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October 13, 2020

Stroock Client Alert

By: Akshay N. Belani, Evan Hudson, Richard G. Madris, André B. Nance, Eric Requenez, John J. Sottile

On August 26, 2020, the SEC adopted amendments updating the definitions of (i) “accredited investor” in Rule 215 and Rule 501(a) of Regulation D under the Securities Act of 1933 (the “Securities Act”) and (ii) “qualified institutional buyer” in Rule 144A under the Securities Act (the “Amendments”).  Prior to the Amendments, the definition of accredited investor prohibited all persons who did not meet certain income or net worth requirements, regardless of their sophistication level, from participating in investment opportunities in products that were, pursuant to Regulation D, not subject to the disclosure requirements of the Securities Act. By updating the definition, the SEC has expanded such investment opportunities to sophisticated investors who have the knowledge and expertise to make informed decisions about such investments but were otherwise prevented from investing due to the existing income and net worth requirements. 

The final rule was published in the Federal Register on October 9, 2020 and will become effective on December 8, 2020, 60 days after its publication. [1] This Stroock Client Alert describes key components of the Amendments.

Credentialed Individuals

Pursuant to the amended definition of accredited investor, natural persons holding certain qualifying credentials will now be able to qualify as accredited investors. As an initial matter, the SEC designated the General Securities Representative license (Series 7), the Private Securities Offerings Representative license (Series 82) and the Licensed Investment Adviser Representative (Series 65) as qualifying credentials, while retaining the ability to add additional qualifying credentials in the future by order.            

Knowledgeable Employees

In addition to expanding the definition of “accredited investor” to individuals with specific professional credentials, the SEC amended the definition to include “knowledgeable employees” of private funds when making investments in those funds. The definition of “knowledgeable employees,” pursuant to Rule 3c-5(a)(4) under the Investment Company Act of 1940 (the “Investment Company Act”), includes “among other persons, trustees and advisory board members, or persons serving in a similar capacity, of a Section 3(c)(1) or 3(c)(7) fund or an affiliated person of the fund that oversees the fund’s investments, as well as 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.”[2] The SEC’s rationale for including knowledgeable employees is that such persons, through their positions as employees, are likely to have obtained significant investment knowledge and experience and be able to make informed decisions about investment in the fund.  Further, the SEC noted that “allowing these employees to invest in the funds for which they work (and other funds managed by their employer) as accredited investors also may help to align their interests with those of other investors in the fund.”[3] Additionally, the SEC noted that the inclusion of these employees as accredited investors will not affect the accredited investor status of funds with assets of $5 million or less. Under Rule 501(a)(8), a private fund with assets of $5 million or less can qualify as an accredited investor if all the fund’s equity owners are accredited investors. Capturing a private fund’s employees as accredited investors permits those employees to invest in the fund’s offerings while allowing the fund to retain its accredited investor status.           

Additional Entities

The Amendments also add several entities to the definition of “accredited investor.” SEC- and state-registered investment advisers, exempt reporting advisors, rural business investment companies (“RBICs”) and limited liability companies with $5 million in assets have all been added to the definition of “accredited investor,” as well as new a catch-all category for “any entity owning ‘investments,’ as that term is defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million that is not formed for the specific purpose of acquiring the securities being offered.”[4]

Family Offices

The Amendments also add to the definition of “accredited investor” certain family offices and their family clients, with “family office” defined in the “family office rule” set forth in Rule 202(a)(11)(G)-1 of the Investment Advisers Act of 1940 as: “(i) it has at least $5 million in assets under management, (ii) it is not formed for the specific purpose of acquiring the securities offered, and (iii) its prospective investment 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.”[5] The “family clients” are defined as those whose investment is directed by the family office.

Spousal Equivalents

A final addition to the definition of “accredited investor” is the inclusion of the term “spousal equivalent,” defined as a cohabitant occupying a relationship generally equivalent to that of a spouse, and allowing for the inclusion of joint income from spousal equivalents when calculating joint income under Rule 501(a)(6), and when determining net worth under Rule 501(a)(5).  This change will allow both spouses and spousal equivalents to pool their finances to qualify as accredited investors.  In a note to the Amendments the SEC clarified that “[j]oint net worth can be the aggregate net worth of the investor and spouse or spousal equivalent; assets need not be held jointly to be included in the calculation.”[6]

Amendments to QIB Definition

The SEC also amended Rule 144A to update the definition of “qualified institutional buyer” (“QIB”) to avoid inconsistencies between the entity types that are eligible for accredited investor status and QIB status.  The Amendments add RBICs to Rule 144A(a)(1)(i)(C) and limited liability companies to Rule 144A(a)(1)(i)(H), as well as new paragraph (J) to Rule 144A(a)(1)(i), as another catch-all which allows “institutional accredited investors under Rule 501(a), of an entity type not already included in paragraphs 144A(a)(1)(i)(A) through (I) or 144A(a)(1)(ii) through (vi), to qualify as qualified institutional buyers when they satisfy the $100 million threshold.”[7]  This new category in the QIB definition will encompass the new category in the accredited investor definition for entities owning investments in excess of $5 million that are not formed for the specific purpose of acquiring the securities being offered under Regulation D, as well as any other entities that may be added to the accredited investor definition in the future, although such entities would also have to meet the $100 million threshold in order to be QIBs under Rule 144A.  As a result, Indian tribes, governmental bodies and bank-maintained collective investment trusts will now qualify as QIBs.

Conclusion

Given the extensive number of comments received and considered in connection with the Amendments, and the care the SEC took to explicitly reserve the ability to amend and add to the definitions, it is likely we will see future amendments and additions under which a greater number of individuals and entities will be covered under future expansions to the definitions of “accredited investor” and “qualified institutional buyer.” The aggregate effect of the Amendments and the likely effect of future amendments, is a liberalization of the securities laws.

Although the Amendments will capture a larger and more diverse population of investors than the previous definitions of “accredited investor” and “qualified institutional buyer,” the SEC was neither able to estimate nor did it speculate on the extent of such increase.  Private investment funds and other issuers that rely on Regulation D to offer securities should work with legal counsel to prepare amendments to their subscription documents and offering materials in advance of the December 8, 2020 effective date of the Amendments.

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For More Information:

Akshay N. Belani

Evan Hudson

Richard Madris

André B. Nance

Eric Requenez

John J. Sottile

[1] Accredited Investor Definition, 85 Fed. Reg. 64,234 (Oct. 9, 2020) [hereinafter Amendments].

[2] Amendments at 64,244.

[3] Amendments at 64,244.

[4] Amendments at 64,247.

[5] Amendments at 64,249.

[6] Amendments at 64,277.

[7] Amendments at 64,257.

This Stroock publication offers general information and should not be taken or used as legal advice for specific situations, which depend on the evaluation of precise factual circumstances. Please note that Stroock does not undertake to update its publications after their publication date to reflect subsequent developments. This Stroock publication may contain attorney advertising. Prior results do not guarantee a similar outcome.