SEC Examining Accredited Investor Standard
Last Friday SEC Chair Mary Jo White explained in a letter responding to Representative Scott Garrett, that the SEC “has begun a comprehensive review of the accredited investor definition.” Mr. Garrett had written to Ms. White at the end of October, asking for a review of the accredited investor definition as mandated by Dodd-Frank. Ms. White’s correspondence to Mr. Garrett suggests that a major overhaul of the accredited investor standard could be in the works.
Generally the Rule 506 private placement market is restricted to accredited investors. As Mr. Garrett points out, the 506 market raises equity capital in excess of $1 trillion annually, exceeding the combined public equity and debt markets. These private placements are appealing for companies issuing stock because they don’t have the same reporting and disclosure requirements of public offerings. But, because there is generally less information available to evaluate these offerings and because these offerings are subject to less regulation, the SEC mandates that only sophisticated investors can participate. The idea is that sophisticated investors will be better able to protect themselves from unscrupulous securities issuers.
Currently individuals can qualify as accredited investors by satisfying one of two financial status tests:
- The investor either has to have a net worth (exclusive of value of primary residence) exceeding one million dollars; or
- The investor has to have an annual income of $200,000 (or a joint annual income of at least $300,000 with his or her spouse).
The net worth and income tests are used as a proxy for sophistication, but of course everyone knows there’s not a 1:1 correlation between wealth and sophistication. For this reason, this standard has long been criticized. Yet there is also an unstated but implied component of ability to bear risk of loss in the current standard, which may be an important component.
One drawback to the private placement market is the lack of liquidity–there is no public exchange where holders of private stock can be assured of selling their stock if they need to liquidate their holdings. Individuals with greater wealth or income are better situated to withstand the lack of liquidity problems that come with private placements.
David Teten’s excellent article “Asset Management is a Bizarre Industry Ripe for Disruption” provides another layer of context for this discussion:
“Angel investing is the highest-performing asset class we know (albeit the most illiquid and opaque). Across a dozen different research studies, we’ve seen median returns of 18%-54%. But, the traditional wealth management industry does not make fees on angel investing, so it’s an underpublicized opportunity.”
Angel investing is a subset of private placements–these investment opportunities comprise the highest performing asset class and are restricted largely to accredited investors. You could see how Occupy Wall Street folks might be frustrated with the current state.
Highlights from Ms. White’s Letter
Ms. White made it abundantly clear that the SEC is considering and evaluating alternative criteria for the accredited investor definition:
“Commission staff, including staff from the Division of Corporation Finance and the Division of Economic and Risk Analysis, has begun a comprehensive review of the accredited investor definition. The review will encompass, among other things, the question of whether net worth and annual income should be used as tests for determining whether a natural person is an accredited investor. As part of that review, Commission staff also plans to consider and independently evaluate alternative criteria for the accredited investor definition suggested by the public and other interested parties.”
Professional and educational background are explicitly mentioned as potential qualifying criteria. Mr. Garrett’s original letter to Ms. White suggests that including CPAs and CFAs in the investor pool would improve information dissemination and analysis (although I question whether investors actually share information with their fellow investors frequently enough for this to make an important difference). Ms. White says that while the SEC is considering alternative criteria, the review is ongoing and no conclusions have been reached. She also reiterates that ability to absorb loss is an important factor.
Mr. Garrett had also posited an interesting substitute for investor sophistication: reliance on a qualified broker or registered investment adviser. In other words, anyone could make a purchase of privately offered securities if they had the recommendation of a qualified broker or registered investment adviser. I thought Ms. White’s discussion of this topic was among the most interesting aspects of her communication:
“An investor’s reliance on a registered broker or investment adviser is one of many factors that the Commission staff will consider as part of its review of the accredited investor definition. Obtaining the advice of a professional advisor may enhance an investor’s ability to make an informed investment decision and therefore strengthen investor protection in Rule 506 offerings. An investor’s use of such an advisor however may not necessarily measure the investor’s understanding of the risks of the investment. As part of its review, the Commission staff may determine that it is feasible to analyze the extent to which investors file claims against professional advisors arising from investments in unregistered offerings. Such an analysis may assist in evaluating the level of protection afforded to investors when relying on professional advisors.”
This response is interesting from a policy perspective on a few levels. Ms. White is correct that investors may not understand transactions even with the help of an investment adviser. But, conceptually private placements are much easier to wrap your mind around than many other investment vehicles, such as annuities–which investors can currently invest in without meeting sophistication requirements. It’s interesting that the SEC mandates that investor sophistication is an important factor. I’m not saying that I necessarily disagree with the policy decision: 7 out of 10 of even the most promising startups will fail–and investors will lose nearly everything. So while the risks are easier to understand, they are of a greater magnitude.
At this point, any potential changes to the accredited investor definition are just that: potential changes. The Wall Street Journal speculates that the SEC could implement changes by next summer. But at this point it’s impossible to do more than speculate when these changes, if there are changes, may be implemented. In any event, we’ll keep up on the issue and plan to post updates to this blog.