HEDGE
FUNDS
LAWS FOR ADVISERS & FUNDS: ACCREDITED INVESTORS
Accredited Investors
Before you accept an investor into your hedge fund, you – the "issuer"
– will need to determine if a prospective investor is accredited.
To determine accreditation, there are two tests: The Income Test and the
Net Worth Test. In short, accredited investors include individuals with
a minimum annual income of $200,000 ($300,000 with spouse) or $1 million
in net worth and most institutions with $5 million in assets.
Income Test
Income Test: Rule 501 (a)(6) states that any natural person who had an
individual income in excess of $200,000 in each of the two most recent
years or joint income with that person's spouse in excess of $300,000
in each of those years and has a reasonable expectation of reaching the
same income level in the current year shall be deemed an accredited investor.
To compute income, an individual may use only one of three income tests
for the entire three-year period.
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Determining Whether an Investor Meets Individual Income Requirements
Although no specific test is used, staff comments have rejected the notion
of gross receipts or revenues as an appropriate test for individuals running
a business. Rather, for such individuals, income has been considered by
the staff to mean:
• Salary and bonus income;
• Taxable income (gross receipts less cost of goods or services
and expenses) in the case of sole proprietorships;
• Distributable income from trusts and partnerships;
• Interest and dividend income excluding unrealized gains; and
• Vested contributions to a profit-sharing or pension plan made
on behalf of an individual.
Future income is relevant to the computation of income. It should be noted
that issuers are required to inquire into the proposed investor's income
for the year in question to determine whether an individual can meet the
income levels required by Rule 501(a)(6).
It is not clear whether an issuer may merely accept an investor's representation
as to his future income. If the prospective investor has a consistent
pattern of income that exceeds $ 200,000, or $300,000 joint income, the
investor's representation may be accepted. If past income includes unusual
and perhaps non-reoccurring income, it might be judicious to request that
the investor supply supporting explanation from his or her accountant.
Rule 501(a)(6) permits spouses to jointly combine their incomes provided
that such joint income is $ 300,000 or more per year. However, it may
not permit investors to use separate income for certain years and joint
income for other years to meet the test.
Net Worth Test
Rule 501(a)(5) states that any natural person whose individual net worth,
or joint net worth with that person's spouse, at the time of purchase
exceeds $1,000,000 shall be deemed an accredited investor. Neither the
Securities Act of 1933 nor the various rules and interpretations associated
with the law in this area define exactly what makes up net worth.
Rule 501 (a)(5) and (6) allow for combining net worth with the purchaser's
spouse even if only one is the purchaser and does not exclude any of the
purchaser's assets (such as home and furnishing, clothing, jewelry, etc.)
from the net worth calculation.
If a significant question comes up as to whether your investor is accredited
based on the net worth test, there are two options to provide a definitive
answer. The first is to request a no-action letter from the SEC. The second
is to request that prospective investors provide you with an audited financial
statement of net worth.
To satisfy its obligation to determine net worth, issuers, in addition
to obtaining representations of net worth, should require prospective
purchasers to provide financial statements or provide specific financial
information.
While some issuers permit prospective investors to prepare their own financial
statement, the better practice would be to have it either prepared or
confirmed by an independent third party, such as the prospective investor's
banker or accountant. Regulation D has somewhat liberalized the requirement
of audited financial statements from certain issuers. Since audited financial
statements for individuals are rarely available, reasonable belief most
likely can be demonstrated by obtaining an unaudited financial statement
for individuals.
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Partnerships as Accredited Investors
The staff of the SEC has stated in a no-action letter that the net worths
of all the partners in a general partnership purchaser may be combined.
It allowed the combined net worths of the general partners to be considered
as opposed to the net worth of the general partnership itself. However,
it should be noted that that partnership was deemed to be an ''investment
general partnership'' and acted as a pass-through vehicle for its partners,
and was not formed for the purpose of making the particular investment.
In addition, the net worth of a consolidated group of corporations may
be combined.
Trusts as Accredited Investors
In the case of a trust, the staff has permitted the net worth of the grantor
(not the trust or its beneficiaries) to be considered where the trust
is revocable. With respect to a purchase by an irrevocable trust, the
net worth of the trust itself is used to determine whether the net worth
requirement is met. In some cases, even the grantor of an irrevocable
trust will be deemed the purchaser where the grantor possesses significant
rights with respect to the trust. Note, however, that if a bank is acting
as fiduciary, any trust can qualify as an accredited investor under Rule
501(a)(1).
Issuer's Corner
Although not required, it is suggested that issuers obtain from those
persons considered to be accredited investors the following:
• Representations and financial information confirming net worth
in the case of investors whose accredited net worth status depends on
net worth exceeding $1 million; and
• Representations and copies of relevant portions of individual
tax returns, along with representations as to the expectation of the level
of future income, in the case of the investor whose accredited status
depends on income.
A showing of reasonable belief by the issuer accompanied by a good faith
effort to secure assurances should be sufficient to meet the terms of
the exemption; misrepresentations by a ''would-be accredited investor''
would not be sufficient to lose the exemption.
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Other Accredited Investor Tests
In addition to the Income and Net worth tests (discussed above), there
are several other ways investors can demonstrate accredited investor status:
• A bank as defined in Section 3(a)(2) of the Securities Act of
1933, or a savings and loan association or other institution defined in
Section 3(a)(5)(a) of the Securities Act of 1933 (whether acting in its
individual or fiduciary capacity);
• A broker or dealer registered pursuant to Section 15 of the Securities
Exchange Act of 1934;
• An insurance company as defined in Section 2(a)(13) of the Securities
Act of 1933;
• An investment company registered under the Investment Company
Act of 1940, as amended (the "Investment Company Act"), or a
business development company as defined in Section 2(a)(48) of the Investment
Company Act;
• A Small Business Investment Company licensed by the United States
Small Business Administration under Section 301(c) or (d) of the Small
Business Investment Act of 1958, as amended;
• A plan established and maintained by a state, its political subdivisions,
or any agency or instrumentality of a state or its political subdivisions,
for the benefit of its employees, if such plan has total assets in excess
of $5 million;
• An employee benefit plan within the meaning of the Employee Retirement
Income Security Act of 1974 if investment decisions are made by a plan
fiduciary, as defined in Section 3(21) thereof, which is either a bank,
savings and loan association, insurance company or registered investment
adviser, or an employee benefit plan that has total assets in excess of
$5 million or, if a self-directed plan, with investment decisions made
solely by persons that are accredited investors;
• A private business development company as defined in Section 202(a)(22)
of the Investment Advisers Act of 1940, as amended;
• An organization described in Section 501(c)(3) of the Internal
Revenue Code, a corporation, Massachusetts or similar business trust,
or partnership, not formed for the specific purpose of acquiring the securities
offered hereby, with total assets in excess of $5 million;
• A trust, with total assets in excess of $5 million, not formed
for the specific purpose of acquiring the securities offered hereby, whose
purchases of securities are directed by a sophisticated person who has
such knowledge and experience in financial and business matters that he/she
is capable of evaluating the merits and risks of the prospective investment;
or
• An entity in which all the equity owners are accredited investors.
Ready for help or have a question?
Please call Hannah
M. Terhune, Attorney, at (202) 498-7533 or e-mail legal@greencompany.com.
All consultations are done by phone and e-mail. Consultations may be split over several sessions.