Decoding Rule 501(a) of Regulation D: What Investors Should Know

Key Takeaways:

• Rule 501(a) of Regulation D of the Securities Act of 1933 defines how an individual or entity can qualify as an accredited investor, which is required to buy some unregistered securities.

• Because there are not as many disclosure requirements for unregistered securities relative to registered offerings, unregistered securities are generally riskier investments but with potential for higher returns. 

• So that more people and entities can qualify as an accredited investor, the SEC in 2020 undated the accredited investor qualifications while maintaining the law’s original intention to shield investors from prospectively risky investments.

Investors would do well to understand Rule 501(a) of Regulation D, particularly those seeking to engage in the private securities market. To that end, the following decodes the rule and provides what investors should know. 

Introduction

Rule 501(a) of Regulation D of the Securities Act of 1933 defines how an individual or entity can qualify as an accredited investor, which is required to buy some unregistered securities.

Following the stock market crash of 1929, Congress passed the Securities Act to help protect investors from fraud, deceit, and misrepresentation in the sale of stocks, bonds, and other securities.   

Advantages of Regulation D for Companies

There are advantages of this regulation for companies, the main ones being:

• Benefits of private-placement exemptions. Private-placement companies may raise capital without having to register the securities with the SEC.
• Simplified capital raising compared to public offerings. To gain funds, private companies may simply sell securities to eligible investors, including accredited investors. Public companies must raise capital via early-stage investors, by reinvesting profits, by selling stock, or by borrowing through banks or bonds.

What is Rule 501(a) of Regulation D?

The rule is part of Regulation D of the federal legislation that defines the qualifications for being an accredited investor – in other words, those who may invest in unregistered securities. 

Because there are not as many disclosure requirements for unregistered securities relative to registered offerings, unregistered securities are generally riskier investments but with potential for higher returns. 

Accredited investors is a classification defined by the U.S. Securities and Exchange Commission (SEC) in Rule 501(a) of the Act of ’33. Such investors – primarily high-net-worth individuals – invest in private companies, commonly startups. For such companies, it is prohibitively costly to register the securities they wish to sell. So, they raise funds by selling securities to qualified investors.   

Expanded Criteria Under Rule 501(a)

So that more people and entities can qualify as an accredited investor, the SEC in 2020 revised the accredited investor qualifications while maintaining the law’s original intention to shield investors from prospectively risky investments.

For individual investors, modifications recognize that a person can be capable of understanding an investment’s potential risks, even if they do not have a high net worth or income. Here are the accredited investor requirements, with revisions:

• Income. The individual must make a minimum of $200,000 ($300,000 with a spouse or spousal equivalent) during the past two years and anticipate earning at least that amount in the current year. With the revision, “spousal equivalent” was added to income and net-worth definitions.
• Net worth. A person or couple must have a net worth of $1 million or more, exempting the equity in their primary residence as well as most liabilities against it. To meet the requirement, the update permits couples, including spousal equivalents, to use their combined net worth.
• Directors, executive officers, and general partners. Those employed by the company selling the securities are eligible only when buying those securities. The update did not change this provision.
• Knowledgeable employee. Those who work for a hedge fund or other private fund can qualify to invest in their employer’s funds. This qualification is new.
• Family client. The family client of a family office – an entity created to invest familial wealth – that has under management at least $5 million in assets. However, the client may be required to have the investment overseen by someone with more business and financial experience. This qualification is new.
• Professional certifications requirement. Individuals must hold, in good standing, the Series 7, Series 65, or Series 82 license, which pertain to selling securities and providing investment advice. This new requirement is particularly applicable to investment advisors, brokers, and bankers.

For entities, the update added a number of new categories of eligibility for accredited investors:

• Financial institutions. This includes banks, registered investment companies, and insurance companies.
• Entities owned by accredited investors. Entities that an accredited investor owns also qualify as such an investor.
• Entities with at least $5 million in assets. Such entities may not be established specifically to purchase the securities. Previously including partnerships, corporations, trusts, employee benefit plans, and 501(c)(3)s qualified. The update adds family offices and limited liability companies.
• Investment advisor. With this new qualification, state- and SEC-registered investment advisors are eligible, with the exception of reporting advisors and rural business investment companies.
• Entities with at least $5 million in investments. As long as the entity was not created specifically to purchase the securities. The amendment now allows tribes or nations of indigenous peoples, funds, governmental bodies, and entities organized under foreign countries’ laws. 

Rule 501(a)’s Impact on Securities Offerings

The rule does affect securities offerings:

• Limitations and applicability of Reg D exemptions. Federal securities laws require companies that offer or sell securities to register the securities with the SEC or claim an exemption. Under rule 506 of Regulation D, a company may sell its securities to accredited investors, as defined in Rule 501. 
• Criteria for purchasers. Accredited investors as well as qualified purchasers may invest in certain private-investment opportunities that are not registered with the SEC. Qualified purchasers, who may participate in more opportunities than accredited investors, have their own qualifications.

Standards Under Rule 501(a)

• Rationale behind the accredited investor rule. The SEC limits non-accredited investors from some investment opportunities for their financial safety. Amendments to the 501(a) rule seek to simplify, harmonize, and enhance exempt offerings, with the goal of expanding opportunities while maintaining investor protections. 
• The consequences of non-compliance. Investors who are untruthful about their qualifications may be personally liable for investor losses should the deal fail, in addition to possible regulatory penalties or prosecution.

Key Terms Defined by Rule 501(a)

• Aggregate offering price. This is determined by the number of securities offered, multiplied by price-per-security to the general public.
• Business combinations. These are entities that obtain control of at least one business.
• Number of purchasers. A company may sell securities to accredited investors and a maximum of 35 other purchasers.

Verification Under Rule 501(a)

To verify eligibility for participating in private-capital markets, accredited investors may be required to submit documents including tax returns, financial statements, tax assessments, their credit report, or brokerage statements.

The Value of Rule 501(a) in Alternative Investment Opportunities

Accredited investors have a broad range of opportunities in which to participate, including alternative investments. Such private-market offerings — including real estate, real estate investment trusts, and venture capital — can protect against volatility and inflation, due to their low correlation to public markets.

Yieldstreet, the leading alternative investment platform, offers these opportunities and more. In fact, it has the broadest selection of alternative assets – those other than stocks and bonds – of any other platform. To date, $4 billion has been invested with Yieldstreet, with a 9.6% IRR.

Such opportunities serve another crucial purpose – investment diversification. Crafting holdings comprised of varying assets can mitigate overall risk and even improve returns. In fact, portfolio diversification is key to long-term investing success.

Portfolio Diversification and Alternative Investments  

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations, with minimum investments as low as $10,000.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

In Summary

Rule 501(a) is important in private investing and is valuable in broadening investment opportunities. Its 2020 update expands qualifications and reduces barriers to access to such investment opportunities, which include alternative investments.