Investor groups and private businesses are at odds over who can invest in unregistered offerings. A recent report has stoked the fire, as the Securities and Exchange Commission (SEC) explores options to balance providing investor protections with preserving access to capital and fostering innovation and growth.
Setting the stage
Businesses are generally allowed to solicit equity financing for unregistered shares from only accredited investors. Investors are classified as “accredited” if they make $200,000 a year, or $300,000 jointly with a spouse, or have at least $1 million in net worth, not including their primary residence. The restriction, under Rule 501 in Regulation D of the Securities Act of 1933, assumes that accredited investors are wealthy enough to fend for themselves in risky deals, such as equity financing for start-ups.
But this rule hasn’t been adjusted for inflation since it was issued in 1982. If its definition were adjusted for inflation, the individual income threshold would rise to approximately $433,000 to $491,000, according to the SEC’s Report on the Review of the Definition of “Accredited Investor.” This report, published in December 2015, estimates that the $1 million net worth threshold from 1982 is equivalent to about $2.16 million to $2.45 million today.
Based on this report, SEC Chair Mary Jo White instructed her staff to make a recommendation to the commission about amending the definition. The report suggested several alternatives:
- Raise the financial limits to account for inflation.
- Index the financial thresholds to inflation or another financial benchmark so that they’re periodically updated to reflect the cost of inflation.
- Add some nonfinancial criteria, such as market knowledge or financial skill.
- Leave the definition as is.
The SEC report has stoked the debate between investors and private businesses about how to define “accredited investors.”
Investor groups, including the Consumer Federation of America and Americans for Financial Reform, say the report suffers from “major shortcomings” that require more thorough analysis before proposing a rule change.
For example, these groups contend that the report doesn’t identify a population of investors who are able to fend for themselves without protections — and the legal definition can’t be adjusted until the pool of sophisticated investors is identified. They also said that the study lacks a meaningful assessment of the likely effect of the various alternatives put forward.
Preserving access to private equity financing
Businesses criticized the report for different reasons. They want a large, diverse pool of accredited investors to promote continued innovation and growth in the United States.
For example, the Biotechnology Innovation Organization (BIO), which represents more than 1,100 biotech companies and academic institutions, is concerned that some of the changes contemplated in the study would decrease the pool of investors, shrink the capital available for companies and delay research. The BIO wants the SEC to maintain the current financial threshold. It claims that the existing definition of “accredited investor” sufficiently protects investors in unregistered offerings because the SEC’s report didn’t identify any specific investor protection red flags that have arisen under the current definition.
Furthermore, the BIO estimates that, if the SEC increases the annual income to $500,000 for individuals and $750,000 for married persons and increases the net worth test to $2.5 million, these changes would decrease the size of the accredited investor pool by nearly 65%. This estimate assumes no provisions are included for grandfathering in investors who meet the current standards. Maintaining some eligibility for today’s accredited investors would be one possible way to help reduce the shock to the system.
Maintaining the status quo
On May 18, the SEC’s Advisory Committee on Small and Emerging Companies met to discuss the report on accredited investors. In the end, members voiced reluctance to tinker with the accredited investor standard. They fear that a change to the standard could reduce the number of eligible investors for small companies seeking capital. For now, at least, it appears that the current definition of accredited investors will prevail.
Stay tuned for more details from the SEC. The Dodd-Frank Act calls on the SEC to review the standard every four years and amend it as needed.
Sidebar: Exceptions for start-ups
As of May 16, there has been an exception to the accredited investor rules under the 2012 Jumpstart Our Business Startups (JOBS) Act. New crowdfunding guidelines allow private companies to sell shares to investors regardless of wealth or income as long as the company has submitted annual financial reports to the Securities and Exchange Commission (SEC).
There are a few caveats to this exception to Rule 501 in Regulation D of the Securities Act of 1933. Companies can raise only up to $1 million through crowdfunding, and offers must be solicited through online portals that are approved by the SEC. There are also limits to how much crowdfunding investors can contribute in any 12-month period based on their net worth and annual income.
In a February bulletin, the SEC warns investors that they “should be aware that early-stage investments may involve very high risks, and [they] should research thoroughly any offering before making an investment decision.”