In this Ropes & Gray podcast, asset management partners Melissa Bender and Marc Biamonte, and asset management counsel Jessica Marlin discuss the changes recently adopted by the SEC to modernize the definitions of an “accredited investor” in Securities Act Rules 215 and 501(a) and a “qualified institutional buyer” under Rule 144A.
Melissa Bender: Hello, and thank you for joining us today on this Ropes & Gray podcast, the latest in our series of podcasts focused on topics of interest for asset managers and institutional investors. I’m Melissa Bender, a partner in our asset management group based in San Francisco. Joining me today are Marc Biamonte, an asset management partner in our New York office and Jessica Marlin, counsel in our asset management group and also in New York. Today, we will be discussing the recent changes the SEC adopted to the definitions of an “accredited investor” in Securities Act Rules 215 and 501(a) and a “qualified institutional buyer” under Rule 144A.
The “accredited investor” definition plays an important role in the SEC’s framework for exempt offerings. The current accredited investor definition primarily uses income and net worth thresholds to identify natural persons as accredited investors, however, some entities—such as banks, savings and loan associations, registered broker-dealers, insurance companies and investment companies registered under the Investment Company Act of 1940—qualify as accredited investors based on their status alone. Other entities may qualify as accredited investors based on a combination of their status and the amount of their total assets. Qualifying as an accredited investor is significant because accredited investors are often eligible to participate in investment opportunities that are generally not available to non-accredited investors, such as many investments in private companies and offerings by certain hedge funds, private equity funds and other private funds.
Jess, would you like to take us through an overview of the amendments?
Jessica Marlin: Thank you, Melissa. The SEC made nine primary additions to the accredited investor definition – three for natural persons and six for entities. For natural persons, these include adding knowledgeable employees, individuals with professional certifications (preliminarily these include series 7, 65 and 82), and spousal equivalents. For entities, these include limited liability companies who otherwise meet the qualifications applicable to corporations, all SEC and state registered investment advisers, exempt reporting advisers, rural business investment companies, any entities, including Native American tribes, owning investments in excess of $5 million, and family offices with at least $5 million in assets under management and their family clients. Similar revisions were made to the QIB test. All of the other aspects of the definitions, including the monetary thresholds were maintained.
Overall, these additions broaden the scope of the definitions and therefore broaden the pool of individuals and entities eligible to invest in private offerings. However, we caution that these revisions taken together are not particularly material from an offering perspective – they are largely aimed at codifying long-held staff positions, clarifying issues and memorializing some technical issues with these definitions that have existed due to their age (for example, clarifying that LLCs can qualify as accredited investors), and therefore you shouldn’t view this as a particularly monumental change to a sponsor’s offering ability, especially where otherwise offering only to qualified purchasers under 3(c)7 which is already a higher standard. These changes will be effective 60 days from being published in the Federal Register. Once published, the effective date will appear on the SEC website where this final rule is listed.
These amendments were adopted substantially as proposed in December 2019 and are part of the SEC’s overall effort to simplify and streamline rules, while broadening market access. In response to the proposed rules, some major groups pushed for the SEC to take this a step further, and declare that any qualified purchaser is by definition also an accredited investor. However, the SEC declined to take this approach, which would have very much simplified the subscription agreement process for our private fund sponsor clients, among others. These groups argue that someone who meets the qualified purchaser test, is also very likely to have the sophistication required of an accredited investor.
The final release makes the point that while the accredited investor definition originally focused on wealth as a proxy for financial sophistication of natural persons, the SEC is now taking the view that wealth should not be the only way that an individual investor can establish financial sophistication. These additional categories for natural persons are reflective of that view.
Marc, could you discuss the amendments to the definition of accredited investors for natural persons, which are probably the more significant of the amendments here?
Marc Biamonte: Sure, thanks, Jess. Probably of most particular note, is that the knowledgeable employee exception, which previously only applied as an exception to the qualified purchaser requirement (meaning that knowledgeable employees still needed to be accredited investors) is now applicable both to the accredited investor requirement and the qualified purchaser requirement. As a result, to the extent a sponsor had “knowledgeable employees” who didn’t meet the prior accredited investor income or net worth qualifications, these employees would now be able to invest in the sponsor’s funds. This comes up not infrequently for our clients and especially with their more junior employees, so this will be helpful to those folks wanting to invest.
The second addition relevant for natural persons is to permit individuals with certain professional certifications to qualify as accredited investors. This is noteworthy in that it is a new concept under the accredited investor definition. The proposed rule outlined a list of exclusive attributes that the SEC would consider in determining precisely which certifications qualify an investor as an accredited investor. These generally include certifications, designations, and examinations that demonstrate a person’s financial experience and sophistication, and ability to evaluate the risks of an investment. By order, the SEC has initially included series 7, series 65 and series 82 FINRA license holders, but has the flexibility to include others in the future.
The third amendment added the category of a “spousal equivalent.” For this purpose, a “spousal equivalent” is a cohabitant occupying a relationship generally equivalent to that of a spouse. So for an investor to jointly qualify with another person as an accredited investor by “pooling” assets, that other person can be a spouse or a spousal equivalent. The SEC also codified several staff interpretations in this area, including that the calculation of “joint net worth” can the be the aggregate net worth of the investor and the investor’s spouse or spousal equivalent, that the securities being purchased by an investor relying on the joint net worth test need not be also purchased jointly, and finally that when determining the accredited investor status of an entity qualifying on the basis that all its equity owners are accredited investors, you can look through to natural persons.
Melissa, will you take us through the changes to the accredited investor test for entities?
Melissa Bender: Yes, thanks, Marc. The first addition for entities is that they now permit “any entity owning investments” in excess of $5 million that is not formed for the specific purpose of acquiring the securities being offered to qualify as an accredited investor. This catch-all category was added in part to allow foreign governments, entities organized under foreign jurisdictions, labor unions, and Native American tribes to qualify as accredited investors. However, the SEC specifically used the term “investments” rather than “assets” to better demonstrate the investor has experience investing and therefore, in their view, has a level of sophistication similar to that of other institutional accredited investors. As an example, occasionally, we come across this issue of how to qualify a Native American tribe. Historically, many Native American tribes active in the private fund space created entities for accredited investor qualification purposes due to this technical issue of a “tribe” not being able to qualify as an accredited investor. Foreign governments often take a similar approach. So while this is really a clarification that is not particularly interesting for many investors, this clarification certainly alleviates some technical issues that have plagued these groups of investors in the past.
The second addition for entities is an explicit provision for family office and family office clients with $5 million in investments that were not formed for the specific purpose of acquiring the securities offered, and that have their investments directed by a person who is capable of evaluating the risks of the investment. However, for most family offices, this is less significant because most family offices already qualified as accredited investors.
The third, fourth and fifth additions were to extend accredited investor status to all SEC and state registered investment advisers, exempt reporting advisers, and Rural Business Investment Companies, none of which have to meet the $5 million threshold.
Lastly, in the sixth addition for entities, the SEC codified a long-held staff position by specifically adding limited liability companies that otherwise meet the conditions applicable to corporations.
Marc, could you speak to the amendments to the QIB test?
Marc Biamonte: Thanks, Melissa. As Jess mentioned earlier, as part of the same rulemaking, similar amendments were also made to the definition of “Qualified Institutional Buyer” in Rule 144A under the Securities Act. Rule 144A provides a non-exclusive safe harbor from registration under the 1933 Act for certain private resales of securities to QIBs. We note that the QIB test is relevant for private credit funds who routinely need to be able to make a QIB representation in order to purchase many privately offered debt securities. They either need for the fund itself to qualify as a QIB, which requires that the fund has $100 million in investments at the time of the reprepresentation, excluding capital commitments and cash, or they need for all their investors to be QIBs.
Like the accredited investor changes, these amendments expand the list of entities eligible for QIB status while still maintaining the requirement that the entity in the aggregate owns and invests on a discretionary basis at least $100 million in securities of issuers that are not affiliated with such entity. The SEC specifically added Rural Business Investment Companies (RBICs) and limited liability companies. The SEC also added any entity type that qualifies as an accredited investor under revised Rule 501(a) that isn’t already enumerated under the Rule 144A, so long as the entity meets the $100 million threshold.
Jess, when do sponsors need to think about revising their subscription documents?
Jessica Marlin: Thanks, Marc. As I’d mentioned, these final rules will be effective 60 days’ from being published in the federal register. As of the date of this podcast, they have not been published. So for any closings, on or after the date of effectiveness, you can admit investors under the new rules. We would not recommend relying on the rules before they are effective. As a result, you can start the process of updating your form of subscription agreement and questionnaire now, but you won’t want to distribute updated sub docs to prospective investors until you know that they will be admitted at a closing after the new rules are effective.
Thank you, Marc and Melissa, for joining me today in this discussion, and thank you to our listeners. For more information on the topics we discussed or other topics of interest to the asset management industry, please visit our website at www.ropesgray.com. And of course, we can help you navigate any of the topics we discussed – please don't hesitate to get in touch. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening.
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