For the first time in nearly 40 years, the U.S. Securities and Exchange Commission is lowering the barriers to investing in private securities. How much lower is unclear, however.
Three of the five SEC commissioners voted to publish a proposal for updating the definition of “accredited investors,” a category of individuals and institutions that are allowed to take part in private financial markets, on Dec. 18. The general public has 60 days from the proposal’s publication in the Federal Register (the official record for the U.S. government) to comment on whether the securities regulator should approve the expanded definition.
The proposal was lauded by many in the cryptocurrency community, who hoped the new definition would allow individuals to participate in unregistered token offerings based on how well they understand the products, not arbitrary standards of wealth.
However, though the proposal lists a number of criteria and considerations the SEC is evaluating, the final expanded definition might not widen the pool of new accredited investors all that much, industry lawyers said.
“So far it appears that this expansion of accredited investor status is mostly applicable to Wall Street insiders such as licensed brokers or ‘knowledgeable employees’ of private investment funds,” said Zachary Kelman, a partner at Kelman Law. “It’s not as expansive as people would like to think.”
While the proposals look promising, “as in all things, the devil is in the details,” said Drew Hinkes, general counsel at Athena Blockchain and an attorney with Carlton Fields.
The text provides a tentative framework for which credentials from academic institutions would qualify, including an examination or series of exams administered by a self-regulatory organization.
That part “could have a massive impact,” Hinkes said.
But according to the full text of the proposal, the SEC would have to designate the specific certifications, designations or credentials that would qualify an investor.
“Does that mean anyone with a four-year degree from an accredited university, which would probably include millions of new investors, or is it limited to Ph.D.s, which would probably not be material?” Hinkes said. “We'll find out when we get more details from the commission. For now, it's promising but not yet actionable.”
The SEC proposal touches on recommendations stretching over a decade, with some of the amendments stemming from a 2015 report and others reaching as far back as 2007.
Some $1.7 trillion was raised in 2018 in Rule 506 offerings, including equity and debt, compared to $1.4 million raised in registered offerings, the text said, indicating significant demand for these types of exempt offerings.
“We are mindful that an overly broad definition could potentially undermine important investor protections and reduce public confidence in this vital market,” the proposal said. “At the same time, an unnecessarily narrow definition could limit investor access to investment opportunities where there may be adequate investor protection given factors such as that investor’s financial sophistication, net worth, knowledge and experience in financial matters, or amount of assets under management.”
Commissioner Hester Peirce said investors' sophistication – that is, their understanding of the markets they’re investing in – should be used to determine accreditation status.
“Our current definition includes investors that spend their days cruising around in a Ferrari that Daddy bought them, yet excludes investors whose weeks are spent earning money and weekends are spent figuring out how best to invest it,” she said in a statement.
However, Commissioner Allison Lee, who voted against the proposal, said in a statement the proposal could create some “serious risk to retail investors,” citing elderly individuals and retirees as examples.
Similarly, Christopher Gerold, president of the North American Securities Administrators Association, said the proposal could expose retail investors “to the significant potential harms associated with unregistered, illiquid offerings” with no ongoing disclosures.
The proposal "offers several changes to the definition, but few if any improvements, and clearly misses an opportunity to provide meaningful reform to this outdated standard,” he said.
While expanding the definition of “accredited investor” to include more individuals and entities is widely being hailed, the framing of the conversation online has largely ignored the term’s historical context, Kelman said.
Under current law, an accredited investor is an individual with $1 million in assets or at least $200,000 in annual income; a married couple with at least $300,000 in annual income; banks, savings or loan institutions defined under the Securities Act of 1933; brokers or dealers defined under the Securities Exchange Act of 1934; investment companies registered under the Investment Company Act of 1940; licensed small businesses; state plans with at least $5 million in assets; employee benefit plans with at least $5 million in assets; or a few other entities.
Historically, the status was granted to the wealthy as “a function of practicality rather than privilege,” Kelman said.
“The exemption for wealthy investors is premised on their financial latitude to lose their shirt without posing systemic risks such as bank runs and financial crises,” he said.
To be clear, Kelman said the proposal “represents a step in the right direction,” but treating it as a question of accessibility rather than systemic risk ignores that the concept of an “accredited investor” (if not the specific term itself) was created in the wake of the Great Depression.
“In my view, shifting the premise of the accredited investor status from ‘systemic risk mitigator’ into ‘investor IQ test’ raises a question as to why investors need SEC protection at all,” he said.
Indeed, Peirce said the move “takes some important first steps” in updating the definition by factoring in “an investor’s actual sophistication,” rather than finances.
Likewise, Commissioner Elad Roisman appeared to support moving away from the historical approach, calling wealth a “crude measure” of an investor’s ability to make decisions about which markets they participate in.
“I doubt that even the Commission who first adopted Regulation D would argue that they came up with perfect criteria for who should qualify as an accredited investor,” he said. “Did anyone consider the outcome that only the wealthiest Americans would have access to investments that would have the most upside for growth over time?”
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