Review of the 2023 SEC Staff Report on “Accredited Investor” Definition
VerifyInvestor.com
On its blog, VerifyInvestor.com recently reported on the Security Exchange Commission’s (“SEC”) proposed changes to the definition of “Accredited Investor."
In that post, we noted that the SEC might be considering changing the current definition of “accredited investor” to increase the wealth threshold requirements that must be met for individuals and entities to qualify as accredited investors. We also pointed out that the SEC might link the wealth metric to inflation.
Being an “accredited investor” and having an accredited investor status certificate is as important to investors as knowing how to find and verify accredited investors is to issuers. Central to both of these issues is qualifying under the SEC’s definition of “accredited investor.”
But how the SEC defines “accredited investor” is changing.
Today, we present a review of the 2023 SEC Staff Report on the “Accredited Investor” definition.
SEC Issues 2023 Staff Report on Accredited Investor Definition
On December 15, 2023, the SEC issued a Staff Report on the Accredited Investor Definition (referred to herein as “2023 Staff Report” or “the Report”). The Report examines the current definition of “accredited investor” and presents several proposed changes to that definition — including tying the wealth requirement to inflation.
The Report does not decide how the definition of “accredited investor” should be changed but rather invites comment by the general public on the issue.
Regulation D and the Importance of the “Accredited Investor” Definition.
After explaining its responsibility for reviewing the definition of “accredited investor” as it applies to natural persons once every four years in accordance with Section 413(b)(2)(A) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), the SEC notes that, as it concerns the SEC’s most recent review of the definition of “accredited investor,” the intent of the 2023 Staff Report is to focus on:
“…changes in the composition of the accredited investor pool since the definition was adopted; the extent to which accredited investors have the financial sophistication, ability to sustain the risk of loss of investment, and access to information that has traditionally been associated with an ability to fend for themselves; and accredited investor participation in the Regulation D9 market and the market for exempt offerings more generally. …”
Regulation D (Reg. D), which is part of the Securities Act of 1933 (“Securities Act”), provides limited exemptions to the rule that all public offerings of securities must be registered with the SEC. If a transaction comes within one of the Reg. D exemptions, it will be considered a “private placement,” and the issuer will not have to file a registration statement with the SEC.
This is advantageous for start-ups and small businesses because being exempt from registration requirements makes raising capital quicker and easier. Plus, not having to register with the SEC avoids regulatory hassles and time-consuming effort. It also means that there is reduced regulatory oversight. Not having to file a registration statement with the SEC also means that far fewer disclosures must be provided to investors and accredited investors concerning an exempt offering. Not surprisingly, Reg. D is the most widely used securities exemption.
Reg. D is comprised of three separate rules:
Reg. D also provides a definition of “accredited investor” in Rule 501(a).
The 2023 Staff Report emphasizes that the “accredited investor” definition is central to the Rule 506 exemptions.
Whether an offering qualifies for a Rule 506 exemption turns on whether or not the investors in that offering are “accredited investors.” For example, under Rule 506(c), all investors must be accredited investors and the issuer must take “reasonable steps” to verify that each investor is an accredited investor. Rule 506(b) on the other hand, allows issuers to make offerings to both accredited investors and non-accredited investors. However, while the offering can be made to an unlimited amount of accredited investors, only 35 non-accredited investors may participate in any single offering.
The Report also indicates that the definition of “accredited investor” is not only significant for SEC oversight but for many other laws that govern securities. Whether an individual or entity qualifies as an “accredited investor” can impact a range of other federal and state securities laws that the SEC does not regulate.
The SEC’s Definition of “Accredited Investor” Has Changed Over Time.
Both individuals (i.e., natural persons) and entities can qualify as “accredited investors.”
Over the years, in accordance with its responsibilities under the Dodd-Frank Act, the SEC has amended and changed the definition of “accredited investor” — often changing or expanding the criteria that a natural person or entity must meet to fit the definition.
Most notably, the SEC changed the definition of “accredited investor” in 2015 and again in 2020. The 2020 changes expanded the definition of "accredited investor" to include additional categories of natural persons and institutional investors.
Because the SEC’s mission is to protect investors, its definition of "accredited investor” the Report indicates that for purposes of registration exemptions, the definition is “intended to encompass those persons whose financial sophistication and ability to sustain the risk of loss of investment or ability to fend for themselves render the protections of the Securities Act’s registration process unnecessary.”
While some of the more recent changes to the definition expanded the definition to allow investors, for the first time, to qualify based on knowledge or certain credentials, historically, the SEC’s definition of “accredited investor” has centered on indices of wealth only. It has not centered on investment experience, expertise, or knowledge.
The idea behind this was, and apparently still is, the notion that if a person is wealthy, then he/she has the appropriate level of knowledge and experience needed to properly evaluate the risks of an investment. Whether this concept is actually true or not has been hotly debated.
Basically, the SEC has expressed this idea of wealth equals knowledge by focusing the definition on indices of wealth — including net worth. Briefly, the definition of “accredited investor” in Rule 501(a) of Reg. D includes:
individuals that have a high-income net worth, or
companies or financial institutions that have more than $5 million in assets, or
companies or financial institutions whose equity owners are all accredited investors.
Regulation D’s definition of “accredited investor” — which is grounded almost completely in an individual or entity’s income and wealth — was intended to provide a “bright-line test” for determining whether investors qualified as accredited investors. The income and net worth of an investor were seen as the most important factor issuers and the SEC could use to determine which investors were financially sophisticated and able to “fend for themselves” and could sustain the risk of loss, thus did not require the protections afforded by SEC registration.
Over the years, the SEC has made substantive changes to the definition of “accredited investor.” According to the 2023 Staff Report:
In 1988, the SEC added the $300,000 joint income test for natural persons, and eliminated a standard under which a person could qualify as an accredited investor based on the purchase of $150,000 of the securities being offered when the purchase price did not exceed 20% of the person’s net worth.
In 1989, it amended the definition to include plans established and maintained by state governments and their political subdivisions, and their agencies, for the benefit of their employees, so long as the plans had total assets in excess of $5 million.
In 2011, the amendments added the $1,000,000 net worth standard for natural persons, but specified that this amount could not include the value of an investor’s primary residence.
In 2020, the definition was expanded to encompass additional categories of “accredited investors.” It added investment advisors, rural business investment companies, LLCs with total assets in excess of $5 million, family offices, family clients, and a “catch-all” category for certain entities owning investments in excess of $5,000,000, to the list of “accredited investors.” The expanded definition also allowed natural persons to qualify based on obtaining certain certifications or by proving his or her status as a “knowledgeable employee.”
These changes to the definition of “accredited investor” were not without comment or controversy. Nevertheless, they increased the number of individuals and entities that could qualify as accredited investors.
2023 Proposed Changes to the Definition of “Accredited Investor.”
The 2023 Staff Report reiterates that the definition of “accredited investor” is central to the Reg. D exemptions and that it is the determining factor in deciding which investors, and how many, can participate in an exempt offering. The definition also determines how much money can be raised from such investors. With this in mind, the SEC points out that its 2023 review of the definition of “accredited investor” has a unique focus.
According to the SEC, their 2023 review targets:
“…changes in the composition of the accredited investor pool since the definition was adopted; the extent to which accredited investors have the financial sophistication, ability to sustain the risk of loss of investment, and access to information that have [sic] traditionally been associated with an ability to fend for themselves; and accredited investor participation in the Regulation D market and the market for exempt offerings more generally.”
Although the SEC admits that it has limited data, including little to no data on the Reg. D market or whether current Reg. D market practices are actually protecting investors or not, nevertheless the SEC asserts that since the original adoption of the definition of “accredited investor,” the pool of investors has grown steadily. In the SEC’s view, the primary reason for this is that the wealth thresholds for determining who qualifies as an individual for accredited investor status have not been adjusted to reflect inflation over time.
Because the SEC lacks sufficient data regarding individuals, it estimates the number of U.S. households that make up the pool of qualifying households and finds that overall, the number of households that qualify for accredited investor status has increased over time.
The 2023 Staff Report then presents a series of tables adjusted for various household income and inflation-adjusted variables to estimate the number of households that would qualify for accredited investor status if the thresholds were not adjusted for inflation, and then if the thresholds were adjusted for inflation.
Table 1 presents information for households qualifying for accredited investors based on the existing income and net worth criteria.
Table 2 presents the number of qualifying households using CPI-U (Consumer Price Index) and PCE (Personal Consumption Expenditures Chin-Type Rice Index) inflation-adjusted thresholds based on the SCF (Federal Reserve Board’s Survey of Consumer Finances).
Table 3 estimates the number of households that would qualify as accredited investors after 10, 20, and 30 years, using the existing income and net worth thresholds, and assuming the rate of inflation remains constant.
The SEC believes that the number of individuals who qualify as accredited investors has increased over time, in part, due to the 2020 changes made to the definition of “accredited investor.”
In addition, the SEC points out that how individuals can qualify has also changed. In particular, the Report notes that one major factor in increasing the number of individuals who qualify as accredited investors has been the increase in the number of people who have retirement savings. Because more people invest in retirement savings in 2023 than they did in 1982 when Reg. D was adopted, retirement savings have accounted for a significant increase in the number of individuals able to qualify as accredited investors.
Are Financial Thresholds Really an Indicator of Investor Sophistication?
As part of its analysis of the definition of “accredited investor,” the 2023 Staff Report looks at how effective the current definition is in assessing whether an individual is financially “sophisticated” and can fend for himself.
In so doing, the SEC admits that historically, it has used wealth as a proxy for sophistication, and yet financial sophistication is not always, or only, demonstrated by wealth. Rather, financial sophistication requires an ability to “adequately analyze the risks and rewards…or to gain access to information about an issuer or investment opportunity — or the ability to assess and mitigate the risk of a loss.”
Admittedly, says the SEC, it is difficult to determine whether financial wealth alone is a good indicator of these abilities.
Likewise, financial thresholds alone cannot predict whether an investor can properly assess the risks of an investment. According to the SEC, they lack sufficient information to assess whether investors who have more money have more bargaining power in the market to request additional disclosures or information from issuers and funds. As a result, the SEC cannot ascertain how well the financial thresholds protect investors.
And yet, the 2023 Staff Report does not suggest some other metric for measuring investor sophistication.
What Should the Definition of “Accredited Investor” Be?
Because of Reg. D exemptions do not require extensive disclosures as registered securities do, and given the increase in the use of Reg. D exemptions over the years, plus the 2020 expansion of who can qualify as an accredited investor, the Report states that it is critical that the definition of “accredited investor” ensure that individual investors can fend for themselves and obtain all necessary information required to make an informed investment decision.
But what, exactly, should that definition be tied to?
Over the years, says the SEC, it has received numerous proposals and suggestions on how to revise the “accredited investor” definition. Some of these would tie the definition to inflation, others would delete the financial thresholds completely, while others suggest making incremental inflation adjustments.
The 2023 Staff Report carefully details arguments on both sides of the issue of whether the definition of “accredited investor” should be tied to inflation.
Ultimately, the 2023 Staff Report does not decide the issue. Rather, the SEC requests readers to provide their input and suggestions on the points made in the 2023 Staff Report.
Accredited investors are invited to respond to the SEC’s 2023 Staff Report.
At VerifyInvestor.com, we offer a world-class accredited investor verification service. Our services are fast, efficient, cost-effective, confidential, and reliable. We help companies fully and easily comply with their legal obligations to verify investors as accredited investors.