The Securities and Exchange Commission currently is reevaluating the definition of what constitutes an “accredited investor,” the standard for determining who is eligible to invest in most privately offered ventures. An “accredited investor” generally includes a natural person with an annual income exceeding $200,000 or a net worth of $1 million. Institutions generally must have total assets in excess of $5 million to be “accredited.”
The accreditation standard has been in effect since 1982. It is contained in Rule 501 of Regulation D, the SEC regulation that establishes certain exemptions enabling companies to sell securities to investors without undertaking a registered offering. The criteria for accreditation have been updated only twice in the past 32 years: first, in 1988, to add joint income or joint net worth thresholds for married couples; then again, in 2011, as part of the rulemaking under the Dodd-Frank Act, to exclude the value of one’s primary residence from the net worth standard. The Dodd-Frank Act also stipulated that the SEC must review the accredited investor definition every four years, which is why the Commission is doing so now.
Recently, I came across an interesting article entitled “SEC, Stop Insisting Rich Means Smart” by Joanna Schwartz, CEO of EarlyShares, a private investment platform for accredited investors. Ms. Schwartz clearly has a vested interest in seeking to expand the definition of accredited investor.
Ms. Schwartz poses the question: “What makes an investor ’sophisticated’ enough to have access to private investments?” She contends that the SEC answers that question primarily by assuming that “sophistication” must be based on “some measure of income or net worth.” According to Schwartz, “It’s an arbitrary assumption that’s outdated at best and elitist at worst.”
The SEC is considering various options, including raising the income threshold for accreditation to $500,000 for individuals and $700,000 with spouse, or $2.5 million net worth. Obviously, such increased thresholds would further restrict access to private investment opportunities.
Although acknowledging the importance of the goal, Ms. Schwartz accuses the accreditation standards of being a mere “pretext of investor protection.” She argues, however, that determining sophistication based solely upon financial standing unfairly blocks financially savvy, but “non-rich” investors from getting richer by investing in privately-offered investment opportunities. So, in her view, the accreditation standards are more exclusionary than they are protective.
Ms. Schwartz believes that she has a better solution: a standardized testing process to enable individuals to become accredited investors. Of course, she also suggests the possibility that persons with advanced degrees or professional financial designations or licenses could be exempted from the testing requirement. This system, she believes, would actually evaluate investment acumen, rather than assuming it is based on an arbitrary measure like wealth.
It is hard to see how Ms. Schwartz’s solution is any less elitist than use of financial measures as a proxy for sophistication. Moreover, she offers no suggestion regarding what it would take to establish the infrastructure necessary to test all persons who would be seeking accreditation under her alternative. The net result, of course, is that her proposal may inadvertently deter persons with the financial wherewithal to invest, but not the time or ability to take an exam.
Ms. Schwartz also fails to acknowledge that the wealthy presumably are in a better position to absorb and withstand the consequences of their own financial decisions. Perhaps what Ms. Schwartz really wants is an additional, not alternative, path toward accreditation. Again, however, there is no indication that a much more expensive and infrastructure-heavy determination process would create a better balance in terms of protecting investors who “need” such protection, while reducing barriers to financial opportunities for those who do not. In the meantime, however, it seems likely that the SEC will have little option but continuing to use financial criteria as a proxy for investor sophistication, even if it is a less than perfect one.