Revisiting the "Accredited Investor" Definition to Better Protect Investors
Commissioner Luis A. Aguilar
U.S. Securities and Exchange Commission*
Thank you and good morning. I want to start by welcoming the members of the Advisory Committee on Small and Emerging Companies to today’s meeting. I appreciate your efforts and look forward to today’s discussions. I would also like to thank the staff of the Division of Corporation Finance’s Office of Small Business Policy for organizing this meeting.
Since its formation in 2011, this Committee has provided the Commission with advice related to privately-held small businesses and the smaller publicly traded companies.[1] It is well-known that these businesses have an outsized impact on the growth of our country’s economy and on job creation for all Americans.[2]
As you know, today’s meeting will focus on the definition of “accredited investor.” This definition is critical to the Commission’s Regulation D exemption from the registration requirements of the Securities Act of 1933. Regulation D may be the Commission’s most widely used exempted offering. It is regularly used by small businesses to raise funds in the capital markets.
As many of you know, roughly one month ago today, this topic was the subject of a lively discussion at the Commission’s Forum on Small Business Capital Formation.[3] At the November 20th Forum, I spoke about the urgency and importance of improving upon the “accredited investor” definition.[4]
The “accredited investor” definition is critical for the protection of investors. At its essence, the definition attempts to identify those individuals who are expected to be able to fend for themselves and protect their interests. The current “accredited investor” definition attempts to do that for individuals by focusing on whether an individual has 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.[5]
Generally speaking, securities offerings made to “accredited investors” under Rule 506 of Regulation D are exempted from the registration and disclosure requirements of federal securities laws and the securities purchased cannot be freely resold.[6] Because of the importance of the “accredited investor” definition, Congress has mandated that the Commission undertake a periodic review of the definition, as applied to natural persons, to determine whether it should be modified for the protection of investors.[7]
Notwithstanding the Congressional mandate, there are those that think that the Commission should not review the income and net worth tests contained in the “accredited investor” definition.[8] The view is that we should not examine a definition that identifies eligible purchasers to be “millionaires” and other affluent persons – and that these individuals simply do not need to be protected.[9]
While that might make for a nice sound bite, it simply fails to convey who is really impacted. Accredited investors are not only individuals like Bill Gates or Warren Buffett – but constitute a large pool that includes a large swath of Americans. For example, generally, the following individuals would be eligible “accredited investors:”
- A single working parent of three children with an annual salary of $205,000, and likely with a home mortgage to pay;
- A recent widow who inherited $1 million, but is not earning a separate income; and
- A senior retiree who has accumulated over $1 million in his or her retirement account and needs that money for the retirement years.[10]
While these individuals qualify as “accredited investors” under the income and net worth tests, there is nothing in the definition that helps to identify whether these individuals have the financial sophistication and/or investment experience to be able to assess whether any particular investment is appropriate for them.
Many observers believe that the definition’s failure to consider investors’ actual financial sophistication is a serious flaw.[11] As the SEC’s Division of Economics and Risk Analysis has reported, many investors whose financial wealth gives them “accredited investor” status may have limited investing experience.[12] In addition, other studies have shown that accumulating financial wealth is not necessarily correlated with intelligence.[13] One finance professional has found that “there are often people whose net worth puts them in the accredited category. They may be smart and successful in their fields, but most are confused about the basics of investing and managing money.”[14]
It is time for the Commission to review the appropriate conditions for determining whether someone is, or isn’t, an “accredited investor.” Beyond the fact that Congress mandated a review of the definition, it is an appropriate task to be undertaken by the agency responsible for regulating the capital markets. Investors who are considered “accredited” under these rules are carved out from the basic investor protections that the securities laws mandate with regard to registered securities offerings. These protections – provided, in part, through mandatory filings and required disclosures – simply do not exist for those deemed to be “accredited investors.”[15]
As a result, the single working parent with three children, the widow with the inheritance, and the retiree all deserve the Commission’s attention to make sure they are not made more vulnerable by an “accredited investor” definition that may fail to distinguish between individuals who can protect their own interests and those who cannot. For these reasons, it is entirely appropriate for the Commission to review whether the “accredited investor” definition is accomplishing its intended goals.
Moreover, as the Commission’s Investor Advisory Committee (“IAC”) has pointed out, the current “accredited investor” definition may be under-inclusive. Potential investors who most people would consider to be financially sophisticated, such as a Chartered Financial Analyst or a graduate professor of corporate finance, may not have the income or the accumulated net worth to be eligible to be “accredited investors,” but they may actually be better able to protect their own interests.
This is why the IAC has recommended changes to the accredited investor definition that take into account other ways of measuring financial sophistication. These recommendations include assessing an individual’s specialized work experience, investment experience, licensing, or other professional credentials.[16]
Ultimately, it is important that we get this definition right. There is no doubt that the definition of “accredited investor” under Rule 506 of Regulation D will remain critical to the success of capital formation.[17] In the long-run, the continued success of Rule 506 ultimately will depend on whether the “accredited investor” definition appropriately identifies the individuals who do not need the protection of the Commission’s securities registration and disclosure requirements – and those who do.
For these reasons, I am pleased that this Committee will today focus on the definition of “accredited investor,” and I look forward to your discussions. Thank you.
[*] The views I express today are my own, and do not necessarily reflect the views of the U.S. Securities and Exchange Commission (the “SEC” or “Commission”), my fellow Commissioners, or members of the staff.
[1] SEC Advisory Committee on Small and Emerging Companies, http://www.sec.gov/spotlight/acsec-spotlight.shtml.
[2] For these purposes, small businesses are defined as those independent businesses with fewer than 500 employees. See U.S. Small Business Administration Office of Advocacy, Frequently Asked Questions, available at http://www.sba.gov/sites/default/files/advocacy/FAQ_March_2014_0.pdf. The statistics show that small businesses make up 99.7% of U.S. employer firms, 48.5% of private-sector employment, and 37% of high-tech employment. Small firms were responsible for 63% of net new jobs created between 1993 and mid-2013, or more than 14 million of the nearly 23 million net new jobs created during this period. See id.
[3] The relevant panel was titled “Should the Commission Revise the Accredited Investor Definition?.” The panel discussed generally how DERA’s analysis found that under the income and net worth standards, first established in 1982 and not adjusted for inflation, 1.8% of American households qualified as “accredited investors” in a 1983 survey, while 9.9% of American households qualified as such in a 2013 survey. According to the DERA analysis, adjusting these standards for inflation would reduce the accredited investor number to roughly 3.5% of American households. The panelists then debated whether finding the correct “accredited investor” definition was an answerable question, and whether and how the “accredited investor” definition should be revised. While panelists noted that simply applying an inflation adjustment to the current “accredited investor” definition could reduce the total number of “accredited investors,” the panelists debated other ways to revise the definition, including ways to take into account an investor’s financial sophistication. Panelists also pointed out that there is more pressure to have a working definition of “accredited investor” given the recently adopted Rule 506(c) under Regulation D, which permits more opportunities to engage in high pressure sales tactics legally. One panelist added that the states have long advocated for an adjustment to the accredited investor definition, while also pointing out that although investment sophistication is extremely important, there should not be an undue verification burden imposed upon issuers.
The Commission’s Forum on Small Business Capital Formation also included some panelist recommendations for the accredited investor definition. These included the following: (1) Preserve the definition of accredited investor so that the pool of available investors is not materially diminished and application of the exemption is both workable and verifiable; (2) Maintain the current financial thresholds ($200,000 income per individual; $300,000 for joint filers, or $1 million net worth not including primary residence) for individuals to qualify as accredited investors who may invest unlimited amounts in exempt offerings; and (3) Add a category for individual “sophisticated investors” who have the requisite knowledge and experience to invest in exempt offerings, irrespective of financial thresholds. Enable such investors to certify accredited status using an expanded, detailed, Investor Qualifying Questionnaire that requires substantive qualitative information about the purchaser well beyond simple “check-the-box” certification. This questionnaire should be deemed to satisfy the principles-based methodology for an issuer to “take reasonable steps to verify” the accredited status of investors under Rule 506(c).
[4] See Commissioner Aguilar, The Importance of Small Business Capital Formation (Nov. 20, 2014), available at http://www.sec.gov/News/PublicStmt/Detail/PublicStmt/1370543532516.
[5] The definition of “accredited investor” applicable to Rule 506 is set forth in Rule 501(a) of Regulation D [17 CFR 230.501(a)] and includes any person who comes within one of the definition’s enumerated categories of persons, or whom the issuer “reasonably believes” comes within any of the enumerated categories, at the time of the sale of the securities to that person. The categories include: (A) any natural person whose individual net worth, or joint net worth with that person’s spouse, exceeds $1,000,000, excluding the person’s primary residence and any indebtedness secured thereby (up to the value of such residence); and (B) any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.
[6] Under Securities Act Rule 502(d), purchasers who acquire securities in a Regulation D offering cannot resale such securities without registration under the Securities Act, or without another exemption from registration being available. See Securities Act Rule 502(d) (Limitations on resale). After a one-year holding period, and assuming certain other conditions are met, Securities Act Rule 144 thereafter allows public resale of restricted and controlled securities (assuming the seller is not an affiliate of the issuer). See Rule 144 under the Securities Act.
[7] Under the Dodd-Frank Act, Congress requires the Commission to undertake a review of the definition, as applied to natural persons, to determine whether it should be modified for the protection of investors, in the public interest, and in light of the economy. The Dodd-Frank Act mandates that the Commission commence this review no earlier than this past July 2014, and at least once every four years, thereafter. See Section 413(a) of Title IV of the Dodd-Frank Act, available at http://www.gpo.gov/fdsys/pkg/PLAW-111publ203/pdf/PLAW-111publ203.pdf.
[8] These commenters generally oppose any upward adjustment in the “accredited investor” net worth or income tests. See e.g., Comment Letter from Angel Capital Association (Feb. 28, 2014) (“ACA has studied this issue at length, and recommends that the SEC make no change to the existing financial thresholds for a natural person, in light of the massive growth in size of the exempt market and its critical importance to the economy – particularly in job creation.” In its letter, ACA also supports broadening the accredited investor definition to also include those with requisite sophistication, but who do not meet the financial thresholds) , available at http://www.angelcapitalassociation.org/data/File/pdf/ACA_Accredited_Investor_Def_Comment_Letter_02-28-14_(2).pdf; see also Comment Letter from the Small Business Investor Alliance (Oct. 8, 2014) (stating that “so long as the current financial thresholds remain in place as a method to establish sophistication, SBIA believes it may make sense to provide alternative methods in which investors could be classified as ‘sophisticated’ as has been suggested by the Committee and members of Congress.”) (emphasis in original), available at http://www.sec.gov/comments/265-28/26528-87.pdf.
[9] See Commissioner Gallagher, Opening Remarks to the 2014 Government-Business Forum on Small Business Capital Formation (Nov. 20, 2014), available at http://www.sec.gov/News/PublicStmt/Detail/PublicStmt/1370543507810.
[10] In fact, many households meeting the accredited investor threshold are likely to be elderly, with savings accumulated over the course of decades (which must, in turn, last the rest of a lifetime). I am particularly concerned as to seniors that may be targeted by general solicitations, as many older Americans may lack the financial literacy necessary to understand the risks of an investment in restricted, unregistered securities. See SEC, Study Regarding Financial Literacy Among Investors As Required by Section 917 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, at p. 15 (Aug. 2012), available at http://www.sec.gov/news/studies/2012/917-financial-literacy-study-part1.pdf (“…surveys demonstrate that certain subgroups, including women, African-Americans, Hispanics, the oldest segment of the elderly population, and those who are poorly educated, have an even greater lack of investment knowledge than the average general population.”). This risk may be heightened by cold-calling and other forms of general solicitation. To that end, seniors and other unsophisticated investors targeted for their relative wealth may not be protected by the definition of “accredited investor,” but, in fact, may be more vulnerable because of it.
[11] See Recommendation of the Investor as Purchaser Subcommittee and the Investor Education Subcommittee: Accredited Investor Definition, at p. 3, available at http://www.sec.gov/spotlight/investor-advisory-committee-2012/accredited-investor-definition-recommendation.pdf (last visited Dec. 7, 2014) (stating that “[t]he current accredited investor definition for natural persons uses financial thresholds based on income and net worth as proxies for access to information, financial sophistication, and ability to withstand potential losses. It is true that some individuals who meet the income and net worth criteria of the definition will also be financially sophisticated, and some may be able to gain access to information of the type provided in public company registration statements. However, there is nothing in the definition itself that guarantees that this will be the case. Indeed, the limited data that exists suggests that though there is a correlation between income and financial literacy, a significant percentage of even the wealthiest investors score poorly on tests of basic financial literacy. Such tests don’t begin to measure the type or level of financial sophistication needed to evaluate the potential risks and benefits of private offerings. At the same time, individuals who fail to meet the financial thresholds in the current definition may possess the financial sophistication and access to information necessary to make an informed investment decision. In other words, the current definition is, at best, a highly imperfect proxy for financial sophistication and access to information.”) See also Paul Sullivan, Deciding Who’s Rich (or Smart) Enough for High-Risk Investments, The New York Times (Jan. 13, 2012) , available at http://www.nytimes.com/2012/01/14/your-money/deciding-whos-rich-or-smart-enough-for-high-risk-investments.html?pagewanted=all&_r=0/ (“In other words, using money as a stand-in for financial sophistication is a fairly unsophisticated solution.”).
[12] Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, SEC Release No. 33-9415, at p. 75 (July 10, 2013), available at http://www.sec.gov/rules/final/2013/33-9415.pdf (stating that “evidence suggests that only a small fraction of the total accredited investor population has significant levels of direct stockholdings.”).
[13] See Jay L. Zagorsky, Do you have to be smart to be rich? The impact of IQ on wealth, income and financial distress, Intelligence (2007) (finding that while income and IQ scores are related, there is no correlation between IQ scores and overall wealth).
[14] John E. Girouard, The Sophisticated Investor Farce, Forbes (Mar. 24, 2009), available at http://www.forbes.com/2009/03/24/accredited-investor-sec-personal-finance-financial-advisor-network-net-worth.html?partner=contextstory.
[15] For example, under Rule 506, no information statement or other disclosure is required to be provided if all the purchasers are accredited investors. Form D, the Notice of Exempt Offering of Securities, does not currently require any substantive disclosure. See Electronic Filing and Revision on Form D, SEC Release No. 33-8891 (Feb. 6, 2008), available at http://www.sec.gov/rules/final/2008/33-8891.pdf.
[16] See supra note 11, at p. 2. Recently, the Commission’s Investor Advisory Committee (“IAC”) provided the Commission with its own recommendations regarding possible ways to amend the accredited investor definition. In brief, the IAC recommended that the Commission revise the accredited investor definition to enable individuals to qualify as accredited investors based on various ways of assessing their financial sophistication, such as through specialized work experience, investment experience, licensing or other professional credentials, or perhaps even through a qualifying test developed by, or in collaboration with, securities regulators. In particular, the IAC suggested that individuals who have attained certain professional credentials, or who have relevant professional experience, such as individuals with Series 7 securities licenses or those with Chartered Financial Analyst designations, could qualify as accredited investors without regard to their income or net worth. The IAC also suggested that the Commission could look to certain individuals with professional experience that qualifies them as financial experts, such as persons who have work experience in the private equity sector or have spent some period of time as a director of a large business. The IAC also suggests that the Commission look to individuals with certain investment experience to qualify as accredited investors. See id.
[17] The Commission’s Division of Economics and Risk Analysis estimated that capital raised through Regulation D offerings is quite large – $863 billion reported in 2011 and $903 billion in 2012, while Rule 506 accounts for 99% of amounts sold through Regulation D. See Vladimir Ivanov and Scott Bauguess, Capital Raising in the U.S.: An Analysis of Unregistered Offerings Using the Regulation D Exemption, 2009-2012, SEC Division of Economic and Risk Analysis (July 2013), available at http://www.sec.gov/divisions/riskfin/whitepapers/dera-unregistered-offerings-reg-d.pdf.
Last Reviewed or Updated: Dec. 17, 2014