By Kimberly Shaw Elliott
Registered representatives and investment adviser representatives may soon purchase for themselves the unregistered products they recommend to other investors, without proof of their financial resources. These financial professionals join an expanded list of other potential investors that will be considered “accredited investors” eligible to invest in unregistered securities. The market impact of this new SEC rule is unknown. Securities firms are reminded, however, that a broadened definition of who may purchase an unregistered security does not replace standard compliance evaluations of whether a potential investment is suitable for or in the best interest of a given investor, including its own representative.
Public offerings of securities must be registered with the SEC. Potential purchasers therefore have the benefit of the detailed information contained in a prospectus as well as financial information about the issuer before a purchase is made. Some individuals and entities, known as “accredited investors,” are deemed, however, to have sufficient knowledge and expertise to participate in investment opportunities that do not have the rigorous disclosure and procedural requirements, and related investor protections, provided by registration under the Securities Act of 1933. In a rule issued August 26, 2020, the SEC significantly expanded the definition of accredited investor.
Prior to the change, any determination of who is an accredited investor was based upon measures of wealth or income. Under long-standing rules, an accredited investor must have a net worth (excluding primary residence) of more than $1 million, or must have earned income above $200,000 per year ($300,000 combined with a spouse) for at least three years. The SEC believes it is time to update these older standards.
“…[R]elying solely on financial thresholds as an indication of financial sophistication is suboptimal,” wrote the SEC, “ including because it may unduly restrict access to investment opportunities for individuals whose knowledge and experience render them capable of evaluating the merits and risks of a prospective investment—and therefore fending for themselves—in a private offering, irrespective of their personal wealth. While these individuals may have fewer financial resources, they should be able to assess investment opportunity, allocate their own capital and make their own informed decisions.”
To further this view, the SEC updated the definition of accredited investor to add new categories of natural persons that may qualify as accredited investors based on certain professional certifications or designations or other credentials or their status as a private fund’s “knowledgeable employee.” The revision also expands the list of entities that may qualify as accredited investors, adds entities owning $5 million in investments, adds family offices with at least $5 million in assets under management and their family clients, and adds the term “spousal equivalent” to the definition.
Self-certification of the needed financial sophistication was rejected, as was any adjustment to the wealth tests. The SEC stated that it may consider changes to either in the future. The Dodd-Frank Act requires the SEC to evaluate its experience every four years. The next quadrennial review of the accredited investor definition will be due in 2023.
Several of the new qualifications relate specifically to securities industry personnel. This release addresses those individuals and the firms they represent.
Registered representatives (“RRs”) and investment adviser representatives (“IARs”) were approved as accredited investors. Essentially, the SEC ruled that if one can advise others to make a particular investment, he or she should be qualified to make that same purchase for him/herself.
In a separate order issued at the same time as the new rule, three initial designations were approved to grant accredited investor status: the General Securities Representative license (Series 7), the Private Securities Offerings Representative license (Series 82), and the Licensed Investment Adviser Representative (Series 65). Persons who have passed the requisite exams and hold their certifications or designations in good standing are deemed to have sufficient sophistication to participate in investments that lack the protections afforded by registration. Even individuals who no longer work in the industry but hold registrations that have not yet lapsed may still be accredited. For example, so long as two years have not expired since a RR left the employ of a broker dealer, that individual is still registered as a Series 7 and will qualify until the registration lapses.
By adding this initial list of industry professionals, the SEC is taking a measured approach. Other certifications, designations and credentials may be added after the commission gains experience with the broadened rule.
Knowledgeable Employees of Private Funds
Knowledgeable employees of a private fund may now also purchase that fund, regardless of wealth. A knowledgeable employee includes: 1) an executive officer, director, trustee, general partneror advisory board member, and 2) an employee of the private fund or an affiliated management person of the private fund who has participated for at least one year in investment activities of the fund.
Registered Investment Advisers and Exempt Reporting Advisers
Both SEC-registered and state-registered investment advisers now qualify as accredited investors. It does not matter whether the RIA is registered as a firm or an individual. The SEC rejected the notion that RIAs who are natural persons should be evaluated solely under the wealth criteria. Instead, it stated the belief that, “registered investment advisers, including those that are sole proprietorships, have the requisite financial sophistication needed to conduct meaningful investment analysis.”
Included in the expanded definition of accredited investors are exempt reporting advisers. “We believe exempt reporting advisers, as advisers to private funds, have the requisite financial sophistication needed to conduct meaningful investment analysis…. Additionally, private funds themselves are institutional investors and all investors therein are presumed to be financially sophisticated.”
Impact on the Market is Uncertain
Exempt offerings dominate the capital market and continue to grow in absolute number and as compared to public offerings. The SEC reported that in 2019 registered offerings accounted for $1.2 trillion (30.8 percent) of new capital, compared to approximately $2.7 trillion (69.2 percent) that was raised through exempt offerings.
The SEC estimates that nearly 700,000 individuals hold the Series 7. It declined to estimate how the new rule will increase the number of accredited investors but it believes that the number of newly eligible purchasers will not be significant and that their investments will have minimal effects on the private markets. The more relevant inquiry, it wrote, is whether the criteria capture the necessary level of sophistication. Similarly, the SEC was unable to estimate the impact the newly qualified RIAs and exempt reporting advisers may have on the markets
Despite the difficulty in measuring potential effects of the rule, the SEC determined that it is good public policy to expand the field of potential purchasers to include those who have the financial sophistication to evaluate the risks and rewards.
Impact for Firms- Continued Compliance Vigilance
While not addressed by the SEC, we thought it would be helpful to add our impressions of how this new rule may impact firms’ compliance posture.
For pooled investments in investment companies such as mutual funds, expanding the definition of accredited investor beyond the wealth standard may have little impact. The Investment Company Act requires that any investment company be registered with the SEC unless strict exceptions are met. One exception is for investments owned by “qualified purchasers” who have at least $5M in investable assets. Also known as “super-accredited investors”, the wealth standard for this group is far higher than the wealth requirements for accredited investors. Accredited investor status will be insufficient to qualify RRs and IARs who wish to make a purchase in these unregistered funds if those individuals are not also qualified purchasers. Similarly, RIAs themselves are now considered accredited investors under the new rule but many RIAs, even those managing significant dollars of clients’ assets, may not themselves meet the requirements to be qualified purchasers.
Expanding potential purchasers to include licensed industry personnel might create new opportunities for private equity sales. Non-pooled investments are not subject to the Investment Company Act so potential investors need not meet the higher wealth standards established for qualified purchasers. Meeting accredited investor status will be sufficient for potential investors seeking to purchase an interest in a firm offered as a private placement. Any examination should not end there, however.
Meeting the standard to purchase an unregistered security will not, by itself, make an investment suitable for or in the best interest of a particular investor. Firms should consider what is suitable for individuals who fail to meet the wealth standards but now qualify solely because they have the required certifications.
Broker dealers and advisory firms must have compliance policies in place to consider the particular facts and circumstances of each client, including his or her financial situation and investment objectives, before approving any investment or recommendation. Not the least of these considerations is the fact that most private investments require large minimum purchases. Diversification, over-concentration and the ability to bear the financial risk must still be considered. Compliance personnel must also be aware of potential conflicts of interests that may arise if an adviser encourages purchases by customers that may increase the value of the adviser’s own investment in the same security.
The new rule takes effect 60 days after publication in the Federal Register. As of the date of this release, the rule has not yet been published.