SEC to Revise "Accredited Investor" Definition
Posted on Jul 8, 2014 11:55am PDT
In connection with the duties imposed on it by the Dodd-Frank Wall Street
Reform and Consumer Protection Act, the SEC is set to come out with further
revisions to the definition of "accredited investor" in July
2014. Under Rule 506 of Regulation D under the Securities Act, issuers
can raise unlimited funds from accredited investors in private offerings.
In addition, hedge funds often make use of the exemptions afforded by
Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940, which
rely on a fund's ability to use the private placement exemption under
the Securities Act, usually by way of Rule 506. When the SEC last reviewed
the definition of "accredited investor" in July 2010 in connection
with the passage of the Dodd-Frank Act, the definition was revised to
exclude the value of a person's primary residence in the calculation
of such person's net worth for purposes of meeting the minimum $1
million net worth test. The Government Accountability Office's July
2013 report and market survey (titled Alternative Criteria for Qualifying
as an Accredited Investor Should Be Considered, herein the "GAO Report")
notes that this revision resulted in certain investors no longer qualifying
as accredited investors. What the SEC has in store this time around may
be even more far-reaching.
Under the current definition set forth in Rule 501 of the Securities Act,
an individual is an "accredited investor" if such person (i)
has a net income in excess of $200,000 (or $300,000 with a spouse) in
each of the prior two years and reasonably expects the same for the current
year or (ii) has a net worth in excess of $1 million (either alone or
with a spouse), excluding the value of such person's primary residence.
These thresholds have been largely unchanged since the 1980s.
Any changes to the "accredited investor" definition should balance
the SEC's two primary (but competing) goals of protecting investors
and encouraging capital formation for small businesses. One proposal has
been to simply adjust the thresholds in the definition for inflation.
For example, the GAO Report noted that adjusting the $1 million net worth
threshold for inflation to $2.3 million would decrease the number of qualifying
households from approximately 8.5 million to 3.7 million. Some commentators
have panicked that such a reduction in the number of eligible accredited
investors would have a substantial negative impact on private investment
in the United States. On its face, one can see the cause for alarm —
but what the GAO Report does not tell us is what percent of funding by
accredited investors has historically been provided by those that would
no longer be eligible after adjusting the thresholds for inflation. It
seems quite likely that a 60 percent decrease in eligible households would
result in a drastically smaller decrease in funds provided by accredited
investors, on the assumption that smaller accredited investors have historically
provided a smaller percent of capital raised. Still, many have argued
that existing thresholds are sufficient (noting, for example, the limited
claims of investor fraud in the private placement market) and that any
increase will discourage growth at a time when the economy is still rebounding.
Though the GAO Report cites net worth as the most important criteria for
determining accredited investor status (based on, in part, its indication
of an investor's ability to absorb loss and presumed sophistication),
the report did note other potential modifications to the definition that
the SEC may consider, including, among others, (i) a liquid investments
requirement (i.e., a minimum dollar amount of investments that can be
easily sold and whose value can be verified), (ii) use of a registered
investment adviser, and (iii) self-certification, licensing or other education
standards to establish investor sophistication (e.g., attorneys and certified
public accountants may be deemed to be accredited investors), in each
case in addition to, or in lieu of, existing requirements. Requiring $250,000
of a person's net worth to be liquid would certainly protect investors
by making sure they can better absorb potential losses, but would come
at the cost of reducing the number of eligible accredited investors and
thus available capital. Requiring use of a registered investment adviser
or establishing other sophistication criteria (in the absence of other
financial requirements) may result in new eligible accredited investors
and available capital, but may result in investors participating in private
placements who are unable to withstand potential significant losses.