February 21, 2020
Allan Grauberd, partner and Chair of Moses & Singer capital markets practice
Howard Fischer, partner, securities litigator and former SEC Senior Trial Counsel
Allan Grauberd, an experienced transactional securities counsel, and Howard Fischer, a former SEC enforcement counsel and securities litigator, discuss the SEC’s proposed modifications to the definitions of accredited investor and related measures.
The discussion is in two parts. The first focuses largely on the proposed expansion to the definition of “accredited investor,” i.e., who is allowed to invest in unregistered offerings—as well as some of the history behind that change. The second part focuses on issues related to capital formation and access to economic activities that the defenders of the proposed rules emphasize, among other aspects.
PART I: WHO ARE ACCREDITED INVESTORS?
Allan: Over the last year, the SEC has been aggressively pursuing an agenda of regulatory reform. In addition to a significant restructuring of the rules for shareholder proxies, and a modification of auditor independence standards, the SEC has proposed rule-making related to the question of who qualifies as an accredited investor. It first issued a “concept release” on June 18, 2019, that solicited public comment on methods for “harmonizing” the exempt offering framework under the Securities Act1 It followed that with the proposed amendments, which were published on December 18, 2019. The public comment period has just ended2.
Allan: Howard, as a former SEC insider, what can you tell us about the internal considerations motivating the proposal? Are there any divisions within the SEC about this? Give us the inside scoop.
Howard: The proposed rules are controversial within the SEC, and the split breaks along partisan lines. Other than the Chair, each of the four other Commissioners issued public statements accompanying the announcement of the proposed rules. These statements illustrate not only the political divide at the Commission, but also outline distinct views as to the proper scope of regulation, the appropriate limits of investor protection, and the centrality of promoting capital formation to the SEC’s mission.
Commissioner Lee, a Democrat appointee, views the proposed rules as “expanding the pool of investors in the opaque and indisputably high-risk, private markets.” She sees using wealth as a proxy for sophistication as problematic, noting that many retirees, after a lifetime of savings, satisfy the wealth thresholds, but lack the relevant experience managing investments, leaving them susceptible to fraud. She also criticizes the failure to index the thresholds to account for inflation over the last four decades.
Commissioner Jackson, the other Democrat on the Commission, argued that the revisions were not based on data but driven instead by ideology. He stressed that private placements correlated to a high rate of misconduct and customer complaints, and expressed concern that the proposals exposed ordinary investors to unacceptable levels of risk.
The Republican Commissioners, on the other hand, see the proposed changes not as exposing unsophisticated investors to greater risk, but as providing them access to greater opportunities. Commissioner Peirce sees accredited investor limitations as essentially an infringement on liberty and “as one of the more offensive concepts lurking in our federal securities laws” with a “corrosive effect on an individual’s economic liberty.” For her, the current rules are not only a restriction on liberty, but are biased against individuals from the American heartland where lower incomes relative to locales like “New York or San Francisco” further limit their freedom.
Commissioner Roisman operates from the assumption that the accredited investor restrictions preclude “millions of Americans [from] opportunities for them to invest their wealth in private offerings.” He assumes not only that private offerings are “investments that have the most upside for growth over time” but also that newly accredited investors will provide much needed capital to smaller companies.
These differing viewpoints reflect a fundamental disagreement as to whether the revisions are exposing investors to greater opportunities, or to greater risks, and reflect a substantial dispute as to the worth of investing in unregistered opportunities.
Allan, can you walk us through the current status of the law? As well as proposed changes?
Allan: What does it mean to be accredited? Currently, for individuals, it is based on income or net worth. The current definition of an accredited investor is set out in Regulation D. Rule 501 defines an individual accredited investor as one with a net worth exceeding $1 million (excluding the value of a primary residence), or an income of $200,000 over the last two years, or joint income of over $300,000 with their spouse over the same period, and an expectation of the same income level in the current year.
An accredited investor is able to invest in private offerings. Regulation D is a safe harbor exemption for private offerings that are not required to be registered under the Securities Act of 1933. While unaccredited investors can invest in certain private offerings under Regulation D (under Rule 504 for example)3, there are investment round limits and state blue sky restrictions that make these offerings less practical. As a general matter, most private offerings are conducted under Rule 506(b), which allows an unlimited dollar raise and does not require any specific information be provided to accredited investors (even though up to 35 unaccredited investors can participate if they are “sophisticated”). The problem with even a limited number of unaccredited investors participating in a 506(b) offering is that they must be provided “prospectus style” disclosure. To avoid this burden, most offerings simply prohibit participation of unaccredited investors.
Howard: So how do the proposals move away from current rules? And how drastically do they change the current standards?
Allan: It appeared that the SEC’s original goal was to more drastically expand the universe of those considered accredited. The actual expansion is a little less ambitious than originally anticipated.
The main premise of the proposal is that wealth should not be the sole proxy for financial sophistication (21)4. Instead, the Commission would accept as qualifying various professional qualifications and licenses.
- Commission intends to have a flexible view of the type of educational qualifications that would allow the Commission, by order, to certify accredited status. (28)
- Initially, the expected certification will be limited to various securities licenses, including the Series 7, Series 65, and Series 82. Of those, only the Series 65 exam allows a person to take the test without being affiliated with a FINRA member firm. (29-30).
- The SEC proposed to add a new category of accredited investors: registered investment advisers. (47).
Howard: Allan, we discussed this first when the initial concept release came out, and one of the things that struck us both was the difference between the scope of the original plans and what was ultimately announced. What was the most surprising omission from the original concept release? What is it surprising not to see?
Allan: All in all, the emphasis on securities professionals as being the only certifications the Commission is publicly advocating for is disappointing. The democratization of the accredited investor world should have a way in without requiring all the public securities knowledge inherent in the Series 7, 65 and 82 exams. It is also unclear that having various securities licenses provides the kind of training most appropriate for investing in restricted offerings. For example, knowing how to critically read a private placement memorandum and how to analyze a Reg. D offering are different skills than knowing how to assess the securities or debt of a listed company or of government bonds. While some aspects of the listed exams focus on private offerings, it is a far broader exam than needed.
It would seem self-evident, as Commissioner Lee pointed out, that having a certain level of income or net worth does not imply a level of investment sophistication. The idea that finding different channels into the accredited investor world is a worthwhile goal would suggest a recognition that there are a variety of ways to educate oneself on the needed skills to be an investor in private placements. Indeed, as a practitioner, there are a specific variety of skills that are necessary to make investment decisions, mostly dealing with the ability to evaluate a business plan, financial statements, corporate structural issues, as well as experience with valuation and tax issues. The SEC seems open in the release to broadening the types of professional credentials and testing that might allow others to qualify, but at this point does not venture beyond the familiar professionals it regulates (28,39).
In addition to questioning whether certain advanced degrees like law and accounting should be a qualifying skill, or experience in finance and investing (38-39), the Commission also asks if they should support the development of an accredited investor examination (39). A tailored course would seem much more suited to the needed skills then other types of degrees and certifications. See for example VC University’s online course and certification (Sponsored by the National Venture Capital Association and Berkeley Law of the University of California).
The Commission notes that those having general advanced degrees are not viewed as appropriate for certification in the absence of a focus on securities and investing (32).
The Commission also questions whether the extension of accredited investor status to those individuals not meeting net worth and income standards suggests a need for limits on investment size (similar to the crowdfunding exemption). (38)
Howard: One can question how much of an expansion this actually is. After all, it is entirely likely that most of the people who have securities licenses also qualify on the basis of income and assets, so you are not significantly expanding the number of accredited investors.
On the other hand, wealth as the determinant of investor readiness makes little sense. When I was at the SEC, I prosecuted a number of cases involving unregistered offerings where the investors were “qualified” in the economic sense – doctors, psychiatrists, professionals of various stripes – but that did not stop them from being victimized. These investors did not understand how to read a prospectus, how to analyze how fees were charged, or how to critically look at investment strategies. Frequently, they were induced to invest such substantial sums (including borrowing money) that the failure of the fraudulent schemes left them relatively destitute. The idea that accredited investors would only invest risk capital that they could afford to lose was not borne out in the cases I handled.
Allan: This points to understanding risk allocation skills, which are of course not connected to the current financial standards in the accredited investor qualifications. Requiring educational qualifications that are more suitable to private offerings seems the way to proceed, including understanding their higher risk profile. I hope that future SEC certifications head in that direction.
1. See our client alert, The SEC Goes Big With A Concept Release Suggesting An Ambitious Re-Examination Of Private Capital Formation Exemptions
2. As of February 20, 2020, well over a hundred comments had already been filed.
3. See our article The Revised Regulation D Rule 504 Exemption-Bigger And Better December 15, 2016
4. Numbers in parentheses refer to the numbered pages of the SEC’s December 18, 2019, which can be found at https://www.sec.gov/rules/proposed/2019/33-10734.pdf