Introduction: what is an “accredited investor” and why does it matter?
Under the Securities Act of 1933 (the “Act”), the issuer of any securities offering must follow the strict registration and disclosure requirements of the Securities & Exchange Commission (the “SEC”), unless such offering is subject to an exemption. ((See 15 U.S.C. § 77d (1933).)) One such exemption applies to offerings that are deemed “not public.” ((Id.)) In 1952, the Supreme Court clarified that when an offering is “private” when it is made to those who are shown to be “able to fend for themselves” and thus do not need the protection of the Act. ((Sec. & Exch. Comm’n v. Ralston Purina Co., 346 U.S. 119, 125 (1953). )) Over the years, the SEC has promulgated rules to more clearly carve out exemptions for “private” offerings to persons who are “able to fend for themselves.” One such rule, Rule 506 of Regulation D, allows for sales of securities to an unlimited number of “accredited investors,” or individuals that have either an annual income of at least $200,000 per year ($300,000 with their spouse) or a net worth of at least $1 million. ((17 C.F.R. § 230.506 (1982).)) Today, a great number of private offerings rely on Rule 506, making the “accredited investor” definition an extremely important concept in securities law.
The rationale behind the current “accredited investor” definition
Regulation D, and the “accredited investor” rule that came with it, was adopted to provide an objective standard with which issuers could confidently determine whether their offering was exempt from the requirements of the Act. ((Wallis K. Finger, Unsophisticated Wealth: Reconsidering the SEC’s “Accredited Investor” Definition Under the 1933 Act, 86 Wash. U.L. Rev. 733, 743 (2009).)) The rule that preceded Regulation D, Rule 146, required issuers to meet requirements based on subjective criteria in order to qualify for the exemption. ((Id. at 739.)) This resulted in compliance problems for small issuers who were uncertain whether the private offering exemption was available. ((Id. at 740. )) After issuing a more objective Rule 242, in 1982 the SEC adopted Regulation D to replace both rules and “simplify and clarify existing exemptions, to expand their availability, and…to facilitate capital formation consistent with the protection of investors.” ((Securities Act Release No. 33-6389, 24 SEC Docket 1166, 1166 (Mar. 8, 1982).))
Criticisms of the current accredited investor definition
There are three main criticisms of the current “accredited investor” definition. First, the “accredited investor” definition has not changed with the times. Indeed, other than a change in 1988 to include consideration of spousal income, the income and net worth requirements have not been adjusted to reflect the not insignificant inflation since 1982. ((Finger, supra note 5.)) Had the thresholds been adjusted for inflation, the income threshold today would be just under $500,000 ($740,000 for a married couple) and the net worth threshold would be nearly $2.5 million. ((Investor Advisory Committee, Recommendation of the Investor Advisory Committee:
Accredited Investor Definition (2014), https://www.sec.gov/spotlight/investor-advisory-committee-2012/investment-advisor-accredited-definition.pdf [hereinafter Recommendation].)) Second, the current accredited investor definition for natural persons uses financial thresholds based on income and net worth as imperfect proxies for access to information, financial sophistication, and ability to withstand potential losses. ((Id. at 3.)) Studies have shown that wealthy investors sometimes lack financial sophistication, while investors below the threshold can be remarkably sophisticated. ((Id.)) Finally, the promulgation of Rule 508, which provides a “safe harbor” for issuers who mistakenly rely on Rule 506 in good faith, makes it less convincing that the bright-line threshold of the “accredited investor” is necessary to provide clarity and confidence to issuers. ((Finger, supra note 5, at 749.))
The uncertain future of the “accredited investor” definition
Due to its importance, Congress has mandated that the SEC undertake a periodic review of the “accredited investor” definition, as applied to natural persons, to determine whether it should be modified for the protection of investors. ((Recommendation, supra note 9, at 2.)) All sorts of proposals have been suggested, from segmenting the class of “accredited investors” into multiple groups, to implementing a system of licensing exams for investors. ((Finger, supra note 5, at 751.)) Still, for all the debate about how best to modify the “accredited investor” definition to suit modern reality, there has been disappointingly little action, which reflects the difficult policy considerations behind changing such an entrenched rule. The question of which investors can really “fend for themselves” will likely continue to be salient for years to come.
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