If you are an investment geek who is 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.
Who are Accredited Investors?
An accredited investor is a person or a business institution, that can invest in securities that are not registered with the Securities and Exchange Commission (SEC). These securities are generally not available to other investors. These 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, such 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 private securities offerings.
Initially, the term “accredited investor” referred to any individual with a certain income level 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 novice, 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 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 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 expectations 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, or director. Besides, you must be associated in a similar way to the issuer of a security that is open for investment.
- In the case of a private business institution, it must have more than $5 million in assets.
- If the institution consists of accredited investors as equity owners, the institution becomes accredited itself.
Further, in 2016, the U.S. Congress changed the definition of an ‘accredited investor’ to include registered brokers and investment advisors.
Besides, 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 that are maintained by a state or its 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 be in excess of $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, is not formed for the sole intention of acquiring securities. The company must have assets in excess of $5 million.
Amendments to the Act
On August 26, 2020, the SEC updated the regulations regarding accreditation. This allowed investors with sufficient professional knowledge, experience or certifications, to be accredited 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, and introduces the following amendments:
1. 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 prove 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.
2. Spousal Equivalent
The amendment also allows the SEC to assess the income and/or net worth of a spouse of the investor.
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. The spousal equivalent is thus in a domestic partnership or civil union with the individual in question. Therefore, not only does this allow greater market access, but also reflects the progressive thinking of the SEC to defy social norms.
3. 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 as accredited investors, This is because of their prior experience in the investment activities of private funds or a firm in the past for at least 12 months.
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 exceeds $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 of “family offices”. These must also have assets under management in excess of 5 million. 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 can 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 conduct due diligence for verifying the accredited status of the investors. There are generally three ways to prove one’s accredited status:
- The investor can obtain 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 out a questionnaire by the seller. They must attach government records such as tax filing or pay stubs. Besides, they must also confirm that they can meet the minimum income requirement in the current year.
- The investor must also present financial statements and 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 accreditation is to safeguard investors against poor decision-making and huge losses. When an investor is financially stable or ‘sophisticated’ they have 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 expensive private funds. This is to ensure that the investor has experience in handling riskier investments. It also ascertains that the investor has a proper understanding of an investment that may have a high chance of failure.
Hence, their accreditation allows such investors to participate in high-yielding real estate crowdfunding opportunities and diversify their portfolios.
Thus, accredited investors hold the potential for transforming the landscape of investments across various niches. With their affluence, knowledge, and experience, they are pioneers in the investment arena in the world.