On 15th January, the Securities And Exchange Commission’s (SEC) discussion paper concerning amending the “Accredited Investor” definition hit the federal register, starting a 60 day consultation period with the public.
The proposed changes signal the latest step in a general direction that the U.S. has been heading towards facilitating better access to capital for startups through the easing of restrictions on individual investors.
Legal And Regulatory Experts Weigh In
Eight experts from the legal and regulatory profession weigh in on their views of the proposed changes. In general, the feedback has been positive, with a few notable dissenting voices.
Keith Higgins, Chair Of The Securities and Governance Practice (Ropes & Gray) And Former Director Of Corporation Finance At The SEC:
The proposal makes several sensible, but modest, changes to update the definition and make it work better. On the more controversial issues, in the absence of evidence that the income and net worth thresholds were themselves the cause of any investor harm, the Commission wisely deferred action, which is good news for those raising capital.
And, although extending accredited investor status to individuals holding certain professional licenses has some logical appeal, it remains to be seen whether this change would expand in any meaningful way the universe of potential investors.
Overall, the proposal is consistent with the thoughtful, targeted approach the Commission has been taking in a number of areas.
Joshua Ashley Klayman, US Head of FinTech and Head of Blockchain and Digital Assets (Linklaters):
Overall, the SEC’s proposal reflects a measured and thoughtful approach. The proposed changes potentially broaden the pool of “accredited investors” under Regulation D, among other things, by including consideration of a natural’s person financial sophistication, rather than merely his or her financial status.
While some may have hoped for a reduction in the minimum financial thresholds (i.e., income and net worth) required for a natural person to be categorized an “accredited investor,” in my view, the fact that the SEC, considered, but declined, to adjust for inflation the existing financial thresholds – which haven’t been increased since their introduction in 1982 – actually may be a major, yet overlooked, win for companies seeking to raise capital.
It’s reported that, in 1982, approximately 0.53% of the U.S. population met the $200,000 income threshold, while, in 2019, roughly 8.9% do. In that sense, as incomes have risen, the “accredited investor” pool arguably has been expanding all along.
Lewis Cohen, Co-founder Of Blockchain And Crypto-focused Law Firm (DLx Law):
The SEC’s common-sense proposals for addressing some of the gaps in the approach to defining who is considered an “Accredited Investor” are helpful. However, broadening the pool of potential investors in blockchain projects is only half the battle. More important is convincing sponsors of blockchain projects to provide the quality and quantity of disclosure that will allow this wider group to make meaningful distinctions among projects.
Alexandra Levin, Partner, Chair of Blockchain Technology & Digital Currency Practice (YK Law LLP):
To me, it has always seemed rather arrogant and elitist to equate financial status with the “sophistication” required to make an investment decision and understand the associated risks.
I’m very pleased that the SEC is proposing changes to the Accredited Investor definition but personally, I don’t think they go far enough. Bill HR 1585 (the “Fair Investment Opportunities for Professional Experts Act”), which was sponsored by Arizona Congressman David Schweikert, the co-Chair of the Congressional Blockchain Caucus, sought to amend the Accredited Investor definition to also include: “an individual who is licensed as a broker or investment advisor by certain entities; and an individual determined by the Securities and Exchange Commission (SEC) to have qualifying education or experience.”
I would expect that a recent graduate who holds a Ph.D. in biomedical engineering would likely be more qualified to make an investment decision in a biotech startup than most Accredited Investors.
Rika Khurdayan – Co-founder (Dilendorf & Khurdayan):
The recent proposal to update definition of an Accredited Investor is a natural progression and an important step towards reducing barriers to capital formation in the US. Previously, in 2012, SEC amended the exemption framework under Regulation D lifting the ban on general advertising and solicitation under rule 506(c). Broadening the definition of an Accredited Investor can further stimulate the Regulation D market.
With that said, SEC has chosen a very cautious and prudent approach, and understandably so. It is hard to find an objective way to test sophistication of an investor. While the proposed changes to not increase the investors pool dramatically, it is a significant stride towards a more inclusive and robust market for private securities. These are great news for both the issuers looking to raise money and investors who could not previously participate in such offerings.
Michelle Ann Gitlitz, Head of Blockchain & Digital Assets (Crowell & Moring LLP Global):
I think the proposal moves the needle to allow more people access to investment opportunities that would be available to institutional investors, with protection. The current accredited investor tests are only financial (income and wealth) and the modifications include individuals who have financial sophistication to participate in transactions, but who are excluded under the current rule. Wealth does not always equate to financial sophistication and the proposed rule recognizes that those with certain professional certifications or designations, knowledgeable employees of private funds, and family offices with at least $5M in assets are appropriate investors.
Mary Kopczynski, CEO & Founder ( RegAlytics, Inc):
This is great for crypto – and pretty much anyone raising capital – because it means will be wider pool of potential investors in any and all companies, tokens, ICOs and securities offerings. On the flip-side, it means a wider pool of these people may lose money, but the idea behind these expanded definitions is that people in these new carve outs are “smart enough” to know what the risks are.
Why Is The Accredited Investor Status So Important?
The SEC faces a balancing act between three responsibilities: protecting investors, maintaining “fair, orderly, and efficient markets,” and facilitating capital formation. The Accredited Investor determination is one of the key tools that the agency has in its armory to enable it to strike that balance.
At its simplest, the Accredited Investor designation determines whether an individual is sufficiently sophisticated an investor to be left to their own devices and make investments in assets in the private market that don’t have the transparency and liquidity that financial instruments such as publicly issued stocks and bonds do. The determination has historically been based on an individual’s wealth, namely, their income, or assets they own.
Critics suggest that the Accredited Investor status is a clumsy proxy for sophistication that puts uneducated investors in a situation of harms way while excluding those that don’t have the financial means but do have the wherewithal to make these types of sophisticated investments. For example, an elderly widower with no financial acumen that may have the assets from a life insurance windfall may be able to invest in private securities but a public accountant cannot.
In addition to this perceived inefficiency, there is a bigger factor at play, which is the emergence of vast and growing pools of capital in the private markets that is being invested, in particular, in technology and biotech companies. Investments which are accessible to only the 8.5 percent of individuals in the U.S. today who fall into the Accredited Investor category. For startups, going public isn’t as attractive as it used to anymore, and with no shortage of private capital floating around, these organizations are now staying private for longer, with some never even going public. That puts them out of reach of normal investors.
What’s more, recent public issuance scandals, such as the failed WeWork IPO, have rocked investor confidence in the transparency and corporate governance of “safe” publicly listed entities, exposing the predatory nature of some private market investors who in the run up to public offering have driven up asset valuations only to unload them later on the public market.
Many unaccredited investors, feel that they have the worst of both worlds, being excluded from the opportunity to invest in the private markets, with access only to public markets where stocks have already appeared to have been run up to unsustainable valuations.
However, the SEC also has plenty of evidence to back up an opposing argument that U.S. investors do indeed need to be protected to themselves. For example, most recently in the fervor of the Initial Coin Offering phenomenon where largely unsophisticated unaccredited investors poured billions into startups, 80% of which went broke or were scams.
Inflation – The Great Leveler
One notable omission from the proposed update is any increase in income and asset requirement in line with inflation.
With the income and asset qualification amount having not been changed since the inception of the act in 1993 (albeit in 2010, the Obama administration removed home assets from the qualification), this has had a fiscal dragnet effect which ends up increasing the amount of individuals who meet the qualification each year because of the effect of inflation on increasing individuals’ wages.
Linklaters LLP, a multinational law firm headquartered in London, in their client alert, were also quick to point out the absence of inflation adjustment. It’s also not a point not lost on Securities And Exchange Committee Commissioner Allison Herren Lee who in a dissenting view notes that the proposal “codif the toll that 37 years of inflation has already taken.”
Dissecting The Proposed Changes With Help From RegAlytics, Inc.
Mary Kopczynski, CEO & Founder of RegAlytics, Inc. provides Forbes with a rundown of the key changes that the agency is proposing.
Adding Categories of Natural Persons Who Qualify as Accredited Investors
Professional Certifications and Designations and Other Credentials:
(Translation: you may not have enough money to qualify, but since you are a professional trained in giving financial advice, we assume you are sophisticated).
There’s a number of ideas out there, such as you have a CPA, an MBA or other such degree that makes you “smart enough”, but the SEC said they reserve the right to change that list periodically. For now the agency is okay with:
Licensed General Securities Representative (Series 7)
Licensed Investment Adviser Representative (Series 65)
Licensed Private Securities Offerings Representative (Series 82)
Knowledgeable Employees of Private Funds:
(Translation: if you’re a junior employee at a VC who doesn’t make enough money to qualify as investor, but your entire job is to review investment opportunities, if you can pull together the minimum investment then, you’re allowed to participate).
Proposed Note to Rule 501(a)(5) – Joint Spouses:
(Translation: SEC is clarifying that it is okay if a husband and wife want to invest together or separately and if the “aggregate” is both their income combined, that is sufficient).
Adding Categories of Entities That Qualify as Accredited Investors
(Translation: these entities formerly weren’t considered accredited unless they had a minimum amount of money).
Registered Investment Advisers
Rural Business Investment Companies
Limited Liability Companies (now allowed, still must have assets of $5M) –LLCs are still considered sort of “new” types of legal entities relative to SEC laws
Other Entities Meeting an Investments-Owned Test – any entity that has more that $5M in assets is okay – such as Indian tribes, labor unions, foreign companies, etc. which used to not be allowed
Proposed Note to Rule 501(a)(8) – Special new rule: if wealthy individuals own an entity that has no money, the entity is qualified by looking through to its owners
Certain Family Offices and Family Clients – Family offices are similar to investment advisors but for a specific wealthy family. In any event, family offices need to have at least $5M.
Permit Spousal Equivalents To Pool Finances for the Purposes of Qualifying as Accredited Investors
Adding “spousal equivalent” to account for same sex marriages and civil unions.
Proposed Amendment to Rule 215
The rules that apply to investors themselves will be the same as the rules for people trying to raise capital. Issuers are therefore allowed to “approach” these newly identified qualified investors for sale. More for mechanics than anything.
Proposed Amendment to Rule 163B
Similar as Rule 215. This is a newish “test-the-water” rule where people are allowed to communicate with investors to see if there is interest before they register with the SEC. This same widened definition of people is now included.
Proposed Amendment to Exchange Act Rule 15g-1
Similar to 215 as well. Broker dealers have to make disclosures to people when selling them penny stocks. But if it’s a qualified investor, the broker doesn’t need to say anything because it is assumed they, as a qualified investor, are smart enough to know. Sourced by Forbes.