February 26, 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, posted on February 21, 2020 (click here for Part I), 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 (below) focuses on issues related to capital formation and access to economic activities that the defenders of the proposed rules emphasize, among other aspects.
PART II: STRUCTURAL CHANGES
Allan: Notably, the proposals reflect a view of unregistered investments that might seem at odds with the traditional SEC view of these as “dangerous opportunities.” The proposals seem to reflect the idea that accreditation rules are obstacles to financial growth opportunities, not dangerous risks.
Howard: The arguments utilized by proponents of increased access, that (1) liberalizing access lets more people enjoy the above-average returns generated by such funds; and (2) that increasing the pool of capital available to investment funds is good for the economy, do not seem to have much empirical support that I have seen. At the very least, the evidence is equivocal at best.
Allan: Howard, you mentioned to me the other day that the SEC proposal justifies a loosening of the accreditation standards by arguing that the proposal will allocate capital to businesses that lack for it, including minority-owned businesses. Can you comment on that?
Howard: The proposal notes that “small businesses typically do not have access to registered capital markets and commonly rely on personal savings, business profits, home equity loans, and friends and families as initial sources of capital. Small issuers that face more challenges in raising external financing may benefit more from increased access to accredited investors.” (129).
I am slightly skeptical that small businesses are ready to go out into the capital markets or, if they are, whether or not these are appropriate investments for newly accredited investors. There doesn’t seem to be much empirical data to support either claim.
Another supposed need being filled is that of minority owned businesses having access to capital. The proposal notes that “businesses owned by underrepresented minorities may benefit from increased access to accredited investors. . .businesses owned by underrepresented minorities were more likely to demonstrate unmet credit needs relative to other groups, which suggests that these businesses may benefit from amendments intended to facilitate private market capital raising.” (129-130). Note the careful language used – the information “suggests” that these businesses “may benefit.” These phrases indicate the lack of empirical data one way or another.
As Commissioner Lee noted in her comments, one issue that bedevils minority-owned enterprises is the recurrent discrimination faced in seeking credit; it is unclear how loosening accreditation standards would ameliorate that discrimination, or how it would prevent its recurrence in the investment sphere. Moreover, it is not clear why more access to debt financing would not resolve this issue.
Allan: Another interesting point regarding a structural matter is the argument that the increased access to information in the internet era has helped level the field between professional and amateur investors. “Given the rise of the internet, social media, and other forms of communication, information about issuers and other participants in the exempt markets is more readily available to a wide range of market participants.” (79). Commissioner Lee cautions, however, that this “fails to consider a growing body of research showing the massive amount of misinformation on the internet, and the inability of many to discern fact from fiction in this environment.” As anyone who spends time on social media can attest, that might not be an arena best suited for the dissemination of relevant and accurate information.
Howard, does your prior experience as a securities enforcer give you any additional insights into this?
Howard: The issue I have seen has not related to the amount of information availability, but to its quality, and to the difficulties inherent in distinguishing between valid sources of information and less legitimate sites. There are a multitude of sites catering to smaller investors, most of which are unmoderated. In prior cases of mine, those websites often played a role in in spreading misinformation, not in countering it.
Additionally, on many of these sites the identity of the people posting was unclear. Investors who relied on these sites for information often had little idea if the sources offering the information were interested parties or not.
One of the last cases I worked on involved a scammer (who ultimately went to prison) who promoted investment opportunities through social media postings and websites purporting to contain independent analysis. Relying on the Internet as a conduit for reliable information does not seem warranted based on the current state of that medium.
Howard: Allan, what other interesting provisions are there in the proposals?
Allan: LLCs now are to be included in the same category as corporations and managers are viewed (without any amendment) to be in the same category as executive officers (most practitioners already considered LLCs accredited under staff interpretations1 or as an entity whose equity owners are accredited under 501(a)(8)) (51-54).
The addition of Rule 501(a)(9) will now qualify as accredited any entity not formed for the specific purpose of acquiring the securities at issue and having more than $ 5 million in investments (rather than simply that value in assets). This would include Indian tribes, labor unions, as well as government bodies and funds. (55-60)
Note the SEC did not make any changes in the status of trusts. It has been hoped by many practitioners that trusts would qualify under 501(a)(8) as an entity in which all investors (substituting here beneficiaries) are accredited (which up to now has been a no-go) Alas, it remains a no-go regardless of the sophistication of the trustee. However, trusts appear to be included under Rule 501(a)(9) regardless of the sophistication of the trustee, essentially making Rule 501(a)(7) obsolete except to those trusts only owning assets and not $ 5 million in investments).
The Commission also proposes to include in the definition of “accredited investors” family offices (entities highly affluent families set up to manage wealth for family members) with more than $ 5 million in assets under management, as well as their family clients. (60-63) The family office would need to be directed by an experienced and knowledgeable person. (63). Also, “knowledgeable employees” of private funds are proposed for inclusion (39).
Other concepts floated in the Concept Release and not included in the proposed rules include an “opt-in” to accredited investor status after receiving certain risk factor disclosure, and permitting an investor advised by a financial professional to qualify (although the latter was raised as a possible area for consideration). As noted earlier, while the SEC generally supports examinations as a way of qualifying for accredited status, it has limited the first certifications to securities licensing exams.
1. See Division of Corporation Finance interpretive letter to Wolf, Block, Schorr and Solis-Cohen (Dec. 11, 1996); and question number 255.05 of Securities Act Rules Compliance and Disclosure Interpretations, available here.