Explaining The New Routes To Investor Accreditation for Individuals (aka Natural Persons)
Written by: Alex Levine, Tokensoft Chief Legal Officer
A lot of questions have arisen (especially in the blockchain and cryptocurrency communities) over the recent expansion of the definition of an accredited investor by the U.S. Securities & Exchange Commission (“SEC”) [see: https://www.sec.gov/news/press-release/2020-191]. In order to clear up any confusion, this post lays out the contours of the different ways natural persons (referred to herein as “individuals”) in the general public can now qualify for accredited investor status along with the steps needed to attain such status. Any other changes to the accredited investor rules that apply to entities are not addressed.
For private offerings of securities, SEC Rules 506(b) and 506(c) of Regulation D are the most commonly used exemptions by issuers and funds. In order to comply with Regulation D, offerings may be made mainly to individuals who are deemed accredited investors without triggering arduous disclosure requirements.
There are now three paths for an individual in the general public to become an accredited investor. The SEC’s amended rule adds two new non-financial categories to achieve accreditation while making it easier for individuals to pool funds with a spousal equivalent partner to meet the net worth or income thresholds for accreditation under the third financial category.
1. Designated Professional Licenses
An individual can now qualify as an accredited investor based on attaining and holding in
“good standing” certain professional certifications, designations, or credentials (referred to herein as “licenses”) as designated by an order of the SEC.
Importantly, the good standing requirement does not require that an individual have any professional connection to the fields related to the designated license. All an individual must do is meet any requirements applicable to attaining and maintaining an active license, including (but not limited to) passing examinations, affiliating with regulated firms, and/or paying annual dues.
The SEC has initially designated that individuals holding Series 7, Series 65, and Series 82 licenses qualify for accredited investor status. These licenses are required for certain broker-dealer and investment adviser representatives. However, the current license designations by the SEC make it difficult for persons in the general public to attain accredited investor status due the specific state-level or firm sponsorship requirements. That said, the Series 65 license is the only one that can currently be obtained by an individual in the general public as that specific license contains no sponsorship requirements. However, in the future, the designation of additional licenses, such as CPA or CFA holders, would significantly broaden the ability of individuals to take advantage of this new route to accreditation.
The specific requirements to attain and maintain the currently designated licenses are as follows:
Affiliation with a FINRA or SRO Member Firm Required
Series 7 License -- (i) Pass the Securities Industry Essentials (“SIE”) Exam, (ii) Pass the Series 7 General Securities Representative Exam, and (iii) Active association with and sponsorship by a FINRA member firm or other applicable self-regulatory organization (“SRO”) member firm [see: https://www.finra.org/registration-exams-ce/qualification-exams/series7].
Series 82 License -- (i) Pass the SIE Exam, (ii) Pass the Series 82 Private Securities Offerings Representative Exam, and (iii) Active association with and sponsorship by a FINRA member firm or other SRO member firm [see: https://www.finra.org/registration-exams-ce/qualification-exams/series82].
Affiliation with a FINRA or SRO Member Firm NOT Required
Series 65 License -- (i) Pass the Series 65 Uniform Investment Adviser Law Exam, and (ii) Meet other specific state-level requirements for becoming an investment adviser that may be imposed before granting a license, such as an application, background check, bonding, and fee payment [see: https://www.finra.org/registration-exams-ce/qualification-exams/series65 and https://www.nasaa.org/exams/exam-faqs/].
More details on the investment adviser licensing requirements for each state can be found here: https://www.financialplannerworld.com/become-a-financial-advisor/.
For example, in California, the requirements for attaining and maintaining an investment adviser license are as follows [see: https://dbo.ca.gov/state-licensed-investment-adviser/]:
Register a new independent investment adviser firm on the Investment Adviser Registration Depository (IARD) electronic system.
Gain access to FINRA’s web-based systems by submitting the required Entitlement Forms to FINRA in order to set up and fund a general account through which you will pay the required registration fees, which include a $40 initial system registration fee, $175 for the Series 65 Exam, and $125 initial registration fee to the State of California.
Complete and submit the Form U-4 Uniform Application for Securities Registration or Transfer through the Central Registration Depository (CRD) system. Form U-4 serves as the Series 65 Exam application as well as registration with California and the SEC.
Complete and submit Form ADV through the IARD system. Form ADV requires provision of detailed information on the education and experience of the individual running the investment advisory firm, the firm’s investment philosophy and fee structure, and other pertinent information for clients and potential clients.
Mail the following documents to the California Department of Corporations: proof of citizenship, samples of contracts that will be used with clients, and a balance sheet if the firm will hold custody of client funds.
Take and pass the Series 65 Exam.
Going forward, complete an annual update to Form ADV and pay an annual renewal fee to the State of California of $125 along with an IARD administrative renewal fee of $100.
Preparing for, taking, and passing the Series 65 Exam requires the following steps:
The Series 65 Exam covers a lot of information. Those individuals who have a basic understanding of finance, economics, and investing will need to study less as will those with knowledge of laws and regulations germane to investment advisers.
While every exam taker is different, it will generally take 2-4 weeks to study for the Series 65, about 30-60 hours of time.
The exam is computer based and contains 130 questions, of which at least 94 must be answered correctly, equivalent to a 72% passing grade. A maximum of three hours (or 180 minutes) is allowed to complete the exam. Once the exam is completed, results are immediately available.
If the exam is not passed, it can be retaken by repaying the exam fees, registering to take the exam again, and generally waiting at least 30 days.
The following substantive topics are covered on the exam:
Economic Factors and Business Information, including basic economic concepts, financial reporting, quantitative methods, and types of risk.
Investment Vehicle Characteristics and Valuation Methods, including cash/cash equivalents, fixed income securities, equity securities, pooled investments, derivative securities, alternative investments, and insurance based products.
Client Investment Recommendations and Strategies, including client profiles, capital market theory, portfolio management, tax considerations, retirement plans, ERISA/special accounts, trading securities, and performance measures.
Laws, Regulations, Guidelines and Prohibition on Unethical Practices, including state/federal securities regulations, fiduciary obligations, and ethics.
2. Knowledgeable Employees of a Fund
An individual qualifying as a “knowledgeable employee” of a private fund can attain the status of accredited investor (but solely for investments made into the private fund itself) through the following types of knowledge or experience:
Being a director, trustee, general partner, advisory board member, or executive officer affiliated with the private fund.
Being an employee of the private fund or an affiliated management person of the private fund who (a) participates in the investment activities in connection with his or her regular functions or duties, (b) has been performing such functions and duties for at least 12 months, and (c) is not performing solely clerical, secretarial, or administrative functions.
This allows for knowledgeable employees of a private fund to take advantage of the upside of a fund’s offerings previously only available to those working at a fund who met the net worth or income requirements. However, the usefulness of this category is very limited for persons in the general public, given that the individual achieving accredited investor status must be affiliated with the private fund making an offering and can only make an investment in that specific private fund itself.
3. Net Worth and Income Thresholds Now Include Spousal Equivalent Relationships
The simplest way still to qualify for accredited investor status is to meet the net worth or income aggregate dollar thresholds. The SEC did not update the required amounts, which allows for accreditation of an individual who has a net worth of over $1 million or income exceeding $200,000 (or joint income with a spouse exceeding $300,000) in each of the prior two years along with an expectation of the same level of income for the current year.
However, the SEC has now clarified that the term “spouse” allows individuals to include joint net worth or income from “spousal equivalents” defined as a cohabitant occupying a relationship generally equivalent to that of a spouse. In addition, joint net worth or income is clarified to ensure ownership of an asset or investment does not have to be jointly purchased or owned for aggregation purposes.
Therefore, an individual may achieve the status of an accredited investor through meeting either of the following financial requirements:
Individual Alone -- Net worth of over $1 million or income exceeding $200,000 in each of the prior two years along with an expectation of the same level of income for the current year.
Individual plus Spousal Equivalent -- Joint net worth of over $1 million or income exceeding $300,000 in each of the prior two years along with an expectation of the same level of income for the current year.
Conclusion and Call for Designation of Widely-Held Financial Licenses
The SEC’s new accreditation rules are a step in the right direction. However, while the categories have the potential to allow for more individuals to utilize their sophistication and training to achieve accredited investor status, the current impact is marginal at best. The big impact will come only when the SEC expands the list of designated professional licenses outside of the FINRA-series universe to those licenses that are broadly held and respected by financial professionals. The SEC should at the very least designate CPA and CFA licenses as meeting the standard for accreditation and issue concrete criteria for adding additional licenses that do not require affiliation with FINRA-member firms or registration with a state-level regulator.