SEC Takes a Look at the “accredited investor” definition

The Securities and Exchange Commission left a new Report on the Review of the Definition of “Accredited Investor” as an early Christmas present under your compliance tree. [Feel free to replace Christmas with New Years or the year end celebration of your choice.] We will need to keep an eye on what happens with this report.

The accredited investor definition falls right into battle zone of the SEC where it needs to balance capital formation on one side and investor protection on the other. I expect there will a Festivus feats of strength contest to see who wins the battle over the definition.

Section 413(b)(2)(A) of Dodd-Frank requires the SEC to study the accredited investor definition every four years. This is the first study. It’s not a SEC inspired review, but one mandated by Congress.

SEC Chair Mary Jo White encourages “investors, companies and other market participants to provide comments as public input will be very valuable as the Commission considers the definition.” The report considers alternative approaches to defining “accredited investor,” provides staff recommendations for potential updates and modifications to the existing definition and analyzes the impact potential approaches may have on the pool of accredited investors.

Few people think that the current income and net worth tests for an accredited investor have much to do with the ability to judge the risks of a private investment. Of course, it also does not mean that non-accredited investors can judge a publicly listed security either.

But the current tests do offer a bright-line than makes it easy toe evaluate a potential investor’s eligibility to participate in the offering.

“Clarity and certainty in the accredited investor definition foster greater confidence in unregistered markets and ultimately could reduce the cost of capital, thereby promoting increased capital formation, particularly for small businesses.”

Given that Regulation D offerings still raise more money than registered offerings, you have to wonder if Congress and the SEC have made it more palatable to stay private.

As for private placements being more risky than registered investments, I will disagree. They may be more or less risky on whether the investment will produce a return. The risk is not in the return. The risk is one of liquidity. A private placement by Exxon may not be any more risky than the public stock. The risk is that there is no market to resell the security. If you suddenly need the cash back from the investment you may have no ability to get it until a liquidation event.

Here are the two groups of recommendations from the Report:

The Commission should revise the financial thresholds requirements for natural persons to qualify as accredited investors and the list-based approach for entities to qualify as accredited investors. The Commission could consider the following approaches to address concerns with how the current definition identifies accredited investor natural persons and entities:

Leave the current income and net worth thresholds in place, subject to investment limitations.
Create new, additional inflation-adjusted income and net worth thresholds that are not subject to investment limitations.
Index all financial thresholds for inflation on a going-forward basis.
Permit spousal equivalents to pool their finances for purposes of qualifying as accredited investors.
Revise the definition as it applies to entities by replacing the $5 million assets test with a $5 million investments test and including all entities rather than specifically enumerated types of entities.
Grandfather issuers’ existing investors that are accredited investors under the current definition with respect to future offerings of their securities.

The Commission should revise the accredited investor definition to allow individuals to qualify as accredited investors based on other measures of sophistication. The Commission could consider the following approaches to identify individuals who could qualify as accredited investors based on criteria other than income and net worth:

Permit individuals with a minimum amount of investments to qualify as accredited investors.
Permit individuals with certain professional credentials to qualify as accredited investors.
Permit individuals with experience investing in exempt offerings to qualify as accredited investors.
Permit knowledgeable employees of private funds to qualify as accredited investors for investments in their employer’s funds.
Permit individuals who pass an accredited investor examination to qualify as accredited investors.

Personally, I think some increase in the income and asset tests are okay if it also includes an ability for an investor to prove financial sophistication to gain access to private offerings.

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