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Let Investors Decide, Part 1

Investors are being locked out by the SECThe SEC's "accredited investor" definition bars investors who earn less than $200,000 a year or have a net worth less than $1 million from taking part in private securities offerings. It's a definition even its mother no longer loves: SEC Commissioner Elad Roisman says it "stands between millions of Americans and opportunities for them to invest their wealth in private offerings," while SEC Commissioner Hester Peirce calls it "one of the more offensive concepts lurking in our federal securities laws." Although the definition was intended to offer "investor protection," it has instead "shut out all but the wealthiest from upside gains that private companies have made over the last several decades," according to Roisman.

In light of such negative opinions from inside the SEC, one might have expected a proposed amendment to the rule to be dramatic. Currently, the SEC's rules define an accredited investor as any natural person: (i) whose net worth, individually or with spouse, exceeds $1,000,000 not counting his primary residence or (ii) who had an individual income of more than $200,000 individually (or $300,000 with spouse) for the past two years and expects to receive the same income this year. But, after taking more than a decade to reconsider it, the SEC's proposal merely expands this old definition, adding certain financial services professionals to the ranks of those well-to-do persons already permitted to invest in private offerings. This is the wrong approach.

The right approach is the most simple: eliminate the accredited investor definition altogether. Permit investors to make their own investment decisions. Far from undoing "investor protection," this change would be one that investors—especially less wealthy ones—would have every reason to welcome.

To understand why, let's start with a bit of background. (For a more in-depth background reading, see this policy analysis.)

The Securities Act of 1933 requires that all offers and sales of securities be registered with the SEC. Issuers of such securities must file a registration statement, which includes a prospectus containing audited financial statements and detailed disclosures about the issuer's business operations, financial condition, risk factors, and management. This disclosure—which is complex and very expensive to complete—is the hallmark of securities sold in our public markets.

But public markets represent only a fraction of the capital raised in the United States. Considerably more capital is raised in private markets: in 2018, private markets raised $2.9 trillion of new capital, compared to $1.4 trillion—less than half as much—in public markets.

Private offerings are made possible by the many exemptions from the Securities Act's registration requirements. The exempt offering framework is complicated—a problem in and of itself—but in general, investors in private offerings receive less information about the security being offered than they would in a registered offering, and resales of the securities from private offerings are often restricted. These private offerings are diverse, and include direct investment in individual companies as well as pooled investment into private equity, hedge, or other funds.

One of the most popular avenues for exempt offerings is Rule 506 of Regulation D. More money was raised under Rule 506(b) in 2018 than in the entirety of the public markets ($1.5 trillion vs. $1.4 trillion). Rule 506 permits an unlimited amount of capital to be raised without registering the offering if the issuer complies with the rule's requirements about, among other things, investor solicitation and eligibility. The accredited investor definition limits who can invest in Rule 506 offerings.

The term "accredited investor" was added to the Securities Act in 1980, which directed the SEC to create rules to qualify "any person who, on the basis of such factors as financial sophistication, net worth, knowledge, and experience in financial matters, or amount of assets under management" as an accredited investor. The SEC's rules have remained largely unchanged since 1982, limiting private market investment to individuals who are worth more than $1 million or who make more than $200,000 a year. The SEC takes for granted that such well-to-do persons are the only ones "whose financial sophistication and ability to sustain the risk of loss of investment or fend for themselves renders the protections of the Securities Act's registration process unnecessary."

What's wrong with that?

In essence, the SEC is limiting the investment opportunities of less wealthy persons. The SEC decides who gets to invest where: public markets only for most, but public and private markets for the wealthy. Such paternalism is objectionable in itself.

What's more, the SEC's justification for its stance—investor protection—makes little sense: yes, private market investing is risky, but so is investing in public securities markets. Even assuming that a particular investor finds the voluminous and lawyered information in a registration statement valuable, these public market disclosures do not mitigate the risk of investing in the company itself. The public market also is no stranger to fraudulent misconduct. Yet the SEC places no limits on investors' freedom to invest in public markets, regardless of an investor's degree of financial sophistication or ability to endure a loss. In light of this, the SEC's limitations on private market investment seem quite arbitrary.

Nor is the SEC's interference harmless. On the contrary, SEC intervention has caused less wealthy investors to miss out on good opportunities in private markets. As the number of public companies has declined over the past 20 years, the amount of time it takes for a company to go public has grown to more than 11 years today, up from 4 years in 1996. This extended timeline likely places a company past its high growth phase by the time it goes public. So, not only do investors have fewer choices in the public markets than they once did, those choices may offer more limited opportunity for returns on their investment. Although there's some debate about whether investors earn better profits in private markets, private markets unquestionably offer investors different investment opportunities than are available in the public markets. More than two-thirds of securities issued in 2018 were in the private markets, and the accredited investor definition prohibited 88 percent of Americans from investing in them.

The simple truth is that the SEC's arbitrary line-drawing makes little sense. Its wealth test misses the mark both by excluding experienced entrepreneurs who are not wealthy and by including heirs to fortunes, lottery winners, and others whose wealth has nothing to do with investment know-how. Not surprisingly, the wealth test is also discriminatory, as the SEC has itself recognized, disproportionately depriving minorities and people in lower cost of living areas of the chance to invest in the private markets. This harms not only investors, but also businesses seeking to raise capital that may be unable to turn to their communities for support.

Nor will it improve matters if the SEC, instead of applying a naive wealth test, defines "accredited investors" as those who can afford to take risks. Investors can be motivated by many goals, not all of which are related to return on investment: for example, the desire to invest in a compelling idea, an interest in supporting a local entrepreneur, the need to diversify their portfolio, or an abiding interest in risk-taking. None of these motivations is captured by a general metric for loss tolerance.

The truth is that no simple, blanket rule can capture individual investor sophistication. The SEC's attempts to employ such a rule are poor substitutes for existing investor protections that are more attuned to individual circumstances, including anti-fraud provisions and standards applicable to investment adviser and broker-dealer conduct. Regulating misconduct by issuers and financial professionals on whom investors rely, rather than screening investors, preserves an investor's freedom to invest as he or she sees fit.

To reiterate: the accredited investor definition should have no place in our securities laws. A better system would preserve firms' options for raising capital, while simultaneously ensuring that investors know what types of information the company is required to disclose. Investors can then judge for themselves whether they wish to have particular information from a company before investing. One way of pursuing this approach has been suggested by Thaya Brook Knight, who proposes that unregistered offerings come with a mandatory disclosure of protections that investors will forgo. Georgetown professor James Angel also has some interesting ideas about a classification system that can assist investors in understanding the amount of disclosure an offering is required to provide.

Unfortunately, the SEC seems determined to do no more than tinker with the accredited investor definition. In my next post, I'll discuss the SEC's proposed amendments in more detail and suggest a compromise between them and jettisoning the definition altogether that, while not a perfect solution, would at least expand less-wealthy investors' freedom to invest in private markets.

 

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