On August 26, 2020, the U.S. Securities and Exchange Commission adopted final rules to expand the accredited investor definition and modernize the disclosure requirements under Regulation S-K Items 101 (Business), 103 (Legal Proceedings) and 105 (Risk Factors). The changes to the accredited investor definition are designed to allow more individuals to have opportunities to invest in private offerings. The changes to the disclosure requirements under Regulation S-K shift from a prescriptive approach to a principles-based one by eliminating some long-standing line item disclosures and providing more generalized disclosure guidance.
Amendment to Definition of Accredited Investor
The final rules amending the definition of “accredited investor” under Regulation D expand the classes of natural persons eligible to qualify as accredited investors by adding individuals with specific professional credentials in the securities business and status as a private fund’s “knowledgeable employee.” Today, individuals can qualify only on the basis of their net worth or earnings, or by their being an officer, director or general partner of the issuer. The amendments also allow certain entities not included within the current rules to qualify as accredited investors. Finally, the final rules expanded the list of entities that are eligible to qualify as a qualified institutional buyer (QIB) under Rule 144A. The changes are further described below.
In the adopting release, the SEC noted that under the current scheme, persons who could be expected to have sufficient investment expertise to watch out for their own interests, but who do not meet Regulation D’s income or net worth tests, are effectively precluded from investing in Regulation D offerings. It further noted the huge sums raised in private offerings (more dollars were raised in unregistered equity and debt offerings in 2019 than in registered offerings). Accordingly, less affluent investors who have the capacity to make informed investment decisions do not have the opportunity to invest in many offerings.
The amendments attempt to remedy this by expanding the “accredited investor” (AI) definition in Rule 501(a) by adding a new class of natural persons “holding in good standing one or more professional certifications or designations or other credentials from an accredited educational institution that the SEC has designated as qualifying an individual for accredited investor status.” By leaving the class of sophisticated persons to be specified by an SEC order rather than including such classes in the rule, the SEC will have the flexibility to expand, or contract, the class included in its initial order by a new order in the future, rather than going through the more bureaucratically cumbersome rule-making process. The amendments provide the following non-exclusive list of attributes that the SEC would consider in determining which professional certifications and designations or other credentials qualify for accredited investor status:
- The certification, designation, or credential arises out of an examination or series of examinations administered by a self-regulatory organization or other industry body or is issued by an accredited educational institution;
- The examination or series of examinations is designed to reliably and validly demonstrate an individual’s comprehension and sophistication in the areas of securities and investing;
- Persons obtaining such certification, designation or credential can reasonably be expected to have sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of a prospective investment; and
- An indication that an individual holds the certification or designation is made publicly available by the relevant self-regulatory organization or other industry body.
In a separate order, the SEC designated the Series 7, Series 65 and Series 82 licenses as the initial certifications, designations or credentials under the expanded rule.
The amendments also add a new class of persons related to issuers that are investment funds. It is similar to the class contained in Rule 501(a)(4) for any person who is a director, executive officer or general partner of the issuer or a director, executive officer or general partner of a general partner of that issuer. This new class would consist of any persons who are “knowledgeable employees”—as defined in Rule 3c-5 under the Investment Company Act of 1940—of the issuer.
Finally, with respect to individuals, the final rule includes “spousal equivalent” along with spouses as a companion for satisfying the existing net income and net worth tests. The amendments codify, by way of a new note in Rule 501(a), an existing Compliance and Disclosure Interpretation of the SEC staff to provide that the purchased securities need not be purchased jointly to use the joint income or joint net worth. The proposed rule defines “spousal equivalent” as “a cohabitant occupying a relationship generally equivalent to that of a spouse.”
The changes to the definitions of entities that qualify as accredited investors are largely intended to include classes of entities that did not exist or were not widely used when Regulation D was first adopted. The final rules include as eligible entities any registered (under either the Investment Advisers Act of 1940 or pursuant to the laws of any state) investment adviser and any Rural Business Investment Company (RBIC). The rules also add a new catch-all subsection to section 501(a) covering any entity of a type not otherwise set forth in the accredited investor definition that is not formed for the specific purpose of acquiring the securities offered and owning investments in excess of $5 million.
The rules also add a new class of accredited investors for “family offices” and “family clients,” each as defined in rule 202(a)(11)(G)-1 under the Investment Advisers Act of 1940. A family office would qualify as an accredited investor if it has more than $5 million in assets under management and was not formed for the specific purpose of acquiring the securities offered, and its investment is directed by a person with such knowledge and experience in financial and business matters that the family office is capable of evaluating the merits and risks of the prospective investment. Family clients of a family office that meets these requirements would also qualify as accredited investors.
In addition, the final rules add a note to Rule 501(a)(8) to make it permissible to look through various forms of equity ownership to natural persons when determining the accredited investor status of entities. This note codifies a staff interpretation provided in a Compliance and Disclosure Interpretation.
Qualified Institutional Buyers
The final rules amend the definition of QIB in Rule 144A(a)(1) to include limited liability companies, RBICs, and any institutional investors included in the accredited investor definition and not otherwise enumerated in the definition of QIB that meet the $100 million threshold to avoid inconsistencies between the types of entities that are eligible for accredited investor status and those that are eligible for QIB status. It does not otherwise substantively change the QIB definition.
Modernization of Disclosures Under Regulation S-K Items 101, 103 and 105
The final rules updating Regulation S-K amend Item 101, which pertains to the description of the registrant’s business, Item 103, which pertains to a description of legal proceedings, and Item 105, which pertains to risk factors. While the changes do not significantly affect the overall content of filings that companies must make under the 1933 Act and the 1934 Exchange Act, they do mark a shift to a more principles-based approach. A more detailed description of the amendments follows.
Item 101 – Business
Subsection (a) of Item 101 requires a description of the development of the company’s business. The amendment retains this requirement but eliminates the specific reference to development over the preceding five years. It also clarifies that information must be provided only to the extent material to an understanding of the general development of the business. This subsection would continue to include the existing examples of the types of development events that are likely to be material (such as bankruptcy proceedings and M&A events) and adds one additional item for which disclosure would be warranted. This new item would require a discussion of a material change to a “previously disclosed” business strategy. There is no requirement that companies disclose their strategies in their 1933 Act or 1934 Exchange Act documents, so this requirement would only apply to a company that has elected to disclose its strategy in the past.
An additional change to subsection (a) allows a company to include in its reports only those material developmental changes that have occurred since its most recent full discussion of the development of its business. A company electing to limit disclosure about the development of its business to these recent activities must incorporate by reference, and hyperlink to, the full development discussion.
The more interesting changes to Item 101 are those made in subsection (c). That subsection requires a narrative description of the business. It previously provided 10 different factors that should be discussed, to the extent material, at the disclosable segment level and two additional factors that should be discussed, if material, at the overall company level. The fact that Item 101 lists the 12 factors made them almost automatically regarded as material, and these factors are consistently addressed in the Business discussion. The amendments reduce the 10 examples to five examples (which are more broadly stated than their specific predecessors), and provide management with more flexibility to describe those aspects of the business that are material to investors. One of the five new examples would require disclosure of “dependence on revenue-generating activities, key products, services, product families or customers” and eliminate the specific requirements to disclose classes of products or services that accounted for more than 10% of revenue and the specific requirement to disclose 10% of the company’s customers. The existing provisions for discussion of working capital practices and the amount of backlog have also been eliminated. The amendments also eliminate the detailed paragraph regarding the discussion of competition and replace it with a simple reference to a discussion of competitive conditions.
The amendments further expand the disclosure requirements regarding factors that are material on a company-wide basis on two fronts. One of these calls for discussion of the effects of complying with government regulations, not just environmental regulations as is currently called for. The second replaces the previous requirement to disclose the number of employees by requiring a discussion of human capital resources and measures that management is focused on in managing personnel. The requirement to provide the number of employees has been retained.
The final rules amend Items 101(a) and (c) and also revise the lead-in to Item 101(h), which pertains to smaller reporting companies, to align that section with the changes made to subsection (a). The other subsections of Item 101 remain unchanged.
Item 103 – Legal Proceedings
The two changes here are not significant and do not affect the substance of disclosure. The first permits this information to be presented by hyperlink or cross-reference to another section of the document where it has been reported. The second raises the threshold for environmental proceedings deemed immaterial from $100,000 to $300,000, but allows companies to use a higher threshold designed to result in the disclosure of any material proceeding. However, disclosure must be made of any such proceeding where the potential monetary sanctions exceed the lesser of $1 million or one percent of the company’s current assets.
Item 105 – Risk Factors
The most significant of the changes to Item 105 apply if the filing contains a risk factor section that exceeds 15 pages. In that case, the document must include in the “forepart” a “series of short, concise, bulleted or numbered statements summarizing the principal” risks, with such summary not to exceed two pages. The risk factor summary is intended to help investors navigate lengthy risk factor disclosures while simultaneously incentivizing companies to reduce their risk factor discussions.
A second revision to item 105 requires that risk factors be organized under relevant subheadings. A related change provides that if generic risks (i.e., risks that apply generically to any registrant or offering) are included, that they be listed under the heading “General Risk Factors.” Finally, Item 105 will now require the disclosure of “material” risks rather than the “most significant risks.”