SEC Rulemaking: Who Now Qualifies As An “Accredited Investor”?
By Louis Lehot, business lawyer and partner at Foley & Lardner LLP in Silicon Valley, and formerly the founder of L2 Counsel, P.C. and the video blog series #askasiliconvalleylawyer, and Ethan Floyd, consulting attorney at L2 Counsel
Have you ever wanted to invest in a startup, a business, a fund or a real estate project, and been turned down because you were told that you did not qualify as an “accredited investor”? Have you ever tried to raise funds for an entity and been advised by counsel that you had to turn down willing investors because they were not wealthy enough to meet the definition of “accredited investor”? Stop the presses…the rules just changed…
On August 26, 2020, the United States Securities and Exchange Commission, or SEC, announced the adoption of a final rule to revise Rule 501(a), Rule 215, and Rule 144A of the Securities Act of 1933, which will come into effect within 60 days. The revised definition of “accredited investor” incorporates new categories of natural persons and entities eligible to participate in our private securities markets. According to the SEC, these amendments are intended to “update and improve the definition to more effectively identify institutional and individual investors that have the knowledge and expertise to participate in those markets.”
Why do these rules exist to begin with? The federal securities laws were adopted in the aftermath of the great depression to protect the integrity of the securities markets, and the SEC was created to police the markets against fraud and protect retail investors. The baseline underpinning the federal securities laws is that all transactions in securities must registered with the SEC, unless an exemption applies. Transactions in the private securities markets most often rely on an individual’s or an entity’s status as an “accredited investor” to avoid the expensive and time-consuming process to register a transaction.
Before the SEC’s most recent amendments, the test for qualification as a “accreditor investor” for natural persons only took under consideration an individual’s income or net worth. Usually, this meant that only the most well-heeled among us could qualify as an “accredited investor” and participate in the private securities markets. More specifically, the old definition included only those natural persons whose individual net worth, or joint net worth with their spouse, excluding their primary residence, exceeded $1 million, and those natural persons that had a personal income of more than $200,000 in each of the 2 most recent years, or joint income with their spouse of over $300,000 in each of these years, and that had an expectation of reaching the identical income level within the current year. This definition led to stratification of those eligible to participate in the United States’ private securities markets based on wealth.
The SEC’s new accredited investor definition also benefits natural persons, by expanding the scope of accredited investors to include those with sufficient professional knowledge, experience, or certifications. As a result, more people will qualify as accredited investors. Specifically, these expansions enable natural persons to qualify based on professional certifications, designations or other credentials, and who are “knowledgeable employees”, as defined in Rule 3c-5(a)(4) under the Investment Trust Act of 1940.
The SEC has also expanded the scope of entities that will qualify as accredited investors. Historically, an entity would qualify for “accredited investor” status been on Rule 501(a)(3) of Regulation D, which applies to an organization, trust, or partnership with total assets worth more than $5 million. Missing from this definition is a limited liability company — which was created after Regulation D was adopted. The SEC’s changes have finally included LLCs in revised section 501(a)(3).
The SEC has also incorporated an investments-owned test to qualify for “accredited investor” status. The investments-owned test is supposed to function as a “catch-all” by including entities not already encompassed within Rule 501(a); such as Indian tribes, labor unions, governmental bodies and funds, and entities formed under the laws of another country. Interestingly, the rule enables entity types that may not yet exist but could exist in the future. To qualify, the entity must merely own more than $5 million in investments. The logic behind this broadening is that these forms of entities should have the sophistication necessary to invest in private markets.
These new definitions serve to extend the scope of investors that are allowed to participate and benefit from investing in our private securities markets. These changes mean a more inclusive and accessible private securities marketplace for more Americans.
Louis Lehot is a partner and business lawyer with Foley & Lardner LLP, based in the firm’s Silicon Valley, San Francisco and Los Angeles offices, where he is a member of the Private Equity & Venture Capital, M&A and Transactions Practices and the Technology, Health Care, and Energy Industry Teams. Louis focuses his practice on advising entrepreneurs and their management teams, investors and financial advisors at all stages of growth, from garage to global. Louis especially enjoys being able to help his clients achieve hyper-growth, go public and to successfully obtain optimal liquidity events. Louis was the founder of a Silicon Valley boutique law firm called L2 Counsel. He previously served as both the co-managing partner and co-chair of the emerging growth and venture capital practice of a global law firm in Silicon Valley.