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The SEC on Aug. 26, 2020, issued a final rule that revises the definition of an “accredited investor” by adding new categories of individuals who may qualify based on their professional knowledge, experience or certifications. Previously, the definition was solely based on a person’s wealth.

The revised definition in Rule 501 in Regulation D under the Securities Act of 1933 means that hundreds of thousands of more people would potentially be able to invest in private offerings. Unlike securities that are registered with the commission and trade on the public markets, securities in private offerings comply with fewer regulatory requirements, but they can also provide greater returns.

Among other things, an individual who holds a Series 7, 65, or 82 license in good standing will qualify. Previously, an individual qualified only if he or she had at least an income of $200,000, joint income of $300,000, or at least $1 million in net worth, excluding a primary residence. It was designed so that the investors can withstand financial losses. That threshold, set in 1982, has not been changed, and some investor advocates said it should be adjusted to reflect inflation. But the final rule does not adjust that threshold.

A Series 7 holder is a licensed general securities representative, and the license was developed by the Financial Industry Regulatory Authority, Inc. (FINRA). North American Securities Administrators Association (NASAA) developed Series 65 — licensed investment adviser representative. FINRA developed Series 82, licensed private securities offerings representative.

The final rules are in Release No. 33-10824, Amending the “Accredited Investor” Definition. The rules become effective 60 days after publication in the Federal Register.

The SEC issued a separate order designating the three licenses that meet the new definition of an accredited investor in Release No. 33-10823, Order Designating Certain Professional Licenses as Qualifying Natural Persons for Accredited Investor Status Pursuant to Rule 501(a)(10) under the Securities Act of 1933.

The commission said that this approach of issuing an order gives the commission flexibility to reevaluate or add other certifications, designations, or credentials in the future. Members of the public may propose additional certifications or credentials for the commission’s consideration, the agency added.

As of December 2019, there were 691,041 registered securities representatives and 17,543 state registered investment adviser representative, according to Release No. 33-10824.

“The Commission’s use of income or wealth as the exclusive proxy for an individual’s financial sophistication and ability to assess and bear risk has long been unsatisfactory,” SEC Chairman Jay Clayton said in a statement. “Individual investors who do not meet the wealth tests, but who clearly are financially sophisticated enough to understand the risks of participating in unregistered offerings, are denied the opportunity to invest in our private markets.”

3 to 2 vote

However, not every commissioner was on board with the rules, with two Democratic Commissioners dissenting. The vote was held without a public meeting.

In a joint public statement, Commissioners Allison Herren Lee and Caroline Crenshaw took issue with the majority’s decision not to index the wealth thresholds to inflation and not providing economic analysis to show how this will affect investors.

They said this policy choice goes against widespread support to raise the thresholds. “Such support is hardly surprising given that the failure to update the thresholds thus far has resulted in an increase of 550% in qualifying households since 1983,” Lee and Crenshaw said.

Clayton disagreed, saying that it is not clear that people with $1.5 million in net worth are any more financially sophisticated than those who have a net worth of $1 million, $500,000, or $50,000.

“This point demonstrates why simply adjusting these thresholds is not the practical question we should be attempting to address,” he said. “Instead, the practical question should be, how do we improve the system we have to more closely track our mission?... We add an alternative test that more accurately tracks the Commission’s policy goal — ‘to identify investors that have sufficient financial sophistication to participate in investment opportunities’ in the private capital markets.”

But Commissioners Lee and Crenshaw also said that the final rule does not address known risks to investors.

“With its actions today, the Commission continues a steady expansion of the private market, affording issuers of unregistered securities access to more and more investors without due regard for the risks they face, and without sufficient data or analysis to ensure that our policy choices are grounded in fact rather than supposition,” they said.

In addition to adding certain financial professionals to the definition, the SEC expanded the list of entities that may qualify as accredited investors:

  • Individuals who are “knowledgeable employees with respect to investments in a private fund;
  • limited liability companies with $5 million in assets and rural business investment companies (RBICs);
  • Indian tribes, governmental bodies, funds and entities organized under the laws of foreign countries, that own investments of more than $5 million;
  • “family offices” with at least $5 million in assets under management and their “family clients”; and
  • add the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors.

Further, the final rule changed the definition of the “qualified institutional buyer” (QIB) in Rule 144A of the Securities Act to expand the list of entities that are eligible to qualify as QIBs, which are companies that own and invest a minimum of $100 million in securities not affiliated with the company on a discretionary basis. Rule 144A will include limited liability companies and RBICs.

The revisions also add to the list of any institutional investors that are not otherwise enumerated in QIB as long as they have more than $100 million.

Republicans in Congress and businesses welcomed the change.

“I have encouraged the SEC to expand and modernize the definitions of an accredited investor and a qualified institutional buyer beyond simple monetary thresholds, to take into consideration education and expertise,” Sen. Mike Crapo, chairman of the Senate Banking Committee, said in a statement. “The adoption of today’s amendments is a welcome development, and I commend the SEC for taking actions to increase investor participation in private offerings and expand access to capital markets.”

Thomas Quaadman, executive vice president of the U.S. Chamber Center for Capital Markets Competitiveness, said the rule will provide Main Street investors greater opportunities to build wealth. And “by expanding the definition of accredited investor, the SEC is providing growing companies new sources of capital,” he said.

The final rule is largely based on a proposal issued in December 2019: Release No. 33-10734, Amending the “Accredited Investor” Definition.

 For more information on this topic, or to learn how Baker Tilly SEC accounting specialists can help, contact our team.

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