Asked and Answered: Private Placement Sales and Tricky Trust Questions from the SEC’s Q&A’s

Broker-dealers who sell private placements often encounter tricky questions related to accredited investor status in certain transactions.  For example, a client recently asked whether an irrevocable trust with less than $5 million in assets could still be considered an accredited investor by virtue of the fact that the trustee and the beneficiary are both natural persons and meet the criteria for being accredited investors. 

First, without delving into too much detail, let’s back up a couple of steps for a quick review.  Remember that when it comes to individuals, whether as trustees, beneficiaries, or grantors, the updated Reg D Rule 501(a) generally defines an accredited investor as: (1) “any natural person whose individual net worth, or joint net worth with his/her spouse, at the time of purchase exceeds $1 million – excluding equity in the individual’s principal residence. See Rule 501(a)(5) for the particulars; (2) any natural person with individual income exceeding $200,000 in each of the last two most recent years, or joint income with a spouse exceeding $300,000 in each of the two most recent years, and has a reasonable expectation of reaching the same income in the current year; or (3) a director, executive officer or general partner of the company selling the securities, or a director, executive officer or general partner of a general partner of the company selling the securities.

Second, with regard to trusts, Reg D Rule 501(a)(7) states that any trust (revocable or irrevocable) can be an accredited investor: (1) if the trust has total assets in excess of $5 million and was not formed for the specific purpose of acquiring the securities and whose investment decisions are directed by a knowledgeable person with experience in financial and business matters capable of evaluating the risks and merits of the prospective investment; or (2) a trust whose trustee is a bank.  See Rules 501(a)(1) and 506(b)(2)(ii), as well as SEC Release 33-6455 (March 3, 1983) if you want to dig deeper.

Stated differently, the question is whether the accredited status of a trustee or a beneficiary can be attributed to a small trust in order for the trust to purchase the securities that it otherwise wouldn’t be qualified to buy standing on its own merits.  Fortunately, this kind of question has come up before in SEC Q&A’s that were recently updated and posted on July 3, 2014. They follow below (with emphasis added). You can find the whole 141-page document from the SEC’s website here. It’s a compilation of updated compliance and disclosure interpretations of the rules adopted under the Securities Act, so it covers a lot of ground. 

Question 255.19

Question: May a trust qualify as an accredited investor under Rule 501(a)(1)?

Answer: Only indirectly. Although a trust standing alone cannot be accredited under Rule 501(a)(1), if a bank is its trustee and makes the investment on behalf of the trust, the trust will in effect be accredited by virtue of the provision in Rule 501(a)(1) that accredits a bank acting in a fiduciary capacity. Furthermore, a trust having a bank as a co-trustee is an accredited investor as interpreted under Rule 501(a)(1) so long as the bank is “acting” in its fiduciary capacity on behalf of the trust in reference to the investment decision and the trust follows the bank’s direction. See the Nemo Capital Partners L.P. no-action letter (Mar. 11, 1987) issued by the Division. [Jan. 26, 2009]

Question 255.20

Question: A trustee of a trust has a net worth of $1,500,000. Is the trustee’s purchase of securities for the trust that of an accredited investor under Rule 501(a)(5)?

 Answer: No. Except where a bank is a trustee, the trust is deemed the purchaser, not the trustee. The trust is not a “natural” person. [Jan. 26,2009]

 Question 255.21

Question: May a trust be accredited under Rule 501(a)(8) if all of its beneficiaries are accredited investors?

Answer: Generally, no. Rule 501(a)(8) accredits any entity if all of its “equity owners” are accredited investors. This provision does not apply to the beneficiaries of a conventional trust. The result may be different, however, in the case of certain non-conventional trusts where, as a result of powers retained by the grantors, a trust as a legal entity would be deemed not to exist. The result also would be different in the case of a business trust, a real estate investment trust, or other similar entities. Thus, where the grantors of a revocable trust are accredited investors under Rule 501(a)(5) (e.g., the net worth of each exceeds $1,000,000) and the trust may be amended or revoked at any time by the grantors, the trust as a legal entity would be deemed not to exist, and the trust would be deemed accredited, because the grantors would be deemed the equity owners of the trust’s assets. See the Lawrence B. Rabkin, Esq. no-action letter (July 16, 1982) issued by the Division. [Jan. 26, 2009]

So, unless the trustee is a bank and the bank is making the investment decision, generally the answer is negative.  However, with respect to accredited grantors who retain powers to amend or revoke a revocable trust, the answer is different since they would be treated essentially as “equity owners” under Rule 501(a)(8) and the trust would be deemed “not to exist,” thus allowing the issuer of the securities to look past the trust and rely on the accredited status of the grantor(s).

While not part of the original question, what if the grantor of an irrevocable trust is an accredited investor?  Does the same answer obtain?  Only if certain narrow conditions are met. See below for details.

Question: Are there circumstances under which the grantor of an irrevocable trust would be considered the equity owner of the trust under Rule 501(a)(8)?

Answer: The grantor of an irrevocable trust with the following characteristics could be considered the equity owner of the trust: (1) The trust was a grantor trust for federal tax purposes. The grantor was the sole funding source of the trust. The grantor would be taxed on all income of the trust during at least the first 15 years following the investment and would be taxed on any sale of trust assets during that period. During this period, all of the assets of the trust would be includable in the grantor’s estate for federal estate tax purposes. (2) The grantor was a co-trustee of the trust and had total investment discretion on behalf of the trust at the time the investment decision was made. (3) The terms of the trust provided that the entire amount of the grantor’s contribution to the trust plus a fixed rate of return on the contribution would be paid to the grantor (or his estate) before any payments could be made to the beneficiaries of the trust.  (4) The trust was established by the grantor for family estate planning purposes to facilitate the distribution of his estate. In order to effectuate the estate planning goals, the trust was irrevocable.  (5) Creditors of the grantor would be able to reach the grantor’s interest in the trust at all times.  See the Herbert S. Wander no-action letter (Nov. 25, 1983) and the Herrick, Feinstein LLP no-action letter (Jan. 5, 2001) issued by the Division. [Jan. 26, 2009]

We’ll take a look at other Reg D transaction questions in subsequent posts.