SEC Proposes Changes to the Definition of “Accredited Investor”
The Securities and Exchange Commission (SEC) recently proposed new rules that, if adopted, would modify the definition of an “accredited investor.”1
Importantly, the proposed rules would apply only to individuals investing in certain “private investment vehicles,” such as certain hedge funds and private equity funds. The proposed rules would not apply to investments in other unregistered securities. Moreover, the proposed rules would not modify the definition of an accredited investor with respect to non-natural persons, including institutional investors and business entities.
As of this date, the SEC has not yet adopted the proposed rules as final. Public comments on the proposed rules ended on March 9, 2007.
Background
Since 1982, issuers of securities have been able to rely on Regulation D, a safe harbor adopted under the Securities Act of 1933, which allows them to issue and sell securities in private placements without registering those securities with the SEC. Under Rule 506 of Regulation D, an issuer may sell an unlimited amount of unregistered securities to investors provided those investors are so-called “accredited investors.”2 The purpose of the accredited investor qualification is to limit the purchasers of such unregistered securities to only those individuals having sufficient financial sophistication and, therefore, the ability to evaluate the risks and rewards of investing in a private offering.
Under the current rules, an individual qualifies as an accredited investor if that individual meets either of two tests:
(1) The individual’s net worth, or joint net worth when combined with his or her spouse, exceeds $1,000,000 at the time the securities are purchased (the “net worth test”); or
(2) The individual had an income exceeding $200,000, or a joint income with his or her spouse exceeding $300,000, in each of the two most recent years, and that individual or couple expects to meet those income thresholds in the current year (the “income test”).3
Recently, the SEC has expressed concern that the existing accredited investor standards, adopted in 1982, are now antiquated. In its current rule proposal, the SEC notes that “inflation along with sustained growth in wealth and income in the 1990s has boosted a substantial number of investors past the ‘accredited investor’ standard.” Moreover, the SEC added, “the increase in the value of personal residences” has further contributed in creating accredited investors out of otherwise financially unsophisticated individuals. These concerns, in part, motivated the SEC’s new proposed rules.
Proposed changes
The SEC’s proposed rule would modify the definition of an accredited investor for private investment vehicles by adding an additional requirement: a new minimum existing “investments test.” The purpose of this additional test is to ensure that individuals who qualify as accredited investors are sufficiently financially sophisticated to decide whether to invest in an unregistered offering.
Limited scope. The new rules, however, apply only to individuals investing in the securities of a private investment vehicle. The SEC limited its changes to private investment vehicles out of an apparent concern that certain private pooled investment companies, namely aggressive hedge funds or other similar private equity funds, use “complicated investment strategies” and “offer minimal information” to potential investors. Currently, such funds use the safe harbor of Regulation D to sell unregistered securities to accredited investors. By tightening the qualifications of an accredited investor with respect to such funds, the proposed rules would reduce the number of individuals who would qualify as an accredited investor and ostensibly protect unsophisticated investors, who would otherwise have access to these funds.
As defined, private investment vehicles include any investment company whose outstanding securities are beneficially held by no more than 100 persons. These investment companies would otherwise be regulated under the Investment Company Act of 1940, except that the latter exempts from its regulation such private funds if they have no more than 100 beneficial security holders.4
Venture capitol fund exclusion. The proposed rules do not apply to the issue and sale of securities by “venture capital funds” that would otherwise be considered private investment vehicles. Recognizing the role that venture capital funds can play in the capital formation and management of small businesses, the SEC attempted to create a carve-out for such funds under the proposed rules. Under the proposed rules, a venture capital fund is any company that would qualify as a “business development company” under the Investment Advisors Act of 1940.5
Minimum investment requirement for accredited investor. Under the proposed rules, an individual investing in a private investment vehicle is an accredited investor only if that individual (1) meets either the income or net worth tests and (2) owns (individually, or jointly with his or her spouse) at least $2.5 million in “investments” (as adjusted for inflation) at the time the securities are purchased (the "investments test").
The proposed rules define investments to include all securities, real estate, cash, or commodities held for investment purposes, including personal retirement accounts. Notably, investments would not include any real estate used as a personal residence or place of business. For purposes of valuating investments, a married individual can only count 50 percent of any investments held jointly with his or her spouse towards satisfying the investments test.
Under the existing rules, roughly 8.5 percent of U.S. households qualify for accredited investor status. Under the proposed rules, that figure would drop to only 1.3 percent for private investment vehicles, shrinking the pool of eligible investors in such funds by nearly 85 percent.
What you need to know now
Because the proposed rules affect only individuals investing in private investment vehicles, the rules, if adopted, would have limited applicability.
More importantly, however, the proposed rules may portend perhaps broader changes by the SEC to the requirements for an accredited investor. Given the SEC’s stated concerns regarding the antiquated qualifications for accredited investors under the existing income test and the net worth test, it seems possible that the SEC may propose rules increasing the bars under each test. The result of such a change would be to further limit the ability of businesses to raise capital through private offerings of unregistered securities.
To read the SEC’s proposed rule, visit http://www.sec.gov/rules/proposed/2006/33-8766.pdf.
Footnotes
1 SEC Rel. No. 33-8766.
2 See 17 C.F.R. § 230.506.
3 See 17 C.F.R. § 230.501(a).
4 15 U.S.C. 80a-3(c)(1).
5 See 15 U.S.C. 80b-2(A)(22). In its release proposing the new rules, the SEC seems particularly ambivalent about the proposed definition of a venture capital fund and expressly solicits comments for alternative definitions. Therefore, it seems, if the SEC does adopt the proposed rules, the final version may well define venture capital fund differently.