Tag: Accredited Investor

Reviewing the Accredited Investor Definition


The Securities and Exchange Commission issued a Staff Review of the “Accredited Investor” Definition at the end of 2023. The Dodd-Frank Wall Street Reform and Consumer Protection Act directs the SEC to review the accredited investor definition every four years.  The Staff previously reviewed the definition in 2015 and in 2019 (as part of the Concept Release on Harmonization of Securities Offering Exemptions).

There were several changes in 2020 to the definition of “accredited investor” as a result of the 2019 report. The SEC allowed those meeting the “knowledgeable employee” standard to meet the “qualified purchaser” standard would also be deemed an “accredited investor.” The SEC added a qualification-based standard, initially allowed holders in good standing of the Series 7, Series 65, and Series 82 licenses as accredited investors. And lastly, the SEC added the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors. There were a few other tweaks to the definition.

But the financial thresholds remained unchanged. I think that is likely to change this year. On the Fall 2023 RegFlex Agenda the SEC listed Regulation D and Form D Improvements (3235-AN04) letting us know that the SEC is thinking about “amendments to Regulation D, including updates to the accredited investor definition, and Form D to improve protections for investors.”

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Changes to the Definition of Accredited Investor

The Securities and Exchange Commission made some small changes to the definition of “accredited investor” last week. The changes had been first proposed last December.

The definition of “accredited investor” is at the nexus of the Securities and Exchange Commission’s missions: (1) to protect investors, (2) to maintain fair, orderly, and efficient markets, and (3) to facilitate capital formation.  If you’re an accredited investor you have access to private offerings. That enables capital formation. Private offerings are not subject to review by the SEC so they have fewer protections in place for investors. The commissioners were split on their votes to approve the changes.

Lots of arguments around the accredited investor definition are about an investor’s ability to assess risk in making the investment. I’ve long argued that the risk with a private placement is not the risk of loss, but the risk of liquidity. Some private placements are very risky and some are not. All private placements are less liquid than publicly traded securities. Tesla is at a crazy price right now, but you can sell and exit out of your position in minutes. You may not be able to exit from a private placement position for years.

The big news in the changes in the definition are the items that are missing. There were no changes to the wealth or income levels for qualification. Those levels have been unchanged for decades, broadening the pool of accredited investors with inflation.

The changes to the definition really just make some small expansions.

The SEC added a new category to the definition that permits qualification based on certain professional certifications, designations or credentials.  In conjunction with the changes, the SEC designated holders in good standing of the Series 7, Series 65, and Series 82 licenses as accredited investors. These are deemed as individuals with an ability to assess risk.

For private funds, there is an application of the “knowledgeable employee” definition over to accredited investor status. The SEC established Rule 3C-5 to allow “knowledgeable employees” to invest in their company’s private fund without having to be a “qualified purchaser”. The rule also exempts these knowledgeable employees from the 100 investor limit under the Section 3(c)(1) exemption from the Investment Company Act. However, the knowledgeable employee had to separately qualify as an accredited investor. This rule change covers that gap.

In act of progressive politics, the SEC added the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors.

“The term spousal equivalent shall mean a cohabitant occupying a relationship generally equivalent to that of a spouse.”

There were additional marginal expansions for some investment entities.

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Proposed Changes to Accredited Investor Definition

On Wednesday, the Securities and Exchange Commission proposed changes to the definition of “Accredited Investor” under Regulation D. The reason for the changes is to open the private market to a broader group of individual and institutional investors.

For those hoping for a dramatic change in how to determine accredited investor, you’ll be disappointed. The change eats at the edges and covers a few small openings.

The key to the accredited investor definition is that it limits who can invest in a private placement under Rule 506. If you don’t meet the accredited investor standard you can’t invest.

One expansion is to allow certain credentialed people to be automatically included as an accredited investor. The initial credentials are for registered representatives who have Series 7, 65 or 82 license. The rule notes that there are over 700,000 people who hold those designations, but has no data on how many of these were not previously qualified.

For private funds, there is an application of the “knowledgeable employee” definition over to accredited investor status. The SEC established Rule 3C-5 to allow “knowledgeable employees” to invest in their company’s private fund without having to be a qualified purchaser. The rule also exempts these knowledgeable employees from the 100 investor limit under the Section 3(c)(1) exemption from the Investment Company Act. However, currently the knowledgeable employee still has to be an accredited investor. This rule change will cover that gap.

Commissioner Jackson was opposed to the expansion. He is concerned about the lack of investor protection. He thought there was a lack of analysis in the release. In one instance he cites that the use of brokers expected to protect investors under the proposal. However, the data he looked at found that there was higher instance of fraud when brokers were involved. No vote.

Commissioner Peirce found the current bright-line tests of income and net worth are too simplistic, keeping out qualified people and allowing in more that may not be qualified. She also noted that the geographic disparities in cost of living results in lower salaries and therefore a geographic disparity in accredited investors. Yes vote.

Commissioner Roisman pointed out that he is not currently an accredited investor and would not qualify under the proposed changes. He stated that the definition should be broader. He is also concerned about the lack of investor protections. Yes vote

Commissioner Lee found the changes merely go to expanded the pool of private investors without the data on fraud. She is concerned that the current net worth and income levels are not indexed to inflation, expanding the pool of investors who could enter into private transactions without the protections of the public markets. No vote.

Chairman Clayton noted that there is a consensus that the current definition is less than satisfactory. Yes vote.

Once published, the proposal will be open for comments for 60 days.

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Lower the Wealth Standard for Investing in Private Placements

With the reduction in the number of public companies and larger companies staying private, the Securities and Exchange Commission is once again talking about loosening the “accredited investor” standard.

Much of the concern about private placements is about risk. They seem to be universally labeled as the most risky of investments. The accredited investor definition is categorized as the class of individuals who do not need the ’33 Act protections in order to be able to make an informed investment decision and protect their own interests. They get past the red velvet rope and into the VIP room to buy securities through a private placement. That VIP room is full of fraudsters and high rollers. You get to decide who is who.

It’s not that the ’33 Act protections remove risk. There are plenty of people who have lost money in the stock markets. Prices can fluctuate wildly, fraud exists, the markets get manipulated and we are all being fleeced by high-speed traders.

It’s too easy to label private placements as risky. They cover a broad swath of investments with different levels of risk. Public companies may raise capital through a private placement because its quicker, easier and less expensive than through a public offering. Hedge funds are sold through private placements, but they can be anywhere on the risk spectrum. Of course there are start-ups and crowdfunded firms that are the most risky of investments. This would be true if the capital were raised through a public offering or a private offering.

The risk is incredibly varied for private placements. So labeling them as risky investments is an incorrect categorization.

In my view, it’s not the risk of loss that is the main problem with private placements.

The biggest risk is the loss of liquidity.

Whether the investment ends up being a bad one or a wildly successful one, the investor will have limited ability to access that gain or loss and limited ability to time the realization of that gain or loss.

With an investment in the public markets, the investor can sell at any time. With that investment in Pets.com, you have the chance to sell your stock and get some money back before it goes bankrupt.

The same is would not be true for Pets.com as a private company, like with one of today’s unicorns.  With a private placement, the investor will have a limited ability to sell.

The net worth prong of the accredited investor definition is key because it shows that the individual has other resources and is not reliant on the private placement. Excluding the primary residence was a good change for the definition. Someone who is house rich and cash poor is less likely to be able to deal with the liquidity problem.

Excluding retirement accounts is exactly the wrong thing to do with the net worth requirement. That money is already relatively illiquid. An investor can access it, but is subject to penalty. Retirement money is long term money that will not be subject to liquidity demands and can be invested over the long term.

The current income test is a useful measure of liquidity demands of an investor. A higher income indicates that the investor is more likely to be able to absorb the loss in liquidity from a private placement.

Another recommendation is that private placement investments be limited to a portion of income or net worth. That is better aligned with the liquidity risk. However, it would impossible to verify and incredibly intrusive to implement.

That comes back to the compliance aspect. The more complicated the method for determining whether an investor is an accredited investor that harder it is for a company to use private placements or to open them to individuals. Removing the primary residence from the net worth definition was a good idea to address the liquidity risk, but it makes the confirmation more difficult.

The failure to ensure that all investors in a private placement are accredited investors can lead to very bad results. Complicating the definition will lead to a reduction in the usefulness of this fundraising regime.

In his statement a few weeks ago, Chairman Clayton broadened his thoughts on private placement to not just the accredited investor standard, but the entire private placement regime. He lumped them all together in the “exempt offering framework.” He calls it an “elaborate patchwork.” I agree that a broad restructuring of non-public security sales should be implemented that makes it clear how companies can raise capital with a clear framework for protection and disclosure of risks to investors.

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Financial Choice Act

Congress is currently occupied with health care. That is just one item on the agenda for the Republican leadership in Congress and President Trump. All have mentioned in one way or another to undo some of the evils of Dodd-Frank.

The big questions is how long will it take to move the American Health Care Act through Congress and deliver a bill that President Trump will be willing to sign. The second question is whether Congress will be able to move forward with any other legislation while dealing with health care.

Whenever Congress is ready to work on other legislation, Jeb Hensarling, Chairman of the House Financial Services Committee, has a law he is ready to move forward: The Financial Choice Act.

The Financial Choice Act is the bill that he sees as undoing many of the evils of Dodd-Frank.

“As the dust begins to settle on the post-crisis response, however, there has been a growing recognition that financial regulation has become far too complex and too intrusive and places too much faith in the discretion and wisdom of bank regulators.“

It has many of the things you might expect: repealing the Volker Rule, adjusting bank capital requirements, limiting the powers of the Consumer Financial Protection Bureau, limiting the powers of the Financial Stability Oversight Council, limiting regulatory limits on community banks.

Two items struck me as particularly relevant to private funds: SEC Registration and the definition of accredited investor.

Section 452 changes the definition of “Accredited Investor.” It keeps the two current brightline tests of income and net worth. I think those are key tests given the illiquid nature of private placements. It fixes those standards and removes Dodd-Frank’s requirement that the SEC adjust the amounts every four years.

The bill adds in a third test, allowing anyone licensed as a broker or investment adviser to also be an “accredited investor.” It adds a fourth test, allowing the SEC to create a regulatory regime for individuals to prove that the knowledge, education or job experience to allow them to invest in private placements.

We have seen from SEC Acting Commissioner Piwowar that he on board with opening up the definition of accredited investor.

The bigger change for private equity funds and probably for real estate funds is that it exempts “private equity fund” managers from the registration and reporting obligations of the Investment Advisors Act.

As you might expect, the bill does not take the time to define “private equity fund.” It gives the SEC six months to issue a rule for the definition.

The arguments are that private equity should be treated like venture capital. Private equity does not pose systemic risk. Private equity investors are generally sophisticated. The SEC would be more effective focusing its exam efforts on retail investment advisers.

Obviously this bill is a long way from being enacted. These two small provisions could easily be eliminated from the final law during the legislative process. I expect health care is going to bog down Congress for a long time.

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Changes to the Accredited Investor Standard?

The Securities and Exchange Commission has three mandates: (1) protect investors, (2) maintain fair, orderly, and efficient markets, and (3) facilitate capital formation. Regulation of private securities transaction through the accredited investor standard falls squarely in the conflict between these mandates.

The general statement about why certain investors can invest in securities subject to less regulatory oversight is that they are able to handle the risk. The standard for handling risk is the accredited investor standard and it’s based on tests of income or net worth. In theory, if you had a certain amount of money you could handle the risk.

The existing thresholds for an accredited investor were created in the 1980s. The big change was Dodd-Frank that excluded primary residence from the net worth calculation. The income and net worth test are not pegged to inflation and therefore have become more inclusionary over the past decades.

Last week, Acting Chairman Michael S. Piwowar quoted William Graham Sumner’s Forgotten Man in adding his view of securities regulation. He gave his view on accredit investors:

“Distinguishing investors who can fend for themselves from those who cannot is a line-drawing exercise fraught with peril. The Commission did just that in 1982 when it adopted Regulation D, dividing the world of private offering investors into two categories: those persons accorded the privileged status of “accredited investor” and those who are not.”

Here he steps into a fallacy. Or at least what I believe is a fallacy. He tags private placements as “high-risk, high-return securities available only to the Davos jet-set.”

First, the tests for accredited investor are not so high that you need to be in the Davos Jet-set.

Second, private placements are not all high-risk, high-return investments.

Perhaps the SEC is suffering from a lack of data on private placements. Private placements are investments that the issuer can sell to a smaller group of investors without having to go through the cost of a public offering.

Congressional mandates, SEC regulation, and shareholder lawsuits have made being a public company less attractive. There are additional costs and risks with allowing your securities to trade publicly. Until a few weeks ago, a public company had to worry about [the resource extraction rule conflict materials in its supply chain] and how to calculate the pay ratio between the CEO and its workers.

The risk for private placements is really not the loss of capital. It’s loss of liquidity.

Private placements have limited opportunities for investors to achieve liquidity. That generally means a long hold period. If the investor needs cash, the investor will have to look for other holdings to sell to get that liquidity. Private placements do not have a market for resale, so the investor needs to find a willing buyer in secondary sale process or wait for the liquidity event, if one ever comes.

Using income and net worth tests make sense because of the liquidity risk associated with private placements. The accredited investor will more likely have the income or capital to address the liquidity.

Within the world of private placements there are very risk investments and low risk investments when looking at an investors likely return of capital.

For example look at hedge funds, they may be more or less risky than a mutual fund depending on the investing style. As an investor, you have limited opportunities to receive back your investment and any returns. Most hedge limits have significant notice periods for redemption and often limited redemption to a few times each year for investors to get their hands on cash.

There seems to be a lot of focus on the high-risk early stage investing associate with private placements. Those are only good investments if you can make lots of them. You see something like 5% of startups making money and rest essentially going to zero. Assuming those odds, you need to make 20 investments. The accredited investor standard ends up being low if you just focus on those risky investments and ignore the more plentiful lower risk investments.

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506(c) Enforcement Actions

Although I had a lot of hope that the changing of private placement advertising restrictions by the Securities and Exchange Commission would remove potential foot-faults from the fundraising process, the end result proved challenging. Now it appears that the SEC is on the brink of challenging firms that took at advantage of the loosened restrictions.

private placement

Given the enormous restrictions on being a company with publicly listed securities, private placements have been a vibrant form of raising capital. Although deemed more “risky”, to me that is a poor label without a further discussion of risk. The risk is liquidity, not risk of loss. A huge portion of the private placement market is by firms that provide no more risk than a publicly listed company. There is also capital being raised by start-ups and riskier companies. The common factor is not the risk of loss. The common factor is the investor’s limited ability to sell the security. If the investor needs liquidity, the investor will have limited options.

The main concern of the SEC in passing Rule 506(c) was be the increase in fraud. So far, we have not seen the enforcement actions to back up that fear.

However, the use of advertising under 506(c) for a private placement has been limited. From 2013, when 506(c) became effective, through 2015, there were $2,800 billion in offerings under 506(b) and only $71 billion in offerings for 506(c).

It seems like enforcement proceedings are in process for some firms that abused Rule 506(c). SEC Chair Mary Jo White stated that the SEC has some open investigations. Over the next few months perhaps those become public.

The failure of Rule 506(c) is that it was coupled with a proposed rulemaking that would dramatically change the landscape of private placements. We have not heard anything more on that rulemaking. It’s specter still haunts Rule 506(c) offerings.

I think Rule 506(c) is more than what most fund managers wanted for changes in advertising. Fund managers wanted some safe harbors for advertising to avoid foot-faults. Fund managers want to able to participate in league tables, talk to the press and talk at conferences without the fear that an inadvertent slip of the tongue would wreck havoc on a fundraising. I encountered no fund managers who were interested in media campaigns as part of a fundraising.

It looks like we may get more insight into the SEC’s view of Rule 506(c) when the enforcement actions are announced.

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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.

 

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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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Why I think the Accredited Investor Standard Should Not Change

rich accredited investor

The SEC Investor Advisory Committee is scheduled to vote on a reform plan from a subcommittee at its Oct. 9 meeting. That plan calls for the SEC to rethink the income and net-worth minimums used to define an “accredited investor.”

Much of the concern about private placements is about risk. They seem to be universally labeled as the most risky of investments. The accredited investor definition is categorized as the class of individuals who do not need the ’33 Act protections in order to be able to make an informed investment decision and protect their own interests. They get to pass the red velvet rope and buy securities through a private placement

It’s not that the ’33 Act protections remove risk. There are plenty of people who have lost money in the stock markets. Prices can fluctuate wildly, fraud exists, the markets get manipulated and we are all being fleeced by high-speed traders.

It’s too easy to label private placements as risky. They cover a broad swath of investments with different levels of risk. Public companies may raise capital through a private placement because its quicker, easier and less expensive than through a public offering. Hedge funds are sold through private placements, but they can be anywhere on the risk spectrum. Of course there are start-ups and crowdfunded firms that are the most risky of investments. This would be true if the capital were raised through a public offering or a private offering.

The risk is incredibly varied for private placements. So labeling them as risky investments is an incorrect categorization.

In my view, it’s not the risk of loss that is the main problem with private placements.

It’s the loss of liquidity.

Whether the investment ends up being a bad one or a wildly successful one, the investor will have limited ability to access that gain or loss and limited ability to time the realization of that gain or loss.

With an investment in the public markets, the investor can sell at any time. With a private placement, the investor may have no ability to sell.

The net worth prong of the accredited investor definition is key because it shows that the individual has other resources and is not reliant on the private placement. Excluding the primary residence was a good change for the definition. Someone who is house rich and cash poor is less likely to be able to deal with the liquidity problem.

Excluding retirement accounts is exactly the wrong thing to do with the net worth requirement. That money is already relatively illiquid. An investor can access it, but is subject to penalty. Retirement money is long term money that will not be subject to liquidity demands and can be invested over the long term.

The current income test is a useful measure of liquidity demands of an investor. A higher income indicates that the investor is more likely to be able to absorb the loss in liquidity from a private placement.

I’m all for expanding the definition to more individuals who can prove their financial sophistication. One recommendation from the sub-committee is to have a test for financial sophistication. That’s a great idea to expand the base, but I’m skeptical that there would be many people lining up to take the test.

Another recommendation is that private placement investments be limited to a portion of income or net worth. That is better aligned with the liquidity risk. However, it would impossible to verify and incredibly intrusive to implement.

That comes back to the compliance aspect. The more complicated the method for determining whether an investor is an accredited investor that harder it is for a company to use private placements or to open them to individuals. Removing the primary residence from the net worth definition was a good idea to address the liquidity risk, but it makes the confirmation more difficult.

The failure to ensure that all investors in a private placement are accredited investors can lead to very bad results. Complicating the definition will lead to a reduction in the usefulness of this fundraising regime.

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Narrowing the Safe Harbors

narrow safe harbor compliance

The Securities and Exchange Commission rolled out the accredited investor verification requirement and made it principle-based for purposes of Rule 506(c). You have to take reasonable steps to verify that an investor meets the accredited investor standard. In the same release it created four non-exclusive safe harbors that would deemed to be taking “reasonable steps.”  The SEC recently released six new Compliance and Disclosure Interpretations on the verification of prospective investors as accredited investors.

One safe-harbor method is to review the IRS filings for the two most recent years. That seems straightforward. Just deliver me the two latest tax filings. But the SEC has made that safe harbor nearly  impossible to navigate during the first part of a calendar year. In Question 260.35, the SEC takes a very strict view of the safe harbor. The filings must be for the two most recent years. So if you were to use that safe harbor in 2014, the issuer must get the 2013 and 2012 tax filings.

For most potential investors this safe harbor is inaccessible in January and may extend further into the year depending on when the investor files his or her tax return. I’ve filed an extension for the past few years and don’t get my taxes done until August. I couldn’t prove myself to be an accredited investor using the safe harbor until that point in the calendar year.

The SEC’s solution is to switch to the principles-based approach by reviewing the two most recent available years and getting written representations from the potential investor that:

(i) an Internal Revenue Service form that reports the purchaser’s income for the recently completed year is not available,
(ii) specify the amount of income the purchaser received for the recently completed year and that such amount reached the level needed to qualify as an accredited investor, and
(iii) the purchaser has a reasonable expectation of reaching the requisite income level for the current year.

The SEC is clearly making it hard to navigate the investor verification requirement. It seems to laying mines around the entrances to the safe harbor.

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Image is US Navy 060628-N-4776G-144 The Nimitz-class aircraft carrier USS Ronald Reagan (CVN 76) navigates its way through the narrow strait that make up the inlet to Pearl Harbor for a port visit.jpg