The SEC voted Wednesday to propose rule amendments to the definition of “accredited investor” to enable more qualified individuals and institutions to participate in private markets.
SEC Chairman Jay Clayton believes the proposed amendments are “long overdue.” Clayton was among the three — out of five — commissioners who voted yes in favor of moving forward with the proposal.
The SEC notes that the proposed amendments would allow more investors to participate in private offerings by adding new categories of natural persons that may qualify as accredited investors based on their professional knowledge, experience or certifications.
These include individuals who possess the Series 7 (General Securities Representative Qualification Examination), 65 (Uniform Investment Adviser Law Examination) and 82 (Private Securities Offerings Representative Examination) securities licenses administered by Finra.
The proposal would also expand the list of entities that may qualify as accredited investors by, among other things, allowing any entity that meets an investments test to qualify. SEC staff who presented the proposed amendments at the open meeting Wednesday said the dollar thresholds to qualify as an accredited investor would not be amended.
For brokers and advisors, having more flexible accredited investor rules would mean having a bigger pool of investment products and strategies to offer retail investors who could qualify as accredited investors.
However, state regulators have warned that relaxing the definition of accredited investors could end up hurting retail investors. Consumer advocates say the SEC’s actions could even lead to conditions like those that caused the U.S. stock market crashes of 1929 and 2008.
At the SEC's open meeting Wednesday, both Clayton and SEC commissioner Hester Peirce spoke about why they believe the accredited investor definition should be expanded.
“The current key tests for individual accredited investor status are only financial — we have an income test and a wealth test. These tests have been in place, with a few modifications, for decades. They serve to exclude many individuals from our private markets who clearly have the financial sophistication to participate in those markets,” Clayton said.
“I believe it is important to focus on solutions that provide access to investment opportunities on substantially the same terms as those that would be available to institutional investors with protection — including alignment of interest between individuals and institutions, and transparency — that are akin to the protections in our public market,” he added. “This alignment of interest is extremely important to me.”
Peirce said the current accredited investor definition “is one of the more offensive concepts lurking in our federal securities laws.”
The definition suggests that “an individual cannot be trusted with respect to investing her hard-earned money in private offerings, because she does not have the requisite financial sophistication to understand the increased risk associated with such offerings,” she said.
“Our current definition includes investors that spend their days cruising around in a Ferrari that Daddy bought them yet excludes investors whose weeks are spent earning money and weekends are spent figuring out how best to invest it,” she added.
The public comment period for the proposed amendments will remain open for 60 days following publication in the Federal Register.
The SEC lets accredited investors participate in investment opportunities that are generally not available to non-accredited investors. These include investments in many private issuers and offerings by hedge funds, private equity funds and venture capital funds.
Under current SEC rules, individuals are classified as accredited investors 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 income level in the current year;
- Their net worth exceeds $1 million (individually or jointly with a spouse), excluding the value of their primary residence.
The current accredited investor definition also includes — among others — banks; registered broker-dealers; insurance companies; registered investment companies; employee benefit plans under Erisa (if a bank, insurance company, or registered investment advisor makes the investment decisions, or if the plan has total assets in excess of $5 million) and tax-exempt charitable organizations, corporations, or partnerships with assets in excess of $5 million.
Beware of bad brokers and advisors
SEC Commissioner Robert Jackson, Jr. strongly opposed moving forward with the proposed amendments.
He said the assessment that led to the proposal was “one-sided” and “serves no one — especially not investors.”
Jackson said the premise that retail investors would be getting advice on private-market transactions from brokers or advisors — and can efficiently identify and avoid brokers in this area who fail to protect them from fraud — is flawed.
“Contrary to the [proposed amendments] release’s intuition that brokers will protect ordinary families investing in private markets, the evidence shows that those families will be dealing with the brokers most likely to have wronged clients in the past,” he said.
“Even supposedly sophisticated investors under our current standards have difficulty avoiding high-risk brokers in the private-placement market. And if investors are already struggling to sort good brokers from bad in these markets, it’s far from clear why we should expose even more investors to those risks,” he added.
Consumer Federation of America
Barbara Roper, director of investor protection at the Consumer Federation of America, says the proposed amendments are “based on assumptions that are, at best, unsupported by evidence and, at worst, totally baseless.” She questions the assumptions that led to the proposal to expand the pool of accredited investors and maintain the financial thresholds.
“The vast majority of accredited investors today do not have any special ability to access information that private issuers aren’t required to provide, lack the sophistication to evaluate private offerings in the absence of that information, and are not sufficiently wealthy to withstand potential losses,” Roper says.
“In other words, we know the accredited investor definition does not define a pool of investors capable of fending for themselves without the protections afforded in the public markets. Instead of fixing that problem, the SEC is focused on expanding the pool of accredited investors,” she adds.
Roper is also a member of the SEC’s Investor Advisory Council, which advises the SEC on regulatory priorities, investor protection and investor confidence.
Healthy Markets Association
Tyler Gellasch, executive director of the Healthy Markets Association, says no matter how sophisticated an investor is, “without information and rights, he’s just making a guess.” Healthy Markets is an investor-focused group that aims to educate market participants and promote data-driven reforms.
Gellasch notes that the proposed amendments don’t include “even the most basic disclosures or rights” for accredited investors.
“The SEC is proposing to siphon even more capital out of the transparent markets and into the dark. Perhaps the most telling aspect of the proposal is that it includes almost no analysis of the impact on investors,” he says.
“There is no evidence that smaller investors who qualify under the proposal would be able to access great deals, but there’s a lot of evidence that they can and likely will lose,” he adds.
Highlights of proposed amendments
The proposed amendments to the accredited investor definition would add new categories of natural persons based on professional knowledge, experience or certifications.
The proposed amendments would also add new categories of entities, including a “catch-all” category for any entity owning in excess of $5 million in investments.
In particular, the proposed amendments to the accredited investor definition would:
- add new categories to the definition that would permit natural persons to qualify as accredited investors based on certain professional certifications and designations, such as a Series 7, 65 or 82 license, or other credentials issued by an accredited educational institution;
- with respect to investments in a private fund, add a new category based on the person’s status as a “knowledgeable employee” of the fund;
- add limited liability companies that meet certain conditions, registered investment advisors and rural business investment companies to the current list of entities that may qualify as accredited investors;
- add a new category for any entity, including Indian tribes, owning “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered;
- add “family offices” with at least $5 million in assets under management and their “family clients,” as each term is defined under the Investment Advisers Act; and
- add the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors.