The SEC May Want to Change the Accredited Investor Definition…And That Might Be a Bad Thing

Last month, the SEC Investor Advisory Committee met to discuss a subcommittee’s proposal to amend the natural person definition of an “accredited investor”, as defined under Regulation D. The simplest private securities offerings require sales to accredited investors only, so it is no surprise that most private offerings occur with only accredited investor purchasers. To briefly review, the natural person definition of an accredited investor includes any person with an annual income of $200,000 ($300,000 combined with a spouse’s income) in the past two years with the expectation of surpassing that threshold in the current year, or a total net worth in excess of $1 million (not including the value of one’s primary residence). The committee that discussed potential changes to the accredited investor definition seemed to think that the definition “was broken” or “didn’t work”, apparently simply because the definition has not been amended since it was first adopted in the 1980s, as the committee could not really identify how the current definition was not working or was causing harm. One of the amended versions of the accredited investor definition the committee discussed involved upping the limits to $500,000 annual income ($700,000 with spouse) and $2.5 million net worth, but again the committee apparently did not describe how these new limits would fix any “problem”, nor did the committee apparently give any consideration to any detrimental effect of changes such as these. The committee did note issues with private offerings such as lack of information/disclosures in private offerings, lack of sophistication by investors, inability of investors to bear the risk of their investment, and outright fraud, but again failed to explain how simply raising the financial thresholds would solve any of these problems — except for maybe inability to bear risk, but I doubt that many accredited investors are wagering substantial portions of their wealth on startups, or even anything above what they can afford to lose. While the accredited investor status nominally presumes that an investor is sophisticated (which is a different classification of purchaser under the securities laws), in reality the standard largely ensures that the purchaser has financial means to withstand the risk of loss. Of course, in most private placement offerings there is no limit on how much an individual accredited investor can invest, so presumably an accredited investor who just comes in over the threshold can invest his entire $200,000 annual income or $1 million net worth -— I doubt that anyone can withstand the loss of their entire annual income or net worth. And even though the accredited investor standard presumes that the investor is sophisticated enough to evaluate the investment by sheer reason of his or her wealth, there are obviously individuals who are far more qualified to evaluate investments than many accredited investors. I’d imagine that a CFA making $150,000 a year is probably more qualified to evaluate an investment than even a very wealthy and successful surgeon making seven figures a year. But the surgeon is an accredited investor and permitted to freely participate in most private offerings, while the CFA is not. In the end, I do agree that the accredited investor standard is broken and must be fixed. However, upping the limits doesn’t solve what I consider to be the real problems with the standard — it simply focuses on persons who merely have the financial means to bear the risk of loss, and ignores investors who may have the educational and professional background that properly equips them to evaluate private placement offerings. Simply upping the limits will likely actually cause more harm than good, as raising the limits as proposed by the Investor Advisory Committee could shrink the accredited investor pool by as much as 60%. And I’d be willing to bet that the majority of the accredited investors who participate in Reg. D offerings are in that 60%. So simply raising the limits would shut off an important source of capital for and absolutely kill America’s startups. Bad idea. Seattle startup attorney Joe Wallin suggested leaving the current financial standards in a new accredited investor definition, while also permitting persons who don’t meet the financial standards but possess certain specialized knowledge and/or experience to become accredited investors — persons such as certified financial and investment analysts and other persons who have the education and training to evaluate businesses and the risks of investment. Second, he would limit the amount that persons who fall under the education/training standard could invest, such as 5% of their annual income or net worth. I largely agree with Attorney Wallin’s proposal. I have no problem with permitting people who have the financial means to absorb investment losses from participating in private offerings — let’s be honest, most of those investments will be completely lost. But I think that persons who have the education and training to evaluate investments should also be permitted to invest in private offerings — they’re likely better equipped to figure out who the likely winners are than people who qualify under the wealth standards. However, to address the Investor Advisory Committee’s concerns (read: kill any objection they may have to — *gasp* — expanding the investor pool), especially ability to withstand loss of risk or outright fraud, I would also place caps on the amount that accredited investors under a sophistication standard could invest, but also on accredited investors under the wealth standards. My proposal for an accredited investor rule would look something like this: (1) A natural person is an accredited investor if he or she: (a) Has an annual income in excess of $200,000 ($300,000 in conjunction with his or her spouse) for the past two years and a reasonable expectation of annual income in excess of said limit in the current year (b) Has a net worth in excess of $1,000,000 (either alone or in conjunction with his or her spouse), excluding the value of the person’s primary residence (c) Is a (insert various regulatory credentials and/or registrations such as CFA, CAIA, FRM, or broker/dealer), or, in the judgment of the Commission, possesses sufficient educational background, regulatory credentials, and/or professional training to properly evaluate the merits and risks of a private placement offering (2) A natural person who qualifies as an accredited investor under clause (a) or (b) of the preceding Section (1) may not invest, in private placement offerings, more than 10% of their annual income in any one year if qualified under clause (a) only, or 10% of their net worth at any time if qualified under clause (b) only, or the greater of 10% of their annual income in any one year or 10% of their net worth at any time if qualified under both clauses (a) and (b) (3) A natural person who qualifies as an accredited investor under clause (c) of the preceding Section (1) may not invest, in private placement offerings, more than 5% of their annual income in any one year This rule keeps all current accredited investors, and adds all sophisticated persons to the pool, effectively doing away with the sophisticated investor as a separate classification. An accredited investor who just meets the annual income limit of $200,000 can invest up to $20,000 in any one year, while one who meets the net worth standard of $1 million can have as much as $100,000 invested in private placements at any one time (referring of course to the amount of money originally invested, not the current value of the investments); meanwhile the CFA making $150,000 can invest up to $7,500 in any one year. Of course, the sophistication standards and investment limits would depend on what would be reasonable. I believe this rule also addresses any concerns investor advocates may have about ability to withstand risk of loss, or senior citizens being defrauded by investing their whole retirement in some half-cooked scheme, or whatever doomsday scenario troubles them. Some may oppose limiting the investment ability of accredited investors under the income or net worth standards, but I would imagine that accredited investors usually don’t exceed some annual or total percentage of their income or net worth, be it 10, 15, or 20 percent. And I’d be perfectly open to no limits on the ultra-wealthy, such as persons with annual income in excess of $10 million or net worth in excess of $100 million — people with that kind of money usually aren’t so careless with it as to invest more than they could afford to lose, and I don’t want to have a season of Shark Tank cut midway simply because the Sharks hit their investment limits! Further reading: http://www.crowdfundinsider.com/2014/07/44794-sec-investor-advisory-committee-tackles-non-problem/

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