If you are an investment geek always on the search for investment opportunities, the term ‘accredited investors’ must not be new to you. Real estate crowdfunding or high risk investment opportunities, still prefer ‘accredited investors’ over non-accredited investors. Simply put, accredited investors are wealthy individuals who can invest in high-risk, capital intensive investments globally.
It is estimated that in 2020 there were 13,665,475 accredited investor households in America, which is roughly 10.6% of all American households. Reports also suggest that accredited investor households controlled roughly $73.3 trillion in wealth in 2020. They controlled around 76.3% of all private wealth in America measured by the 2019 SCF.
Who are Accredited Investors?
An accredited investor is a person or a business institution, who can invest in securities that are not registered with the Securities and Exchange Commission (SEC). These securities are generally not available to the other investors. The accredited investors have this access only after they meet certain criteria. These range from income, net worth, asset size, governance status or professional experience. U.S. Securities and Exchange Commission (SEC) set these guidelines. An ‘Accredited Investor’ is any investor who meets one or more of the requirements. Typically, accredited investors include high-net worth individuals, banks, insurance companies, employees benefit plans, trusts etc.
Origin of the term
In the 1930s, federal lawmakers wanted to protect investors in private offerings and securities and help small businesses and startups. Hence, they enacted The Securities Act in 1933 to control the sale of securities in the United States. Eventually, the SEC adopted rule 501 of Regulation D. Rule 501 coined the term “accredited investor.” With this, the SEC wanted to set a benchmark for investors wanting to invest in the private securities offerings. The term “accredited investor’ referred to any individual with a certain level of income or net worth who is financially capable of investing in private securities. Hence, with this standardizing, the SEC ensured that only sophisticated and moneyed investors participate in the private funds, without federal support. As a result, the SEC promoted business growth and protected inexperienced, smaller investors from risky investments.
In July 2010, President Obama signed the Dodd-Frank Wall Street Reform and Protection Act(the Dodd-Frank Act, for short). It introduced some changes in the eligibility criteria for the accredited investors. This act excluded the value of an individual’s primary residence from the individual’s net worth. This amendment came in the wake of the fluctuations in the real estate prices across the country.
How to become an accredited investor?
According to Rule 501 under Regulation D of the Securities Act of 1933, in order to qualify as an accredited investor, it is crucial to meet one or more of the following criteria:
- Have an individual annual income exceeding $200,000 or joint income of more than $300,000 together with a spouse in each of the prior two years. Further, the investor must also have reasonable expectation of the same for the current year.
- Have a net worth exceeding $1 million, either independently or together with a spouse. This excludes the value of the person’s primary residence.
- Be a general partner, executive officer, director or be associated in a similar way to the issuer of a security that is open for investment.
- In case of a private business institution, it must have assets exceeding $5 million.
- If the institution consists of accredited investors as equity owners, the institution becomes an accredited investor itself.
Further, in 2016, the U.S. Congress changed the definition of an ‘accredited investor’ to include registered brokers and investment advisors.
Along with these qualifications, the SEC also considers other qualifications to rate an institution as accredited:
- A bank, or savings and loan association; a registered broker or dealer; registered or qualified insurance companies; or small business development companies that meet some or all of the criteria
- Licensed small business investment companies or employee benefit plans maintained by a state or it’s agencies. However, the plan’s assets must exceed $5 million
- Employee retirement plans, where a financial agency makes the investment decisions. Here, the plan’s assets must exceed $5 million as well
- A private business development company as defined in the Investment Advisor’s Act of 1940
- An organization described in section 501(c)(3) of the Internal Revenue Code which is not formed for the sole intention of acquiring securities. The company must have assets of over $5 million
Amendments to the Act
On August 26, 2020, the SEC updated the regulations regarding accredited investors. This allowed people with sufficient professional knowledge, experience or certifications, to be an accredited investor and purchase private assets. This was a welcome change to increase access to the investment market beyond income brackets. The change came to effect on Dec 9, 2020.
According to the SEC’s press release, “These amendments are part of the Commission’s ongoing effort to simplify, harmonize, and improve the exempt offering framework, thereby expanding investment opportunities while maintaining appropriate investor protections and promoting capital formation.” The statement further states, “the amendments allow investors to qualify as accredited investors based on defined measures of professional knowledge, experience or certifications in addition to the existing tests for income or net worth. The amendments also expand the list of entities that may qualify as accredited investors, including by allowing any entity that meets an investments test to qualify.”
- Professional Certifications, Designations or Credentials
Investors with certain professional certifications, designations, and/or credentials, including Series 7, Series 65, and Series 82 licenses qualify as “natural persons”. The SEC mentions, “the Commission designated three certifications and designations administered by the Financial Industry Regulatory Authority, Inc. as qualifying for accredited investor status:
- Licensed General Securities Representative (Series 7);
- Licensed Investment Adviser Representative (Series 65); and
- Licensed Private Securities Offerings Representative (Series 82).”
This implies that the SEC will require certifications issued from an approved educational institution. This will act as a proof of the investor’s sophistication and ability to weigh the risks of the purchase of a particular security. Thus, with the amendment the SEC will now recognize an individual’s capability to assess every crucial aspect of the investment, over their financial status.
- Spousal Equivalent
With the amendment, the SEC now estimates the income and/or net worth of a spouse of the investor while accrediting an individual. Moreover, the SEC also considers the income and/or net worth of an individual’s ‘spousal equivalent’. A ‘spousal equivalent’ is someone who is not officially married to the individual, but is related to him/her via domestic partnership or civil union. Therefore, not only does this allow greater market access, but also reflects the progressive thinking of the SEC to defy social norms.
- Knowledgeable Employees
The amendment also included a new category of “knowledgeable employees” solely with respect to private funds.
In the press release, the SEC stated, “To qualify as an accredited investor under this category, an investor must be a “knowledgeable employee,” as defined in Rule 3c–5(a)(4) under the Investment Company Act of 1940 (the “Investment Company Act”), of the private fund issuer of the securities being offered or sold. This includes directors and certain executive officers of the private fund, or of an affiliated person of the private fund that manages the investment activities of the private fund (“affiliated management person”). This also includes employees who participate in the investment activities of the private fund or other private funds or investment companies managed by the affiliated management person.” Therefore, the SEC now considers mid to senior level personnel who were deeply involved in the investment activities of private funds or a firm in the past for at least 12 months, as accredited investors.
In addition to this, the amendment also adds a new category ‘for any entity, including Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries, that own “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act’ that exceed $5 million. However, they must not be formed for the specific purpose of investing in a specific security. Further, the SEC also added to the accredited investor definition “family offices”. These must also have at least $5 million in assets under management, and their “family clients” as each term is defined under the Investment Advisers Act.
According to a statement from SEC Chairman Jay Clayton, “For the first time, individuals will be permitted to participate in our private capital markets not only based on their income or net worth, but also based on established, clear measures of financial sophistication.”
How to become accredited?
When selling a security, the seller must verify an investor’s accredited status. Since September 2013, the SEC has required the sellers to verify the status of the accredited investors, through various due-diligence methods. There are generally three ways to prove one’s accredited status:
- The investor can obtain a written confirmation from a financial advisor to the SEC or a licensed attorney. The letter must contain adequate verification proof of the person’s accredited status within the last 3 months.
- The investor has to fill a questionnaire by the seller that requires him/her to attach official or government records such as tax filing or pay stubs. Besides, he/she must also confirm that he/she can meet the minimum income requirement in the current year.
- The investor may also require to present credit reports for assets or liabilities for the calculation of the net worth of the individual.
Purpose of Accredited investors
The purpose of the strict rules and regulations for investor accreditation is safeguarding the investors against poor decision-making and huge losses. When an investor is financially stable or ‘sophisticated’ he/she has the resources to obtain private securities. Even if the investment fails, the investor has sufficient wealth to recover from the loss without the protection of federal or state securities laws.
Moreover, the SEC insists on an investor having sufficient knowledge of finances and investments in capital intensive private funds. This is to ensure that the investor has experience in handling riskier investments. It also ascertains that the investor has proper understanding of an investment that may have high chances of failure.
What are the benefits of being an accredited investor?
- More investment opportunities
Accredited investors have broader access to various investment opportunities like real estate crowdfunding, private placements and other areas. These are unavailable to other investors. Accredited investors can invest in various areas like venture capital, angel investments, hedge funds, commercial real estateetc.
- Portfolio Diversification
With more investment opportunities, accredited investments can unlock portfolio diversification much easily. They can easily invest in alternative markets. As a result, these investments will act as a backup of benefits, in case another investment fails in another market. As a result, portfolio diversification reduces the risk of bankruptcy.
- Investments in small businesses
Accredited investors can support small and mid-sized startups by financing their operations and helping them grow.
- Better return on investments
When an investor makes a costly investment, it is both risky and profitable. High risky investments are also high-yielding opportunities and are generally lucrative for investors. These reap higher returns on investment.
Thus, accredited investors hold potential for transforming the landscape of investments across various niches. With their affluence, knowledge and experience, they are pioneers of the investment arena in the world.
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