In December of 2015, the Securities and Exchange Commission released a report on the definition of an “accredited investor.” It thus opened a new round of discussion on a matter of foundational significance to the alternative investment industry, and it’s worth our while keeping up with this discussion.
Under Reg D, a natural person can count as an accredited investor if his income exceeds $200,000 in each of the two most recent years, or in the case of two spouses, if their joint income has exceeded $300,000 in each year, and if he/she or they reasonably expect to hurdle the same bar again in the current year. In the alternative, natural persons can also qualify as accredited if their net worth exceeds $1 million, either individually or as a couple, and excluding the value of their primary residence.
The Dodd-Frank Act requires the SEC to review this definition at four-year intervals to determine whether it ought to be modified or adjusted for the protection of investors.
Considering Natural Persons
For convenience I will discuss in what follows only the tests that involve natural persons, leaving aside the issue of the institutions that do or do not qualify.
The staff suggests that the SEC “consider” certain revisions of the test, such as the indexation of all the financial thresholds to inflation. On a related point, the staff proposes the grandfathering of the existing investors of particular issuers under Reg D; that is, a reform under which post-indexation and the opening round of threshold increases, the issuers and investors will be allowed to proceed under the pre-indexation definition with regard to future offerings of those securities. The staff appears to prefer that this grandfathering be narrowly construed to “apply to future investments in a particular issuer only, and not to future investments in affiliates of the issuer.”
Indexation would of course tend to contract the number of accredited investors. But other staff recommendations would have the opposite consequence, expanding the number, especially by allowing investors to qualify “based on other measures of sophistication” such as professional credentials, or the successful completion of an examination. The SEC could “explore the possibility of developing an accredited investor examination” possibly based on portions of FINRA’s Series 7 and Series 82 examinations, which cover financial and investing knowledge, “as well as understanding of private offerings and the risks involved with them.”
The report observes that the definition of “qualified” is more than merely a cornerstone of Reg D. It has acquired importance in other federal and state securities law provisions “and has taken on increased significance as a result of the JOBS Act.” For example, issuers relying on section 501 of the JOBS Act need to differentiate between those of their holders of record who are and those who are not accredited investors to ensure than no more than 499 of their holders fall into the latter group.
As of the end of 2015, the SEC had received three public comments on this report. None of these was especially detailed. One of them was from an anonymous individual who seems simply to have wanted to blow off a bit of steam for a paragraph demanding (caps in the original) that the SEC,”STOP the destruction of families and this country by unscrupulous conniving thieves in high priced suits.” Another was from a woman who took the opportunity to complain that somebody at Fidelity spoke to her rudely, “even told me I committed fraud, but I don’t know how.”
The other comment was the most philosophical in tone, including a suggestion that the SEC should leave the definition of a qualified investor untouched, on the general theory that what is working well enough should not be fixed. This commenter especially wants the agency to refrain from indexing to inflation: “if more entities meet the definition over time due to inflation, all the better.”
Certainly inflation hawks can have some sympathy with that. If the U.S. government is pursuing policies that will be undermined by inflation, then as a matter of logic it has three choices: abandon those goals; index everything to which those goals are pertinent to inflation; or stop inflation. Some of us think one of the difficulties with any step toward the second of those is that it lessens the pressure for accomplishing the third.