What is an Accredited Investor?
Investors in start-ups and growing small and medium-sized businesses (“SMBs”) are familiar with the definition of “accredited investor.” Regulation D, the primary SEC regulation that creates a safe harbor for exempt securities offerings by private companies, allows greater latitude for issuers that sell their securities to “accredited investors.” As a consequence, many exempt offerings are intentionally limited to only accredited investors.
What is familiar may soon change, however, if the Securities and Exchange Commission (SEC) acts on recommendations of its staff published in a report last week that would change the meaning of “accredited investor.”
Section 413(b)(2)(A) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) directed SEC to review the accredited investor definition. The Dodd-Frank Act specified that this review shall be conducted not earlier than four years after enactment of the Dodd-Frank Act and no less frequently than once every four years thereafter. On December 18, 2015, the SEC issued its first report under the Dodd-Frank Act, examining the definition of “accredited investor” and setting forth some changes recommended by the SEC staff.
The accredited investor definition is “intended to encompass those persons whose financial sophistication and ability to sustain the risk of loss of investment or ability to fend for themselves render the protections of the Securities Act’s registration process unnecessary.”
Regulation D originated as an effort to facilitate capital formation, consistent with the protection of investors, by simplifying and clarifying existing rules and regulations, eliminating unnecessary restrictions those rules and regulations placed on issuers, particularly small businesses, and achieving uniformity between federal and state exemptions. While it is particularly useful for small businesses, issuers of all sizes conduct offerings in reliance on Regulation D, in general, and Rule 506(b) in particular.
Under the current definition, natural persons are 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. Natural persons are also accredited investors if their net worth exceeds $1 million (individually or jointly with a spouse), excluding the value of their primary residence. Certain enumerated entities with more than $5 million in assets qualify as accredited investors, while others, including regulated entities such as banks and registered investment companies, are not subject to the assets test.
Although regulators and market participants increasingly rely on the accredited investor definition, it has not been comprehensively re-examined since its adoption in 1982. Since that time, general inflationary effects have expanded significantly the pool of persons that qualify as accredited investors. In addition, developments such as increased informational availability, as well as changes in the way investors communicate, have altered the investing landscape. Further, 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. Consequently, 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 accredited investor definition attempts to identify those persons whose financial sophistication and ability to sustain the risk of loss of investment or ability to fend for themselves render the protections of the Securities Act’s registration process unnecessary. An overly narrow definition that limited the number of accredited investors could risk restricting businesses’ access to a crucial source of capital and be inconsistent with the Commission’s capital formation mandate. An overly broad definition, on the other hand, could potentially be inconsistent with the Commission’s investor protection mandate and run counter to one of the basic tenets of the Securities Act by failing to provide investors in need of protection with adequate disclosures before they make an investment decision.
Additionally, a fundamental objective of the accredited investor definition is to create bright-line tests that allow market participants to readily determine an investor’s status under the definition. The need for clarity is particularly important because an issuer relying on an exemption from registration carries the burden of proving that the exemption is available. Clarity and certainty in the accredited investor definition foster greater confidence in unregistered markets and ultimately could reduce the cost of capital, thereby promoting increased capital formation, particularly for small businesses. Indeed, Regulation D was adopted, in part, to bring a greater degree of clarity for small businesses than was present under the prior scheme of exemptions.
In its December 18, 2015, report the SEC staff recommended that the Commission consider any one or more of the following methods of revising the accredited investor definition:
• The Commission should revise the financial thresholds requirements for natural persons to qualify as accredited investors and the list-based approach for entities to qualify as accredited investors. The Commission could consider the following approaches to address concerns with how the current definition identifies accredited investor natural persons and entities:
o Leave the current income and net worth thresholds in place, subject to investment limitations.
o Create new, additional inflation-adjusted income and net worth thresholds that are not subject to investment limitations.
o Index all financial thresholds for inflation on a going-forward basis.
o Permit spousal equivalents to pool their finances for purposes of qualifying as accredited investors.
o Revise the definition as it applies to entities by replacing the $5 million assets test with a $5 million investments test and including all entities rather than specifically enumerated types of entities.
o Grandfather issuers’ existing investors that are accredited investors under the current definition with respect to future offerings of their securities.
• The Commission should revise the accredited investor definition to allow individuals to qualify as accredited investors based on other measures of sophistication. The Commission could consider the following approaches to identify individuals who could qualify as accredited investors based on criteria other than income and net worth:
o Permit individuals with a minimum amount of investments to qualify as accredited investors.
o Permit individuals with certain professional credentials to qualify as accredited investors.
o Permit individuals with experience investing in exempt offerings to qualify as accredited investors.
o Permit knowledgeable employees of private funds to qualify as accredited investors for investments in their employer’s funds.
o Permit individuals who pass an accredited investor examination to qualify as accredited investors.
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