On July 10, thanks to the Dodd-Frank Act which mandated its reinstitution, the revived SEC Investor Advisory Committee met in a public forum to discuss certain securities law issues, including a subcommittee’s initial proposals on the definition of “accredited investor” (as defined in Section 501(a) of Regulation D under the Securities Act of 1933, as amended).
The discussion was led by Barbara Roper, the Director of Investor Protection for the Consumer Federation of America. Currently the definition is intended to serve as a proxy for some form of sophistication and suitability to invest in private offerings conducted without the benefit of publicly filed registration statements. Only accredited investors can participate in these so-called private placements (with certain exceptions). Most of the investment crowdfunding currently being conducted in the United States relies on this definition and only accepts accredited investors as participants in their offerings. The committee didn’t discuss the other six sub-definitions of accredited investors but focused solely on the two applicable to individuals that require either an excess of $200,000 of income in each of the past two years with the reasonable expectation of making in excess of $200,000 in the current year ($300,000 if combined with a person’s spouse) or $1,000,000 in net worth not including the person’s primary residence in order to be “accredited.”
What struck me the most in listening to the committee discuss the definition and its purpose, was that while it must have been said at least fifteen times that the definition “was broken” or “didn’t work,” no one provided an example of how it had failed or the harm being caused. Furthermore, one of the proposed “fixes” was raising the thresholds to $500,000 and $700,000 (with spouse) for income and $2.5 million in net worth, without citing any current harm or the potential detrimental effects of such a change.
I am the first to admit that the current definition is completely arbitrary and is really more of a proxy to ensure that people can bear the loss rather than have some level of sophistication. In fact, in a comment letter filed with the SEC, Kiran Lingam, general counsel to SeedInvest, noted that the current income thresholds actually prohibit U.S. Congressmen, the average Harvard professor, licensed stockbrokers, and some securities lawyers, arguably society’s most knowledgeable individuals with respect to corporate finance and capital markets, from investing in private placements. Thus, the current definition seems to be focusing on ability to bear loss rather than any level of understanding or sophistication. However, this concept received very little of the committees’ hour and 15 minutes of airtime devoted to the accredited investor definition. If truly ensuring ability to bear loss, then the rule should be revised to prohibit investments above a certain level of investable assets, similar to the United Kingdom approach.
Since the committee did not describe any harm caused by the current threshold portion of the definition or provide a sound motive for raising the current thresholds, other than to keep up with inflation, I have set forth some of the potential harms that the committee did mention but provided no evidence of, which cannot be remedied by increasing the thresholds, and offered solutions.
Lack of Information
The committee mentioned that one concern with private placements is that investors could have inadequate information to make an informed investment decisions, since no mandated disclosure documents are required as in a public offering. The solution to this does not seem to be to raise the income or wealth thresholds but to mandate certain disclosures. This may not be necessary however, since the antifraud rules already prohibit misstatements and omissions when offering securities and thus compel issuers to prepare disclosure documentation, but the committee did not address how or if this was deficient.
Lack of Sophistication
The committee noted that certain individuals did not have the understanding or knowledge with respect to investing to make informed decisions. Again, the solution here does not seem to be changing thresholds, but perhaps mandating education or requiring an exam similar to the United Kingdom model approved by the Financial Conduct Authority, which allows investors to take an online exam before proceeding with an investment.
The committee noted that some people cannot afford to lose the money they invest. While this must certainly be true, no evidence was provided that a certain income or wealth level would insulate someone or that the private investments that people are making are any more risky than the public ones in which they are allowed to invest. More income or wealth is always better insulation than less I guess, but it isn’t clear that this is really a problem. We have seen no evidence of destitute former accredited investors that gambled in Regulation D and lost it all and are now on the government dole.
Certainly fraud is a legitimate concern of the SEC and a risk faced by investors. However, there is no reason to think that a person making $200,000 a year is more likely to be defrauded than a person making $500,000. Furthermore, the accredited investor concept was never intended to prevent fraud as the antifraud rules under both federal and state law apply to both public and private offerings regardless of the type of investor.
For me the overwhelming feeling I had while watching the meeting was “what is the problem for which we are solving – is there a problem at all?” While I cannot find any harm under the current definition, I find a tremendous detriment to the capital markets and our economy if the threshold were to be increased. Namely, 60% of the current pool of accredited investors in the US will be lost. These investors are often the only source of capital for small and startup businesses conducting private offerings. It seems ironic that just when Congress has opened new channels to entrepreneurs via Rule 506(c) and the use of general solicitation, the SEC would close that very door by decreasing the potential investor pool. Finally and most frustrating, was Ms. Roper’s deduction that since so few accredited investors, as currently defined, actually participate in private placements, decreasing the potential accredited investor base by 60% would not cause a problem. Unfortunately, that is not the way math works, and I can guarantee you that decreasing the eligible accredited investor base by that amount will have a chilling effect on access to capital for those who need it the most.
It is not clear why swapping out one arbitrary standard for another is beneficial especially when we already have a level of precedent and institutional knowledge developed around the current definition. With so many other issues facing the SEC and financial markets (high frequency trading, pump and dump schemes, conflicts of interest), not to mention the belated implementation of Regulation CF and Regulation A, it seems that their time could be better spent.
So for those of you who care about small and startup businesses, the jobs they create and the communities they build and don’t want to see one of their few capital sources dry up, I encourage you to write a comment letter to the SEC and submit it here. One remarkable thing about the SEC is that they actually read the comments that are posted and thoughtfully consider them. I urge you to be a voice for small business.
Georgia P. Quinn is a senior associate in Seyfarth Shaw LLP’s Corporate department. Ms. Quinn has led Seyfarth’s Crowdfunding Initiative, helping clients stay at the forefront of the enacted and proposed SEC regulations. Ms. Quinn has recently spoken to the Securities and Exchange and Commission, Congressional staff-members, leaders of UK crowdfunding portals and the Small Business Administration Roundtable; chaired a panel on crowdfunding for the ABA; presented to the Canadian Equity Crowdfunding Alliance, the Council of Development Finance Agencies, the Crowdfund Global Expo in San Diego and New York, the New York State Bar Association, at the New York State Securities Bar and in a websem for American Banker. Ms. Quinn is the subject matter expert behind Disclosure Dragon, the first semi-automated disclosure document generating software that helps prepare a PPM, Form C or Form 1-A at a fraction of the traditional time and cost. All views and comments above are strictly her own views and do not reflect the opinion or position of Seyfarth Shaw.