication" level of various individuals and institutions. We will now discuss more about these new amendments and how they may affect you, either as an issuer or an investor.

Limitations of the Accredited Investor Standard

Rule 506(c) crowdfunding trends suggest that public advertising has been crucial to many startups and other private companies. However, preexisting accredited investor tests have greatly narrowed the investor pool for such offerings, since the tests were based mostly on income and net worth. For individuals, this generally means $200,000 USD of annual income ($300,000 USD with a spouse) in each of the previous two years, and has a reasonable expectation to meet the threshold for the current year, or $1 million USD of net worth excluding the value of the primary residence. Now, the new rules will take financial knowledge and experience into account as well.

This is not the first time that reforms to the accredited investor criteria have been discussed. In December of 2019, the SEC requested comments on potential rules similar to the newly adopted regulations, sparking a variety of reactions. In the past, the legislature has attempted changes to the accredited investor standard as well, with little success.

New Ways for Individual Investors to Qualify

Many new categories were added to the individual category as well as some previous categories being amended as listed below:

●  The SEC deems “natural persons” with certain certifications, licenses, and other credentials to be “financially sophisticated” enough to qualify as accredited investors. Accepted certifications from accredited educational institutions will initially include the Financial Industry. Regulatory Authority, Inc. (FINRA) Licensed General Securities Representative (Series 7), Licensed Investment Adviser Representative (Series 65), and Licensed Private Securities Offerings Representative (Series 82).

●  Additionally, "knowledgeable employees" of venture capital or private equity funds would be permitted to invest in those particular funds without meeting the income or net worth tests typically required of accredited investors.

●  Lastly, the spouse definition has been amended to include “spousal equivalent” when combining income to meet the $300,000 USD income requirement or the $1,000,000 net worth requirement.

Expanding the Private Placement Market to More Institutions

The newly adopted amendments to the “accredited investor” and “qualified institutional buyer” definitions will open the private placement market to any entity that meets certain requirements, as long as the entity was not formed for the purpose of investing in the private placement offering in question.

●  These newly allowed entities include governmental bodies, funds, and Indian tribes owning over $5 million USD in “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, and not formed for the specific purpose of investing in the securities offered.

●  Limited liability companies with $5 million USD in assets may be accredited investors, as may SEC- and state-registered investment advisers, exempt reporting advisers, and rural business investment companies (RBICs) as long as it is not formed for the specific purpose of investing in the securities offered.

●  Family offices with $5 million USD or more in assets, along with their “family clients” of those offices, may invest in the private markets.

Regarding the amended “qualified institutional buyer” definition, the SEC press release stated:

“The amendments expand the definition of “qualified institutional buyer” in Rule 144A to include limited liability companies and RBICs if they meet the $100 million USD in securities owned and invested threshold in the definition.  The amendments also add to the list any institutional investors included in the accredited investor definition that is not otherwise enumerated in the definition of ‘qualified institutional buyer,’ provided they satisfy the $100 million USD threshold.”

Supplementary Accredited Investor Method Addition

On November 2nd, 2020 the SEC announced another accredited investor verification method to the non-exclusive list in Rule 506(c). As stated by the SEC the proposed item will, “allow an issuer to establish that an investor that the issuer previously took reasonable steps to verify as an accredited investor remains an accredited investor as of the time of a subsequent sale if the investor provides a written representation that the investor continues to qualify as an accredited investor and the issuer is not aware of information to the contrary.” There is also a five-year time limit on the ability of issuers to rely on a prior verification. Although this was announced recently this particular definition will not be made into law with the other methods on December 8th. Instead this will be added to the final rule 60 days after the SEC publishes it to the Federal Register, which is still pending as of posting this article.

Who Is Financially Sophisticated?

Beyond the credentials mentioned earlier, the SEC has not yet elaborated on the education or knowledge required for “financial sophistication”. We do not yet know which institutions or types of institutions might be called “accredited educational institutions,” or which courses might be needed for qualifying investors to participate in SEC-exempt offerings such as Rule 506(c). The SEC press release stated that members of the public may suggest institutions, courses, and other requirements so that the “financial sophistication” category may expand in the future.

The Financial Industry Reacts

The new additions to the accredited investor definition did not just appear out of thin air. A large amount of dialogue within the industry has focused these changes for a few years now. At SEC open forums and around the private equity industry, industry professionals and investors have been asking for many of these changes and many even disagree and want even more reform of the accredited investor definition. Every one of these changes has been discussed at length by both the SEC and industry professionals. Opinions ranged from support of the proposed amendments to extremes such as the total elimination of the accredited investor definition altogether.

During the SEC open business forum in July 2020, comments were gathered in regards to each amendment topic. For example, many commenters were happy with the addition of a professional certification category, as those individuals felt knowledgeable financial professionals should be able to make smart investment decisions regardless of their personal wealth. In the middle of the opinion spectrum were commenters who mostly agreed with the changes. Many felt the SEC did not go far enough to ensure inclusivity of individuals who may not hold professional licensure, but still possess the knowledge required to make informed decisions on private investments. On the other end of the spectrum, commenters noted that financial professionals may be able to make good investment decisions, but would not be able to bear the burden of investment loss and therefore an accredited investor should still be a high-net worth person for that very reason. How will these changes affect the potential pool of investors?

Although the new changes will increase the number of potential investors somewhat, some crowdfunding experts say that the effects will be quite limited. Adam Kaufman, co-founder, and COO of ArborCrowd noted that the changes aren’t very inclusive and benefit mostly those already in the financial industry. “[The change] only slightly increases things for people in the know, and people with a more acute understanding of the industry. It doesn’t open the net to be drastically more inclusive than that," he said, as cited by Commercial Observer.

Jeff Holzmann, CEO of crowdfunding company IIRR Management Services, has spoken out in favor of lowering the income threshold qualifying an individual as an accredited investor, from $200,000 USD to $100,000 USD. As cited in the Commercial Observer article, he believes that rules created before the Internet age no longer apply in the same way, since the Internet has made investing so much more accessible. In contrast, a Brookings Institute report had previously recommended adjusting the income threshold for inflation, noting that when the rule was created in 1982, only 0.53% of the U.S. population qualified as accredited investors. This change, if implemented in the future, would raise the income requirement to more than $500,000 USD and reduce the pool of accredited investors, which now stands at about 9%.

As cited by Cointelegraph, trading platform Uphold’s chief revenue officer, Robin O’Connell, praised the regulators for adapting, and Zcoin founder Poramin Insom anticipates that the change will benefit future security token offerings. Gemini co-founder Tyler Winklevoss tweeted his praise: "Kudos to the SEC for acknowledging that a penniless GenZ’er can be just as sophisticated an investor as a Wall Street Boomer. Wealth does not equal investment acumen, just look at how the Wall Street ‘experts’ missed the #Bitcoin rocket ship."

The discourse surrounding each and every new amendment varies considerably, as noted by the specific example of the professional certification amendment. How the SEC proceeds with future amendments really comes down to industry engagement. Financial professionals, investors, or anyone in the private equity sector should keep their ear to ground and engage as much as possible with the SEC to make their voices heard.

With third-party accredited investor verification services like VerifyInvestor.com, it's no longer necessary for issuers to conduct their reviews of their investors' sensitive financial information to comply with regulations such as Rule 506(c). Instead, VerifyInvestor.com offers an easier way, and we will be adding the newly adopted accredited investor categories to our verification process. We engage third-party attorneys to conduct expert verification reviews with confidence and confidentiality.

For an helpful infographic that explains the Accredited Investor Definition you can click Accredited Investor Definition infographic