Rethinking Access: Expanding Regulation D Through Investor Sophistication
VerifyInvestor.com
The debate surrounding the definition of “accredited investor” is not a new one.
While many people believe that the Securities and Exchange Commission’s (SEC) definition of “accredited investor” is patronizing, doesn’t capture one’s experience or financial literacy, and unnecessarily excludes “retail” investors from participating in private equity (PE) opportunities, others worry that democratizing access by expanding the definition puts consumers at risk unless they have a deep understanding of the complexities inherent in private equity investing.
This is a debate that has gone on for years and shows no signs of ending anytime soon.
That’s because the way the SEC defines “accredited investor” has profound and far-reaching effects on issuers, entrepreneurs, investors and the overall health of our economy.
Historically, the SEC has defined “accredited investor" solely in terms of an individual’s net worth and wealth. To meet the SEC’s definition of “accredited investor,” an individual must have:
a net worth of at least $1 million USD, excluding the value of primary residence, or
income at least $200,000 USD each year for the last two years (or $300,000 USD combined income with a spouse or spousal equivalent).
By defining who can participate in private equity investments solely in terms of money metrics, the SEC has eliminated most “retail” investors from the game, leaving PE investment almost exclusively to institutions or high-net-worth and wealthy individuals.
To be fair, the SEC has amended the definition several times over the years — most notably in 2020, when it expanded the definition to include knowledgeable employees and those with certain professional certifications as well as family clients of family offices. Nevertheless, many argue that the changes do not go far enough to democratize participation in private equity and that the SEC’s definition still fails to allow individuals to qualify based on financial sophistication, experience or expertise.
And so, the debate rages on.
But why does the definition of “accredited investor” carry such significance in the first place?
Let’s see.
Why is the “Accredited Investor” Definition so Critical?
There are several reasons why the definition of “accredited investor” is of critical importance. Below, we will highlight some of the main reasons that make the definition of continuing interest and conflict among issuers, regulators, and investors.
Because it controls private offering participation under Regulation D and impacts other securities laws.
Probably the overarching reason that the definition is so hotly debated is because it directly affects capital raises under Regulation D — since it determines who can participate in private equity offerings.
Under the Securities Act of 1933 (“Securities Act”), the offer and sale of all public securities must be registered with the SEC. Under the law, issuers are required to file detailed information with the SEC, including audited financial statements and information regarding the issuer’s business operations, financial condition, risk factors, and management. They are also subject to ongoing disclosure requirements. The number of disclosures and their content has increased in complexity and volume over the years. Not surprisingly, registering securities with the SEC is a complex, expensive and time-consuming process for businesses.
In contrast, “non-public” (i.e., private) offerings are not subject to these registration and disclosure requirements. Instead, Regulation D (Reg. D) of the Securities Act carves out limited exemptions under which an offering will be considered to be a “private placement,” thus not subject to the registration requirements.
Qualifying under a Reg. D exemption makes raising capital faster and less expensive for startups and small businesses. Issuers who raise capital pursuant to a Reg. D exemption are not subject to the same disclosure requirements and do not have as much regulatory oversight as public offerings. As a result, Reg. D is one of the most widely used securities exemptions.
The most common exemptions are found in Rule 506 (Rule 506(b) and 506(c)) of Reg. D. To provide a little context, reports indicate that between July 1, 2021 and June 30, 2022, $2.3 trillion dollars was raised under Rule 506(b) — surpassing the $1.2 trillion USD raised by all registered offerings. Similarly, Rule 506(c) offerings raised more money ($148 billion USD) than Initial Public Offerings (IPOs).
While each Rule has its own specific requirements regarding investors and other matters, both Rules mandate that private offerings can only be made to “sophisticated” investors — which is to say, “accredited investors.” Thus, the “accredited investor” definition is central to the Rule 506 exemptions. Qualifying for a Reg. D exemption turns on whether or not the investors in that offering are “accredited investors.”
It is therefore essential that issuers find accredited investors and that they are able to establish with certainty an investor’s accredited status. Having an accredited investor status certificate for each investor provides issuers with peace of mind when it comes to Reg. D compliance.
How the term “accredited investor” is defined can broaden or narrow the investor pool for issuers. Likewise, it can expand or narrow the investment opportunities for investors. In addition, whether or not an individual or entity qualifies as an “accredited investor” impacts a range of other federal and state securities laws that the SEC does not regulate.
Because it affords investor protection.
The next reason why the definition of “accredited investor” is crucial is because it is the “single most important investor protection in the private market.”
According to reports, the private equity market has exploded in recent years and shows no signs of slowing down. In addition, because the SEC has not linked the definition to inflation since its inception, over the past 43 years, there has been a 550% increase in the number of households that qualify for “accredited investor” status.
Because private offerings are not required to register with the SEC, they do not have to make the extensive disclosures required of public offerings. As a result, private equity deals are opaque — or less transparent than public offerings. They also tend to require a longer holding time, making them less liquid than public offerings. Thus, private offerings lack the traditional investor protections.
To counterbalance this, the SEC — whose mission is to protect investors from fraud — uses a restrictive definition of “accredited investor” as the principal means of protecting investors in the private markets. According to the SEC, its definition of "accredited investor” 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.”
Because it determines who can — and who cannot — garner wealth.
Finally, we point out what may seem obvious: that the definition of “accredited investor” decides who can, and who cannot, gain wealth by participating in private equity investments.
By focusing on high-net-worth metrics, the SEC’s definition excludes middle and lower-income individuals from participating in private offerings, in turn limiting their ability to diversify their portfolios and making it harder for them to amass the type of wealth that has made the private market so lucrative and attractive.
These are just some of the reasons why the definition of “accredited investor” is of such a moment to investors, issuers and regulators alike, and why it continues to be such a hotly debated topic.
The Debate Over the Definition Continues.
As noted, the accredited investor definition plays a critical role in protecting individuals from high-risk investment by eliminating investors who, according to the SEC, do not have the financial wherewithal to withstand significant losses.
But, for many, defining “accredited investor” based solely on wealth metrics has severe shortcomings.
The debate over how “accredited investor” should be defined has raged for years, and despite some changes made to it by the SEC, for many, it’s still not working.
Proponents of expanding the definition argue that as the term is currently defined, it is patronizing — since it allows the SEC to decide how people can invest their money. In addition, it does not accurately reflect one’s financial sophistication or knowledge. The accumulation of a certain level of income or net worth is not necessarily indicative of an individual's financial sophistication.
Further, it is argued that the current definition disproportionately impacts Blacks, Hispanics, and young investors — denying them the opportunity to build wealth and diversify their investment portfolios. In turn, the under-inclusive nature of the current definition limits the investor pool for entrepreneurs; negatively impacting our economy.
For years proponents have argued that the SEC should provide alternative ways of qualifying as an accredited investor. Wealth metrics alone, it is argued, do not reflect an individual’s understanding of the risks of investment, nor their “sophistication” or “ability to fend for [themselves]” in private capital markets. The SEC should provide alternative means of measuring an investor’s education and experience. By expanding the ways in which individuals could qualify as accredited investors, the SEC would meaningfully expand the investor pool and foster capital formation, while at the same time meeting its mission of protecting investors.
On the other side of the argument, consumer advocates believe that maybe keeping the private equity investor pool limited to those with considerable wealth isn’t such a bad thing. Making it difficult to qualify as an accredited investor protects lower or middle income individuals from a market that buys and sells illiquid assets, is fraught with complexities that even sophisticated investors find challenging, is opaque, and subject to fraud.
Plus, with more and more households able to qualify for accredited investor status because the SEC has not linked it to inflation, the need to protect retail investors has increased. While some argue that income level does not mean an individual is a sophisticated investor, the reverse is also true — just because an individual meets the SEC’s financial requirements does not mean he or she is a “sophisticated” investor able to withstand the pitfalls of high-risk PE investments. They could very well be:
A single parent with children, making $250,000 USD a year with a mortgage to pay
Retired seniors
A widow who inherited $1 million but is not working
Which brings us back to the point that wealth alone is not a reliable indicator of an investor’s ability to analyze a potential investment or to withstand the risk of loss.
While consumer advocates argue that retail investors don’t have the resources that institutional investors have to conduct thorough due diligence and they don’t understand or appreciate the nuances (i.e., dangers) of PE investing and often rely on professionals who don’t really have their best interests at heart, others posit that the information is out there and available, and retail investors can rely on professionals to help them.
Both sides point out that the current definition does nothing to indicate the level of “sophistication” of an investor, thus really isn’t the protection the SEC thinks it is. Instead, as has been suggested repeatedly, both sides argue that the SEC should develop alternative ways that allow investors to demonstrate their financial sophistication, including (not limited to) professional licenses, certifications, work experience or by taking an SEC-developed and/or approved test.
Whether it concerns issues around finding accredited investors or choosing the right accredited investor program to provide accredited investor status certificates, understanding the securities laws and their requirements is critical. The securities laws touch on a vast number of financial and investment issues of importance to all investors and issuers. VerifyInvestor.com makes verifying accredited investors easy, cost-effective, secure, and reliable. Our services, (which also include qualified purchaser and qualified client verification), are always code-compliant and confidential. We help companies fully and easily comply with their legal obligations to verify accredited investors.