The SEC is considering whether to change the accreditation standards used to determine eligibility in private securities sales – and a more restrictive change might disqualify many persons who currently qualify as “accredited investors.” Many opponents say that this would unfairly limit investment opportunities, potentially affecting millions of people.
The review of proposed changes is coming up largely because of a section of the Dodd-Frank Act, which requires the SEC to review the “accredited investor” definition in its entirety and to engage in further rulemaking to the extent it deems appropriate “for the protection of investors, in the public interest and in light of the economy.”
In the investment world, the prospect that changes in the definition might significantly shrink the pool of private investors has caused a furor. Take the example of David Verrill, executive director of the Center of Business at MIT’s Sloan School of Management, who for years has been part of a group that has invested $25 million in 35 start-up companies. “I would be one of those people who with a swoop of a pen would become unaccredited,” Mr. Verril said. “That boggles my mind.”
Under the current test, an individual qualifies as an “accredited investor” if he or she has at least $200,000 in annual income in each of the two most recent years (or $300,000 jointly for married couples), with an expectation of meeting that threshold again in the current year, or $1 million in net worth without taking into account the primary residence. The exclusion of the net worth of the primary residence was a relatively recent change brought about with the enactment of the Dodd-Frank Act.
Accredited investors are key to private placements made under Rule 506 of Reg D of the Securities Act, which account for 99% of all private placements. Private placements represented a $900 billion industry in 2012, and nearly 90% of those offerings were made solely to accredited investors.
Groups of angel investors – people who make early investments in start-up companies – have been lobbying the SEC to either keep the current guidelines or to include other criteria, such as financial knowledge, investment sophistication, and past experience. Marianne Hudson, executive director of the Angel Capital Association, said that she, too, would be disqualified if the current thresholds were significantly increased. “The real losers would be the entrepreneurs,” she said.
Nevertheless, several consumer advocacy groups have advocated for various increases in the net worth and income requirements under the current definition. One proposal suggests increasing the net worth/income benchmarks to account for inflation. A July 2013 report from the Government Accountability Office estimated that under such a proposal the net worth requirement could increase from $1 million to $2.5 million and the current income requirement could increase from $200,000 ($300,000 jointly) to approximately $450,000 ($675,000 jointly). These numbers would mean that sixty percent (60%) of individuals who current qualify as accredited investors would not qualify under the proposed increased net worth and income standards.
“It would be a shame to see the definition of an accredited investor become even more onerous,” said Jilliene Helman, CEO of Realty Mogul. “The JOBS act was meant to open up the private markets for investors, and adjusting the income or net worth requirements for accredited investors upward would serve the opposite purpose.”
Perhaps the SEC should look across the pond for ideas as to an alternative approach.
In the United Kingdom, the FCA (that country’s financial regulatory body has taken a much more enlightened approach. For private equity investments, the FCA has certain income and net worth tests – which, it should be noted, are actually lower threshold amounts than those in the U.S. Unlike the SEC, however, the FCA also allows individuals to complete an exam – an “appropriateness test” – that is tailored by the issuer based on the specific investment and the associated risks.
The FCA’s novel approach to equity investment gets to the heart of what certain members of Congress have been advocating for -- that an individual’s ability to understand the risks of investment should be measured not by their finances but by their financial understanding. It’s also notable that the private placement industry in the United Kingdom, in particular with respect to debt instruments and peer-to-peer lending, is growing at an exponential rate – and yet investor fraud there remains almost non-existent.
The SEC seems to be aware of the broader economic consequences of any rules change. In a response letter to certain members of Congress who expressed concern about the SEC’s review of the accredited investor definition, SEC Chairwoman Mary Jo White indicated that, among other things, the SEC would examine the positive and negative effects to the economy of expanding the pool of accredited investors by lessening the current income/net worth requirements (and/or broadening the current requirements to include other individuals) or reducing the pool by increasing the current income/net worth requirements.
The addition of stricter / additional conditions could clearly have negative effects on the economy. The recent exclusion of the primary residence from the net worth calculation was already a big change, and there doesn’t seem to be any evidence that the private placement industry is in need of further reform. The passage of the JOBS Act in 2012 showed a legislative intent of loosening restrictions in this area, and other countries like the U.K. seem to be doing fine with such more lenient regimes.
Persons interested in submitting comments on this issue may contact the SEC directly via a website page dedicated to the issue by clicking here.