In the following guest post, David H. Topol of the Wiley law firm takes a look at the recent decision by the U.S. Securities and Exchange Commission to amend the agency’s operative definition of the term “accredited investor.” A copy of the agency’s final rule incorporating the revised definition can be found here. The agency’s August 26, 2020 press release about the change can be found here. I would like to thank David for allowing me to publish his article as a guest post on this site. I welcome guest post submissions from responsible authors on topics of interest to this blog’s readers. Please contact me directly if you would like to submit a guest post. Here is David’s article.
On August 26, in a 3-2 vote, the U.S. Securities and Exchange Commission adopted amendments to the definition of “accredited investor.” The amendments expand the definition to allow a natural person to become an accredited investor based on financial sophistication, rather than only based on income or net worth.
This article summarizes the expansion of the definition of accredited investor. It then discusses the separate comments filed by each of the Commissioners. Those comments reveal an interesting split within the SEC concerning access to the private capital markets. Chairman Clayton and the two Republican Commissioners view the rules as an important first step toward modernizing the definition and expanding access to private capital markets. The two Democratic Commissioners oppose the amendments, which they characterize as a step backward that fails to protect investors from private market risks.
Existing Definition of Accredited Investor
The SEC requires that a company issuing securities to the public register those securities. The registration requirements impose disclosure obligations that are intended to protect investors. However, a company also has the option of selling unregistered securities, provided that it sells those securities only to “accredited investors.”
This approach has important implications for access to a wide range of investments in the capital markets. Unregistered securities include many private equity deals, hedge funds, venture capital funds, angel investments and other private placements. Non-accredited investors do not have access to unregistered securities.
Until now, for individuals, the SEC has used a wealth-based test to determine whether an individual qualifies as an accredited investor. Under Rule 501 of Regulation D, an individual can qualify as an accredited investor if the individual has a net worth of at least $1,000,000, excluding the value of the investor’s primary residence. Alternatively, an individual can qualify as an accredited investor if the individual has an income of at least $200,000 per year for each of the past two years, or $300,000 in combined income if married. The monetary thresholds have remained unchanged for the past 38 years. The regulations also address how entities, including trusts, banks and charitable organizations, qualify as accredited investors.
The SEC’s Revisions to the Definition of “Accredited Investor”
The Dodd-Frank Wall Street Reform and Consumer Protection Act requires the SEC to review the definition of accredited investor every four years. In December 2019, the SEC proposed amendments to the definition of the term. The Commission received substantial comments, and on August 26, it issued the final regulations, which become effective sixty days after publication in the Federal Register.
The SEC left unchanged the wealth-based tests and thresholds for an individual to qualify as an accredited investor. The SEC also added a new category to the definition to allow natural persons to qualify as accredited investors “based on certain professional certifications, designations or credentials or other credentials issued by an accredited educational institution, which the Commission may designate from time to time by order.” The SEC simultaneously issued an order providing that holders of Series 7, Series 65 and Series 82 licenses meet that qualification.
The SEC’s amendments also expand the categories of entities that qualify as accredited investors to include Indian tribes, governmental bodies, and certain other entities that have in excess of $5 million as well as certain “family offices.” There was general support for those amendments in the comments.
Arguments In Support of the Amendments
Chairman Clayton and the two Republican members of the Commission (Hester Peirce and Elad Roisman) each issued statements in support of the amendments. They characterize the changes as an important first step in “modernizing” the definition of accredited investor and suggest that even more changes should be given careful consideration. They make four primary arguments in support of the amendments.
First, they argue that financial wealth is a poor proxy for the financial sophistication necessary to invest in the private capital markets. Individuals who fail to meet the wealth threshold may still have the ability to evaluate effectively private market investment opportunities. Conversely, wealthy individuals may lack that ability.
Second, the majority reasons that it is important to expand access to private capital markets to allow individual investors to benefit from those markets. Commissioner Peirce explains that private markets “are where a lot of economic growth is happening,” and individuals should have the freedom to participate in those markets. Under her view, while there is risk in such investments, the government should not be making decisions about a person’s right or ability to make investment decisions based on those risks.
Third, the majority reasons that it is important to expand access to capital markets to increase the ability of smaller companies to raise money. They argue that many small and local businesses struggle to find accredited investors to invest in their companies. The majority also notes that this problem is more acute outside of large, urban centers where incomes and wealth are higher.
Finally, the majority argues that the impact of limiting access to private markets has a disproportionate impact on minority and women-owned business. They reason that many such business owners may have less access to individuals who meet the wealth-based tests to qualify as an accredited investor, making it harder for such businesses to raise money.
The statements by the majority also reflect receptivity to further expansions to the definition of accredited investor. For example, Commissioner Roisman advocates that in four years, the Commission should consider whether there should be difference in the wealth-based criteria based on geographical variations in average wealth and income.
Arguments Against the Amendments
The two Democratic Commissioners, Allison Herren Lee and Caroline Crenshaw, voted against the amendments and issued a joint statement, characterizing the Commission’s decision as a “failure to modernize the accredited investor definition.” They advance three arguments in support of that characterization.
First, they criticize the Commission for failing to index for inflation the wealth-based tests to qualify as an accredited investor. They note that since the thresholds were last increased in 1983, there has been an increase of 550% in qualifying households. From their perspective, this failure is significant because of “the naturally opaque nature of the private market where issuers are not required to provide the robust disclosures that are features of public offerings.”
Second, the Democratic Commissioners argue that the Commission failed to consider the risk to seniors because “private offerings are not just less transparent, but also illiquid and prone to fraud.” They reason that a substantial amount of wealth is concentrated in senior households and that wealth was often accumulated because of time, rather than because of financial sophistication. Thus, the failure to increase the wealth-based thresholds exposes the senior population to greater risk.
Third, the Democratic Commissioners criticize the Commission for failing to take any steps to enhance the visibility into private capital markets. They contend that there is much that is unknown about how the private capital markets function, including how many investors participate, how much they invest, how those investments fare or even the extent to which the amendments will increase the number of accredited investors. They argue that the rulemaking should have included efforts to increase visibility into the private capital markets.
As all five members of the SEC recognize, private capital markets are expanding, and the revised definition of accredited investor increases the number of individuals able to access those markets. At the same time, the division in the Commission on the amendments reflects an interesting split as to the role of Commission. The majority view focuses on the goal of promoting access to the private capital markets to benefit both investors and smaller companies. The minority expresses concern about the inherent risks, including fraud, in those markets.