Since 1982, the federal government has limited the ability of individuals to invest in private placements, anything from hedge funds to real estate deals, to “accredited investors.” The definition of that term, in Regulation D under the Securities Act of 1933, makes two things, income and wealth, a proxy for financial sophistication: An accredited investor is anyone with an annual income of at least $200,000 for each of the prior two years (or $300,000 together with one’s spouse) or anyone with a net worth of at least $1,000,000. It is estimated that 8.5 million people in the United States currently qualify as accredited investors.
How we got to this point is a story worth telling. The 1933 Act included provisions for private placements that do not require registration. In 1953, the United States Supreme Court ruled that the applicability of this registration exemption depended on whether the purchasers of the unregistered securities could “fend for themselves.”1
There was no regulation until 1974, when the SEC promulgated Rule 146, which based the determination of investor sophistication, not on a monetary standard, but on factors such as knowledge, experience and the ability to bear risk. The SEC adopted Rule 242 in 1980 to modify the standard to include any person who purchased $100,000 worth of an issue of securities or a director or executive officer of an issuer. Regulation D replaced Rules 146 and 242.
In 2011, pursuant to the requirements of the Dodd-Frank Act, the SEC has barred consideration of the equity a person has in a primary residence from the net worth calculation. The SEC has also entertained the idea of significantly altering the definition of accredited investor. One proposal has called for more than doubling the existing thresholds. Just this month, the recently formed Investor Advisory Committee met with the SEC to discuss the issue.
Many in the financial industry have expressed the concern that simply increasing the thresholds could dramatically reduce the pool of investors by as much as 60 percent, a potentially devastating blow to many smaller industry participants, which depend on individuals, not institutional investors.
Like most securities laws, the SEC designed these thresholds to protect investors. But one thing you’ll be hard pressed to find is a rationale for how income and wealth standards by themselves realized this aim in 1982, let alone how they serve the same purpose today, when a person with an annual income of $200,000 is solidly in the middle class.
In other words, the standard is glaringly arbitrary, and has little to do with financial sophistication and much more to do with the ability to bear financial loss. On the other hand, it would be difficult to imagine how Ph.D.-level economists, licensed stockbrokers and investment advisers and, yes, even securities lawyers would not be able to fend for themselves in the markets. Yet many such persons do not fall under the current definition of accredited investor.
Recent history has shown that few if any measures can truly protect even sophisticated investors from widespread securities fraud. And just how sophisticated do you have to be to warrant protection? Judges who are required to determine investor “sophistication,” when considering such things as the suitability of investments, use a fact-intensive inquiry that takes into account factors ranging from education and business acumen to age and investment experience. The results have been anything but uniform. For example, the SEC has held that one with a business degree, a successful company and $3 million brokerage account was not sophisticated.2 In another case, it held that a person was not sophisticated despite being a city’s finance officer.3
And who is protecting those who are unquestionably unsophisticated from bad investments that are available to anyone? Annuities, sold as insurance products, come with an average portfolio management fee of over 2%, commissions as high as 7% and early surrender charges of as much as 20%. That may be a topic for another discussion.
Following this month’s meeting, the Investor Advisory Committee did make several recommendations to the SEC. The Committee analyzed the potential benefits of alternate approaches for measuring sophistication such as standardized testing qualifications (for example, Series 7 exams, Chartered Financial Analyst certifications and other independent tests). It also proposed limiting an individual’s ability to invest in private offerings to a certain percentage of net worth. These suggestions seem impractical. What investor will be willing to take a test to qualify to make an investment? And how do you enforce an asset allocation requirement except by means of portfolio police?
The current standard is designed to be paternalistic, but there is undoubtedly a degree of paternalism in all of our securities laws. That’s not what’s troubling. The real problem is not even that the current definition is arbitrary. What’s worse is that the standard is not a very good solution to the complicated issue of risk, which no definition can eliminate. After all, New York Stock Exchange listed companies go bankrupt.
Or maybe by now the restriction is just a solution in search of a problem. It doesn’t deter fraudsters, who will continue to take advantage of the unsophisticated. And of course, it does nothing to protect us from bad products. Maybe this is oversimplifying a complex issue, but we think the securities laws work best when they deal with common sense disclosures, not dubious restrictions. The accredited investor standard does little more except to give us more boxes to check. And we will keep on checking them.
1 SEC v. Ralston Purina Co., 346 U.S. 119 (1953).
2 In the matter of Frey et al., Initial Decision Release No. 221 (SEC), 2003 WL 245560 (February 5, 2003).
3 In the matter of Ward et al., Admin. Proc. File No. 3-9327 (SEC), 2003 WL 1447865 (March 19, 2003).