SEC Advisory Committee Examines Changes to Accredited Investor definition for individual investors in private placements
By: Robert Rapp, Calfee, Halter & Griswold LLP
Periodic Review of Accredited Investor Definition by SEC
Pursuant to a mandate in the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) the U.S. Securities and Exchange Commission must, beginning in 2014 and each four years thereafter, review of the definition of “accredited investor” applicable to natural persons eligible to invest in exempt private securities offerings to determine whether the definition should be adjusted. The SEC is to review the definition to determine whether it should be “adjusted or modified for the protection of investors, in the public interest, and in light of the economy.”
This review is underway and comes in the wake of a 2013 Report by the Government Accountability Office to the Congressional committees that oversee the SEC, which recommended that the SEC consider alternative criteria to determine accredited investor status rather than rely on the income and net worth criteria that have been in place for so long.
Armed with the GAO Report, the SEC Investor Advisory Committee (itself a creation of the Dodd-Frank Act) undertook an assessment of the current accredited investor definition. Its purpose: to determine whether current qualifying criteria based entirely on financial thresholds best determine an individual’s ability to bear and understand the risks of investing in private placements, and whether criteria other than the existing purely quantitative income and net worth criteria are meaningful proxies for investor sophistication.The Dodd-Frank Act authorizes the SEC Investor Advisory Committee to submit findings and recommendations for review and consideration by the Commission. Concurrently with the mandated SEC review of the accredited investor definition in 2014, the Advisory Committee launched an assessment of, and debate over, whether alternatives would get to the real issue of investor sophistication that underlies accredited investor status.
On October 9, 2014, the Advisory Committee reported its recommendations to the SEC on the accredited investor definition. No specific changes were recommended. Rather, the Committee called upon the SEC to consider overall:
[A]lternative approaches that would better protect vulnerable investors without unnecessarily constraining the supply of capital in the private offering market, including approaches that would enable individuals to qualify as accredited investors based on their financial sophistication, consideration of whether financial thresholds need to be adjusted for inflation, as well as alternative approaches for setting financial thresholds.
Setting the table for recommending specific changes
In July 2014, the Advisory Committee reported on various alternatives, with the starting point being that most of the Advisory Committee members agreed that the accredited investor definition should be changed. The income and net worth criteria for accredited status date to 1982, and have only changed once, not long ago, to take primary homes out of the net worth calculation. A common concern expressed in the Advisory Committee deliberations at that time was that simply focusing on these two criteria is myopic. That is, setting these simple thresholds will never be a good proxy for investor sophistication, which should be the real focus in identifying individuals who do not need the protection that the registration and prospectus delivery requirements of the Securities Act provides. A sub-group of the Advisory Committee was tasked with making specific recommendations to the Committee as a whole for consideration.
On October 9, 2014 the Advisory Committee released its recommendations to the SEC on whether and how to revise the definition of accredited investor. Although, based on prior deliberations, specific recommendations were expected, the Advisory Committee recommendations are stated only in the broadest terms. The Committee came to the conclusion that the current definition of accredited investor as it pertains to natural persons does not effectively address the real question in all instances. It failed, however, to make any specific recommendations for changing the definition. Instead, only broad parameters were put forward to inform further consideration of actual changes by the SEC. Each of these recommendations is discussed below.
The October Recommendations:
The SEC should carefully evaluate whether the accredited investor definition, as it pertains to natural persons, is effective in identifying a class of individuals who do not need the protections afforded by the Securities Act of 1933. If, as the Committee expects, a closer analysis reveals that a significant percentage of individuals who currently qualify as accredited investors are not in fact capable of protecting their own interests, the SEC should promptly initiate rulemaking to revise the definition to better achieve its intended goal.
The Committee observed that the current definition uses financial thresholds based on income and net worth as proxies for access to information, financial sophistication, and ability to withstand potential losses, when there is nothing in the definition itself that guarantees that this will be the case.
Limited data that exists, said the Committee, suggests that although there is a correlation between income and financial literacy, in fact a significant percentage of even the wealthiest investors score poorly on tests of financial literacy, and that such tests do not begin to measure the type or level of financial sophistication needed to evaluate the potential risks and benefits of private securities offerings. Meeting current income and net worth thresholds does not reliably provide assurance that an individual possesses the financial sophistication and access to information that is necessary to make an informed investment decision.
On the other hand, individuals who fail to meet the financial thresholds in the current definition may well satisfy financial sophistication and access to information concerns. While reliance on income and net worth thresholds results in a definition that is clear and relatively simple to implement, the Advisory Committee characterized it as oversimplifying the facts that actually determine what matters. The Committee questioned, for example, whether simply raising the financial thresholds would resolve shortcomings in the current definition. The SEC should not, said the Advisory Committee make a “binary decision” over whether or not to adjust the thresholds to reflect inflation, but must instead consider whether an alternative approach would be more effective in identifying a population of individuals who can fend for themselves.
The Commission should revise the definition to enable individuals to qualify as accredited investors based on their financial sophistication.
Continuing on the theme set forth in its first recommendation, the Advisory Committee expressed concern, particularly in light of the elimination of the ban on general solicitation and advertising of offerings made pursuant to Rule 506 of Regulation D, that there may be individuals better equipped to assess the appropriateness of investing in private offerings than are individuals who meet the financial thresholds but lack financial sophistication. The Committee called upon the SEC to develop a means for sophisticated investors to qualify as accredited. The Committee offered, for example, that qualifying individuals who have attained certain professional credentials, or who have relevant professional experience, may be measures of relevant financial sophistication. Investment experience may be another measure of qualification. “Angel” investors, for example, who are part of a group that follows best practices with regard to due diligence, and that includes financially sophisticated members, may be an appropriate criterion. The Committee also offered that, in theory at least, a test could be developed that individuals could take to qualify as accredited investors.
If the SEC chooses to continue with an approach that relies exclusively or mainly on financial thresholds, it should consider alternative approaches to setting such thresholds –in particular limiting investments in private offerings to a percentage of assets or income—which could better protect investors without unnecessarily shrinking the pool of accredited investors.
Starting from the premise that the risks associated with investing in private offerings are greatly affected by how heavily the individual invests in such offerings, the Advisory Committee observed that the current financial threshold approach to qualifying accredited investors operates as an illogical “on/off switch.” The Committee pointed out that under the current accredited investor definition: “[a]n individual with a net worth of $999,000 can’t invest a dime in Rule 506 offerings, but an individual with a net worth of $1 million can risk it all.” A more sensible approach, said the Committee, might be to allow some investments in private offerings once a person reaches an initial threshold, based on percentage of income or assets, with restrictions being placed and then eliminated as income or assets rise. Such an approach, said the Committee, would significantly reduce the risk that unsophisticated investors would suffer unaffordable losses –which should be the central aim of a definition based on financial capability.
The SEC should take concrete steps to encourage development of an alternative means of verifying accredited investor status that shifts the burden away from issuers who may, in some cases, be poorly equipped to conduct that verification, particularly if the accredited investor definition is made more complex.
The Advisory Committee advocates an independent third party verification system for establishing accredited investor qualification. Using reliable third parties to perform verification of accredited investor status better protects investors from having to share potentially sensitive financial information with issuers in order to participate in offerings, and would also reduce the compliance burden for small issuers who turn to the Regulation D market to raise capital. Verification of purchaser accredited investor status is an express requirement for offerings under Rule 506(c) of Regulation D, in which general solicitation and advertising are utilized.
The challenge of verifying accredited investor status will increase if the definition is made more complex, and the Advisory Committee notes that the implementation concern has caused some who recognize the shortcomings in the existing accredited investor definition to nonetheless resist changes that would make the definition more complex. Independent third party verification, performed in accordance with appropriate standards, and with some degree of regulatory oversight, could reduce such concerns.
The Committee urges the SEC to develop and approach to third-party verification that actively encourages the availability of such services. The Committee did not address the extent to which third-party verification services have already emerged, and the extent to which they are being utilized by private placement issuers, except to call upon the SEC to begin studying the current state of the market with regard to verification practices, and whether third-party verification services are readily available at a price that makes them affordable for small issuers.
In addition to any changes to the accredited investor standard, the SEC should strengthen the protections that apply when non-accredited individuals, who do not otherwise meet the sophistication test for such investors, qualify to invest solely by virtue of relying on advice from a purchaser representative. Specifically, the Committee recommends that in such circumstances the SEC prohibit individuals who are acting as purchaser representatives in a professional capacity from having any personal financial stake in the investment being recommended, prohibit such purchaser representative from accepting direct or indirect compensation or payment from the issuer, and require purchaser representatives who are compensated by the purchaser to accept a fiduciary duty to act in the best interests of the purchaser.
Although not related to any changes in the accredited investor definition, the Advisory Committee took the opportunity to call upon the SEC to strengthen protections that apply to non-accredited individuals who qualify to invest in private placements by relying on a purchaser representative. In Rule 506 offerings that do not involve general solicitation or advertising, up to 35 non-accredited investors are permitted, subject to specific information requirements, and who alone or with a purchaser representative meet the sophistication requirement. The Advisory Committee criticized the current Rule 506 regulatory structure as potentially allowing unsophisticated, non-accredited investors to invest in reliance on a recommendation from a purchaser representative who may be significantly conflicted, and the regulatory structure in place allows purchaser representatives to be paid by the issuer. The Committee calls for elimination of financial conflicts of interest to the degree possible, and for consideration of a system of monitoring the activities of professional purchaser representatives to determine whether additional regulatory oversight is necessary and appropriate.
How much guidance going forward?
Following the lead of the GAO in July, the SEC Advisory Committee debated specific alternatives for measuring investor sophistication and demonstrated ability to understand financial risk. In the final analysis, as seen above, none of them were articulated in the form of specific recommendations –only as loosely described alternatives for the SEC to further consider and develop the details for if it elects to do so.
Without question, there are major challenges to determining how to change the accredited investor definition to expand the class of accredited investors based on sophistication criteria rather than objective financial thresholds. Indeed, it may be in the end that the simplicity and certainty of financial thresholds, which can be modified in a number of ways to better reflect actual investor sophistication, will win out over more subjective sophistication measurements. The Advisory Committee did not identify a clear path in either direction, however, and the rationales offered by the Committee for each of its recommendations do not present a compelling case for doing anything in particular beyond considering alternatives.
SEC Chair Mary Jo White has complimented the Advisory Committee as doing “a very, very impressive job with a range of difficult, subtle, nuanced issues,” and that the SEC will consider the Committee’s approach. That said, the Advisory Committee has perhaps succeeded. Given the opportunity to make specific recommendations, however, the Committee’s work does not portend any near term meaningful consideration of actual alternatives to defining accredited investor status in terms that depart significantly from what has been in place since 1982.
Robert N. Rapp (B.A., J.D., Case Western Reserve University; M.B.A., Cleveland State University) is a partner in Calfee, Halter & Griswold LLP, Cleveland, Ohio, and is Distinguished Practitioner in Residence (“Law, Theory and Practice in Financial Markets”) at the Case Western Reserve University School of Law.