Pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”), the Securities and Exchange Commission (“SEC”) must review the definition of “accredited investor” every four years to determine whether it needs to be modified or adjusted. The SEC staff recently conducted its first review and issued a Report on the Review of the Definition of “Accredited Investor.”
The report provides an in-depth examination of the history of the “accredited investor” definition and discusses possible alternative approaches. The report also responds to comments on the existing definition received from various financial services industry participants, including the Investor Advisory Committee and the Advisory Committee on Small and Emerging Companies. Lastly, the report provides recommendations for potential updates and/or modifications to the existing definition.
Pursuant to the Securities Act of 1933 (“Securities Act”), all securities must be registered with the SEC prior to sale, absent some exemptions. One of the most widely used exemptions is contained in Section 4(a)(2) of the Securities Act for “transactions by an issuer not involving any public offering,” or private offerings. The Securities Act did not define what constituted a private offering, therefore the SEC issued Regulation D under the Securities Act to create a safe harbor for the private offering exemption and to define the category of investors to which private offerings could be made.
These investors were termed “accredited investors” by the SEC, and include sophisticated investors such as banks, private business development companies, certain entities with total assets in excess of $5 million, persons with net worth’s exceeding $1 million, any director, executive officer, or general partner of the securities issuer, persons with income in excess of $200,000 in two most recent years, or $300,000 with spouse, any trust with total assets in excess of $5 million, and any entity in which all equity owners are “accredited investors.”
The “accredited investor” definition in Regulation D is intended to serve as a bright-line category of investors whose financial sophistication and ability to withstand risk of losses from investments renders the protection provided by SEC registration unnecessary. Companies relying on Regulation D do not have to register their securities with the SEC, but instead must file a “Form D” with the SEC after first sale. In addition, these entities must comply with certain other requirements including not using general solicitation or advertising and abiding with the antifraud provisions of federal securities laws.
The income and net worth standards found in the “accredited investor” definition were originally adopted by the SEC in 1983. In recent years, a growing number of commentators have questioned whether the definition has become outdated, particularly given the effects of inflation. In addition, certain developments have occurred since 1983 which do not fall within the existing definition, such as the rise in use of limited liability companies. Therefore, the SEC staff recommends the following in its report: 1) Revising the financial threshold requirements for natural persons to qualify as “accredited investors” and the list-based approach for entities; and 2) Allowing individuals to qualify as “accredited investors” based on other measures of sophistication.
The SEC staff proposes to revise the income and net worth thresholds currently used to identify natural persons as “accredited investors.” As a result of inflation, the percentage of US population qualifying as “accredited investors” under the existing standards has risen from 2% to 10% in the past 30 years. In addition, the existing definition specifically enumerates types of entities that can qualify as “accredited investors,” such as banks, corporation, trusts, and partnerships, and has resulted in the exclusion of certain entities that should also be “accredited investors.”
In order to address these concerns, the SEC staff recommends several approaches to the SEC Commissioners for consideration. One approach is revising the inflation-adjusted income and net worth thresholds from $200,000 to $500,000 for individual income, $300,000 to $750,000 for joint income, and $1 million to $2.5 million for net worth. In the alternative, the SEC recommends keeping the current thresholds but imposing annual investment limitations such as 10% of prior year income or 10% of net worth in any 12-month period. The SEC also recommends indexing all financial thresholds for inflation on a going-forward basis, permitting spousal equivalents to pool their finances for the purpose of qualifying as “accredited investors,” permitting all business entities with investments in excess of $5 million to qualify as “accredited investors,” and adopting grandfathering provisions for issuer’s investors that meet the current “accredited investor” definition.
The SEC staff also proposes to revise the “accredited investor” definition to allow individuals to qualify as “accredited investors” based on other measures of sophistication besides the current financial measures of income and net worth. It acknowledges that financial sophistication and the ability to absorb risk of loss provide different ways of assessing an investor, and the “accredited investor” definition should take this into account. In furtherance of this the SEC recommends several approaches including permitting individuals with a minimum amount of investments to qualify as “accredited investors,” permitting individuals with certain professional credentials such as a Series 7 or Series 65 license to qualify as “accredited investors,” permitting individuals with experience investing in exempt offerings to qualify as “accredited investors,” permitting knowledgeable employees of private funds to qualify as “accredited investors” for investments in their employer’s funds, and permitting individuals who pass an “accredited investor examination” to qualify as “accredited investors.”
At this juncture it is unclear which recommendations the SEC Commissioners will decide to implement. The SEC is currently inviting comments on the existing “accredited investor” definition, as well as its recommendations. Those who wish to submit comments should fill out this online form on the SEC’s website.
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