In my last post, I argued that the SEC's "accredited investor" definition, which prevents investors who make less than $200,000 a year or who are worth less than $1 million from investing in private securities offerings, should be eliminated from our securities laws. Under its current definition, the SEC conflates less-wealthy investors with ones who lack good judgment, reserving considerable investment opportunities only for the well-to-do.
After years of considering options for revising the definition, including scrapping the concept altogether, the SEC has instead proposed nothing more than a modest change. The new proposal somewhat expands the group of investors it considers to have "the knowledge and expertise to participate in our private capital markets" by including people who hold certain professional credentials, such as broker-dealer and investment adviser representatives, as well as some private fund employees seeking to invest in their employers' own funds. The proposed definition thus adds a small subset of financial industry insiders to the set of well-to-do investors it already permits to participate in private securities offerings.
This limited expansion does little to remedy the harms caused by the current rule, which reserves private securities offerings for a small minority of individual investors. The vast majority of investors remain shut out of offerings made under Rule 506 of Regulation D, which permits an issuer to raise an unlimited amount of capital without registering the offering, so long as that issuer complies with the rule's requirements for investor solicitation and eligibility, among other things.
But the proposed definition at least moves the SEC in the right direction: by expanding access to private securities offerings regardless of whether investors are wealthy enough to sustain a loss, the SEC has narrowed its investor protection focus to whether an investor can assess a prospective investment. Given this refined focus, the SEC can and should do better than its current proposal.
To be specific, if the SEC wants to open investment in private securities offerings to those who can assess a prospective investment, it should take the following three steps:
(1) Consider as "accredited" any investor who is being advised by an investment adviser or broker-dealer. The SEC's proposed amendments assume, by their very nature, that investment adviser and broker-dealer representatives are sophisticated enough to make their own investments in private offerings. Their clients should be able to leverage that same expertise to invest. Many of these interactions will be subject to fiduciary duties or the best interest standard, depending on the representative's relationship with the client, providing an additional layer of investor protection.
A limited number of investors are already allowed to rely on the advice of others to purchase exempt offerings. A Rule 506(b) offering can be purchased by a limited number of non-accredited investors if they, individually or together with a purchaser representative, have enough knowledge and experience to evaluate the merits and risks of the prospective investment. This allowance has been used sparingly—from 2013 to 2018, only 6% of Rule 506(b) offerings included at least one non-accredited investor—first, because there's uncertainty as to how to judge an investor's knowledge and experience, and second, because issuers are required to provide additional information to any non-accredited investors who participate in the offering. This allowance is not the panacea that it may seem; these additional burdens on issuers deter participation by non-accredited investors who can assess the investment (alone or with their adviser). And such investors remain shut out entirely from Rule 506(c) offerings that are strictly limited to accredited investors. Adding advised investors to the accredited investor definition would open substantially more opportunities to those who have the ability to judge the prospective investment.
Counting advised investors as accredited also gives investors control over their own circumstances. While it may impose additional costs to investing, obtaining an adviser is far easier than obtaining a new credential, some of which are only available to those employed by a broker-dealer or investment adviser. And, of course, obtaining an adviser is far easier than getting rich enough to meet the accredited investor definition's wealth test.
(2) Permit investors to self-certify as accredited. Issuers generally are allowed to rely on investors' representations for offerings under Rule 506(b), but offerings under Rule 506(c) require issuers to verify that an investor meets the accredited investor definition. Although the rule provides a list of "non-exclusive" methods to conduct such a verification, as a practical matter, issuers generally follow the rule's proscriptions, which include reviewing the investor's tax returns and bank statements. This verification process is onerous for issuers and investors alike and invasive to investor privacy. It also likely results in the exclusion of investors who do not substantially exceed the accredited investor threshold, both to make the review easier and to avoid the potential consequences of an erroneous verification. Recognizing the burdens of verification and investor privacy concerns, the SEC has proposed limited self-certification for investors who are making a new investment with the same issuer. But this tweak to the existing rules does not go far enough.
The best solution would be for the SEC to permit an investor to self-certify under a broader, principles-based, definition of accredited investor. Coupled with clear disclosure about the Securities Act protections that she will forgo by participating in private markets, this will allow an investor to choose for herself whether she meets the sophistication criteria required to invest. Other jurisdictions, like the United Kingdom, permit self-certification of this type for certain sophisticated investors. But even used in conjunction with the SEC's bright-line accreditation definition, self-certification coupled with clear disclosure would be welcome. Self-certification appropriately shifts the burden of compliance to the investor, who bears the risk of the investment. Self-certification also protects an investor's privacy by relieving her of the need to disclose highly personal information about net worth and income.
(3) Consider accredited investor status only for offerings under Rule 506 of Regulation D. The accredited investor definition appears in the Securities Act only in sections that are relevant to Rule 506 offerings. Yet the SEC has imported the accredited investor definition to exempt offerings that are based on other statutory authority. For example, the SEC imposes investment limitations on non-accredited investors for offerings made under Tier 2 of Regulation A, which permits issuers to raise up to $50 million annually subject to certain filing requirements. And while the statute itself imposes investment limitations for crowdfunding offerings based on an investor's income and net worth, the SEC is proposing to permit accredited investors to make unlimited investments. The SEC should not expand this investor caste system into other exemptions.
Of course, allowing more persons to take part in private offerings doesn't mean that anyone allowed to do so should be taking part in such offerings! As SEC Commissioner Elad Roisman has said, "not every private company will turn out to be a good investment, just as not every public company would be a good investment. But depriving people of investment opportunities based on certain income and wealth thresholds objectively makes little sense." That someone is legally able to buy into a hedge fund or invest in a biotech startup is no reason why they should. But the SEC should not prevent them from doing so, especially provided investors can seek expert advice in evaluating potential investments.
Although the SEC's proposal to expand the accredited investor definition is a step in the right direction, it is only a small one. Bigger steps, including but not necessarily limited to those suggested here, are needed to move the needle further in favor of investor choice, even if the SEC is unwilling to eliminate the accredited investor concept all together.
- Part I
- Part II