The New Definition of “Accredited Investor”
For nearly 40 years- spanning six different US Presidents, nine different SEC Chairs and five bull markets- the definition of “accredited investor” has not experienced any substantial modification. That all changed on August 26, 2020, when the Securities and Exchange Commission (SEC) adopted final amendments to the “accredited investor” definition which fundamentally broadens the qualification standards and increases access to investments in the private capital markets. These amendments are game-changing and, for the first time, include both new, non-wealth based, categories for investors that include financial professionals as well as several new entity categories.
The new changes signal the latest step in a general direction that the U.S. has been heading towards facilitating better access to capital for startups and wider access to alternative investments through the easing of restrictions on individual investors.
Who Can Now Qualify as an Accredited Investor?
The rules governing accredited investors are designed to protect individual investors. They’ve operated on the idea that the private markets are riskier and less transparent than public markets and that only higher net-worth investors should thus be able to participate. But the regulations have also drawn criticism for being too exclusionary and keeping investment opportunities among the wealthiest people.
Until now, accredited investors were defined solely by monetary metric: The thresholds stood at a net worth of at least $1 million excluding the value of primary residence, or income at least $200,000 each year for the last two years (or $300,000 combined income if married). The new rules expand the definition to those with knowledge of the financial markets, such as licensed brokers or employees of financial institutions.
The new amendments to the accredited investor definition also increases the list of entities that can qualify as accredited investors. Let’s take a look at the immediate additions to the list of Accredited Investors:
- All holders in good standing of the Series 7, Series 65, and Series 82 licenses (for broker-dealers and investment advisers) without regard to their net worth or annual income;
- “Knowledgeable Employees” of a private investment fund without regard to their net assets or annual income (but this only applies to investments in the investment fund that employs them);
- Limited liability companies with $5 million in assets that was not formed for the specific purpose of investing in the securities offered (even if some of its owners are not accredited);
- “Family Offices” with at least $5 million in assets under management and their “Family Clients” (as each term is defined under the Investment Advisers Act);
- Registered (either state or SEC) investment advisers, exempt reporting advisers, and rural business investment companies (RBICs);
- Any entity, including Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries, that own “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered; and
“Spousal Equivalents” may pool their finances for the purpose of qualifying as Accredited Investors.
Why is this Significant?
For some time the SEC has been kicking around ideas to, in its own words, “simplify, harmonize, and improve the exempt offering framework, thereby expanding investment opportunities while maintaining appropriate investor protections and promoting capital formation.” In particular, since June of 2019, the SEC has released a series of proposals/reports discussing potential amendments to the existing “accredited investor” definition and opening the same to public comment. Their efforts culminated in late August with the adoption and release of its final rule which significantly amends Rule 501. In the final release, SEC Chairman Jay Clayton is quoted as saying:
“Today’s amendments are the product of years of effort by the Commission and its staff to consider and analyze approaches to revising the accredited investor definition, …For the first time, individuals will be permitted to participate in our private capital markets not only based on their income or net worth, but also based on established, clear measures of financial sophistication. I am also pleased that we have expanded and updated the list of entities, including tribal governments and other organizations, that may qualify to participate in certain private offerings.”
These amendments have been a long time coming and represent the culmination of years of heated debate. While there have been various bills and other legislation put forth over the years to accomplish one or more of the final rule amendments, none have succeeded until now. We are truly on the precipice of witnessing a mass opening of the private securities market. Ultimately, this will materially improve the private capital markets as well as allow more investors to participate in them.
The more inclusive definition may have the effect of expanding the opportunities for investors to participate in private funds and those investment opportunities that have historically been relegated to investors meeting a strict requirement of liquid wealth. As a result, many sophisticated investors seeking to make “fund” investments could only do so through registered securities offerings (mutual funds). The wealth test for accreditation presumed that those who had wealth were cerebral enough to fend for themselves in investing in private offerings. However, those who were sophisticated and well-educated on the subject of private offerings, but lacked the net worth, were not. The investment universe is increasingly opening up to investors of varying wealth, and with it, alternatives and private offerings are being democratized and made accessible to investors of varying financial backgrounds.
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