SEC Considers Changes to Definition of Accredited Investor
Just who can invest in hedge funds, private equity funds and other investments seen as risky may change in the near future.
The SEC is collecting public comments on staff recommendations that would change the definition of an "accredited investor" in Regulation D of the Securities Act of 1933. Those recommendations, contained in a 116-page report issued last month by the agency, would, if any were adopted, be the first significant changes to the definition since its adoption in 1982.
"The financial criteria identified in 1982 may no longer serve as the most effective proxies for determining when investors do not require the protections that come from registration under the Securities Act," the SEC said in the report. It noted that developments such as increased informational availability, as well as changes in the way investors communicate, have altered the investing landscape, and that "financial product and process innovation over the past three decades have led to more complex financial markets while greatly expanding the set of available investment opportunities."
Under the current definition, natural persons are considered accredited if their income exceeds $200,000 in each of the two most recent years, or $300,000 in joint income with a person’s spouse, and they reasonably expect to reach the same level in the current year. Natural persons are also considered accredited if their net worth exceeds $1 million (individually or jointly with a spouse), excluding the value of a primary residence. In addition, certain entities with more than $5 million in assets qualify as accredited, as do regulated entities such as banks and registered investment companies.
"The proposed expansion of the accredited investor definition will be a two-edged sword for sellers of privately placed products that rely on the Reg D safe harbor," said K&L Gates partner Michael Caccese. "On the positive side, if the proposals are accepted, there will be an expanded universe of accredited investors that privately offered products can be offered to. It would no longer be limited to income, net worth and other quantitative factors. It may include investors who have certain investment skills, training, credentials, or are represented by such persons."
However, "on the negative side," said Caccese, "it will require the sellers to adopt additional compliance regimes to establish a reasonable belief that the potential offeree is an accredited investor and make sure that the marketing materials are not presented to an entity or person that does not meet the expanded definition of an accredited investor."
The Investment Adviser Association, which plans to comment on the recommendations, found the report and its recommendations generally well done and thoughtful, said IAA general counsel Robert Grohowski.
One area where the IAA is in disagreement with the SEC staff is the staff’s refusal to recommend that individuals who hire SEC-registered investment advisers be allowed to qualify as accredited investors. As cited in the staff’s report, the IAA in prior comment letters urged the SEC to allow investors who hire investment advisers to qualify, since advisers not only are subject to fiduciary duty, but possess financial sophistication, one of the main objectives of the definition sought. The SEC staff considered this, but ultimately decided against recommending it to the Commission.
"Revising the accredited investor definition to include individuals advised by professionals appears to run counter to the Commission’s prior determination to allow persons who are unable to evaluate the merits and risks of private offerings to participate in those offerings only if the issuer provides them with additional information about the issuer," the SEC staff said. "In addition, there may be significant overlap between individuals who receive advice from professionals and those who meet the existing financial standards in the accredited investor definition."
"The SEC will need to weigh competing interests in considering the various options in the staff report," said Ropes & Gray counsel David Tittsworth. "For example, the SEC should avoid unnecessary restrictions that would be inconsistent with the agency’s broad mandate to facilitate capital formation. On the other hand, the SEC must avoid watering down the definition so much that it fails to meet another key mandate of the agency’s mission: to protect investors. And from a practical point of view, it is essential to have a bright line test so that issuers can make a determination with confidence."
The SEC staff recommended that the Commission consider a variety of recommendations for revising the definition that fall under two broad categories:
Revise the financial threshold requirements for natural persons to qualify as accredited investors and the list-based approach used for entities to qualify. The staff noted that since 1982, "the number of U.S. households qualifying as accredited investors has increased from approximately 2 percent of the population to over 10 percent as a result of inflation." This may mean that inflation has "increased the likelihood that the current pool of accredited investors may contain individuals the definition did not originally intend to encompass," it said.
Revise the accredited investor definition to allow individuals to qualify as accredited investors based on other measures of sophistication. The staff suggests that using only financial measures to determine financial sophistication and ability to sustain investment losses or fend for one’s self may not be enough. "It is not likely … that any single criteria – including the existing income and net worth standards – can determine that an individual will possess these attributes," it said, and noted that "very well informed investors who are not wealthy may be in a position to take on risks that they understand well, while very wealthy investors may be in a position to take on risks even if they lack financial sophistication."
Revising the financial thresholds
The staff recommended that, under the heading of revising the existing financial thresholds, the SEC consider the following:
Leave the current income and net worth thresholds in place, subject to investment limitations. Subjecting accreditation to investment limits "could provide protections for those individuals who are less able to bear financial loss," the staff said. The Commission could limit investments for individuals who qualify as accredited investors based solely on current income and net worth thresholds to a percentage of their net worth, such as 10 percent of prior year income or 10 percent of net worth, as applicable, per issuer, in any 12-month period, the staff suggested.
Create new, additional inflation-adjusted income and net worth thresholds that are not subject to investment limitations. Noting that the income and net worth thresholds have never been adjusted since being adopted, the staff said that the $200,000 individual income threshold established in 1982, adjusted for inflation, would be approximately $443,000 to $491,000, and that the $300,000 joint income threshold established in 1988 would be between $529,000 and $601,000 today. The $1 million net worth threshold established in 1982 would be approximately $2.16 million to $2.45 million today. The staff suggested new inflation-adjusted thresholds, such as $500,000 for individual income, $750,000 for joint income, and $2.5 million for net worth.
Index all financial thresholds for inflation on a going-forward basis. "The Commission could consider indexing all financial thresholds in the accredited investor definition for inflation, rounded to the nearest $10,000, on a going-forward basis every four years," the staff said.
Permit spousal equivalents to pool their finances for purposes of qualifying as accredited investors. This revision would allow "spousal equivalents," such as those involved in civil unions and domestic partnerships, to be treated consistently with those involved in marriages.
Permit all entities with investments in excess of $5 million to qualify as accredited investors. This would resolve a current problem faced by certain entities that do not have a mechanism to become accredited investors. These entities include limited liability companies, Indian tribes, labor unions, social enterprises, sovereign wealth funds and 529 plans. "Limiting the exemption to specific entities has resulted in regulatory uncertainty and may not effectively serve the rule’s investor protection objectives," the staff said.
Grandfather issuers’ existing investors that are accredited investors under the current definition with respect to future offerings of their securities. Doing so would "provide protection from investment dilution for any person who would no longer be accredited investors because of any changes to the definition," the staff said.
Allowing other measures of sophistication
The staff recommended that, under the heading of revising the accredited investor definition to allow individuals to qualify based on other measures of sophistication, it consider the following:
Permit individuals with a minimum amount of investments to qualify as accredited investors. "Investments may in some cases be a more meaningful measure of individuals’ experience with and exposure to the financial and investing markets than income or net worth," the staff said. The Commission could consider adding an investments test so that individuals with a minimum amount of investments could qualify as accredited investors, it said.
Permit individuals with certain professional credentials to qualify as accredited investors. Doing so would "recognize an objective indication of sophistication," the staff said. For example, it said, individuals who have passed the Series 7 examination, Series 65 examination or Series 82 examination might qualify. "These credentials may provide demonstrable evidence of relevant investor sophistication because of the subject matter their examinations cover."
Permit individuals with experience investing in exempt offerings to qualify as accredited investors. "Expanding the accredited investor definition to include individuals with relevant investment experience would recognize an objective indication of financial sophistication and allow experienced investors to maintain their accredited investor status," the staff said. Such individuals "presumably have developed knowledge about the private capital markets, including their inherent risks."
Permit knowledgeable employees of private funds to qualify as accredited investors for investments in their employer’s funds. The staff suggested that a private fund’s knowledgeable employees "likely have significant investment experience and sufficient access to the information necessary to make informed decisions about investments in their
Permit individuals who pass an accredited investor examination to qualify as accredited investors. Not that the SEC doesn’t already have enough work with its existing adviser examinations, the staff suggests that it "explore the possibility of developing an accredited investor examination" and allow those who pass to qualify as accredited investors. Portions of FINRA’s Series 7 and Series 82 examinations, which the staff said already cover these areas, could potentially serve as a model.