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From Securities Regulation Daily, November 20, 2014

Lots of questions, no clear answers on accredited investor definition

By Anne Sherry, J.D.

Panelists at the SEC Government-Business Forum on Small Business Capital Formation grappled with how to craft an accredited investor standard that strikes the right balance between facilitating capital formation and protecting investors. Dodd-Frank requires the SEC to review the definition of “accredited investor” as it applies to individuals and determine whether it should be modified.

Current landscape. The accredited investor definition has implications on Regulation D exempt offerings and on the 500-investor threshold for Exchange Act Section 12(g) registration. The current definition of accredited investor was established in 1982 and picks up individuals with either an annual income of $200,000 (individual) or $300,000 (household) or a net worth of $1 million. Dodd-Frank amended this to exclude the primary residence and accompanying mortgage from the net worth calculation.

Rachita Gullapalli, Financial Economist in the SEC’s Division of Economic and Risk Analysis, explained that adjusting the 1982 figures for inflation would more than double each of the income and wealth thresholds and would dramatically decrease the number of U.S. households that qualify as accredited investors. Under the current standard, 9.9 percent of households qualify, she explained, while in 1983 less than 2 percent of households exceeded the same thresholds.

Alternatives. The panelists discussed whether raising the threshold is the right approach. Stanley Keller, a partner with Edwards Wildman Palmer LLP in Boston, posed several alternatives, including adopting a sophistication test in lieu of the wealth/income test; adding qualitative sophistication criteria; and simply doing nothing based on the absence of any evidence of a problem. He noted that the test needs to strike a balance among the competing interests of investor protection, capital formation, and political pressures while also remaining workable and verifiable, given Rule 506(c)’s requirement that the issuer affirmatively verify accredited investor status.

“Fend for themselves.” Mr. Keller traced the origins of the accredited investor standard to the Supreme Court’s 1953 decision in Ralston-Purina, which stated that the availability of the private-offering exemption from Securities Act registration turns on whether the offering’s prospective investors “are shown to be able to fend for themselves.” Professor Donald C. Langevoort of Georgetown University Law Center, who was on the staff of the SEC in the early 1980s when the phrase “accredited investor” was being invented, expressed deep skepticism of this idea. The financial crisis demonstrates that even some of the largest institutions in the world don’t “fend for themselves” very well, he said, and the scientific evidence and research point to systematic flaws in how retail investors make investment decisions.

If whether investors can fend for themselves is not the right question to ask, another criterion that has been discussed is whether the investor has the means to hire an advisor. This replaces one problem with another, Professor Langevoort said, by bringing in the possibility of conflicts of interest in investment adviser relationships. The normative approach that the professor is left with is to ask whether the prospective investor is a person society expects to be able to turn down an investment that he does not understand. Unfortunately, this palpably leads to no obvious answer, he said.

Transparency. While Professor Langevoort said that his inclination would be to nudge the threshold up slightly, he was much more interested in increasing transparency and data collection. Looking at private offerings ecologically, he said the critical question is how much sunlight is being shed. Regulators do not have the answers to questions such as what the added payoff is to a portfolio that attracts more private investments, or how much fraud there is in this area. In the professor’s view, FINRA and the SEC need to work vigorously on bringing more knowledge to this area, but political pushback is moving in the opposite direction by urging privacy.

Angel investors. Jean Peters, Managing Director of Golden Seeds Fund LP and a member of the board of Angel Capital Association (ACA), praised the role of angel investors in capital formation, particularly in “flyover” states where there is little to no access to venture capital. In the view of ACA, there is no problem that needs fixing, at least not by raising the threshold for accredited investor status. The industry group does believe that sophistication is key and would welcome the addition of sophistication criteria. To this point, CorpFin Director Keith Higgins asked what type of investment experience should be considered. For example, he said, if you give your brother-in-law $500 to fund his hotdog stand, that is technically a private placement, so does that argue for accredited investor status? Ms. Peters said that that is not what ACA has in mind, but also asked as a counterpoint why a person should have to be a millionaire to invest $1000 in the exempt market, especially when the crowdfunding rules, if they pass, will permit much larger investments.

States’ interest. Arkansas Securities Commissioner A. Heath Abshure said that the states really want a test that reflects the sophistication of the investor without placing an undue verification burden on the issuer. Commissioner Abshure highlighted the difficulties in coming up with an accurate test, noting that he himself would not qualify as an accredited investor, but he considers himself to know something about investments. Conversely, he knows some accredited investors he “wouldn’t trust with a potato gun.” The difficulty with qualitative measures, however, is workability and fallibility—an investor who loses money may later argue that he or she shouldn’t have been permitted to invest.

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