May 18, 2016
Good morning and welcome to today’s meeting of the Advisory Committee on Small and Emerging Companies. Today’s discussions will cover the definition of “accredited investor” and observations regarding unregistered offerings conducted pursuant to Regulation D. Both topics are part of the ongoing dialogue about small businesses’ access to capital. And, both topics also provide us with an opportunity to consider how to strike the right balance between supporting small businesses’ capital access AND protecting investors.
Last December, the staff of the Division of Corporation Finance issued its first review of the definition of “accredited investor” as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act.[1] The definition has not been significantly revised since 1982. Yet, an understanding of who fits within the current definition is of increasing importance in today’s financing markets. Today, capital raising opportunities for small businesses in the United States are increasingly conducted through unregistered offers, which rely on the safe harbor provisions in Regulation D. In fact, more than $2 trillion was raised privately in 2014. Regulation D offerings accounted for more than $1.3 trillion of this amount. [2] In comparison, registered offerings amounted to approximately $1.35 trillion in 2014.[3]
The individuals and issuers that use Regulation D vary but all Regulation D offers depend on properly identifying “accredited investors”. Does the current definition of “accredited investor” accurately capture who should be allowed to participate in a Regulation D offering? Is the definition too broad or too narrow?
The accredited investor definition is rooted in a bright-line quantitative test, which for individuals, is focused on income or net worth.[4] Does this test place too much emphasis on wealth as a proxy for investor sophistication and risk tolerance? As you discuss the pros and cons of bright line tests, I encourage you to keep in mind the lessons we learned from the financial crisis.
In 2008, hyper-inflated housing valuations created artificial paper wealth for many Americans. At that time the “accredited investor” definition permitted an individual’s primary residence to be included in the calculation of net worth.[5] As a result, many investors qualified as “accredited investors.” In reality, many of these individuals were not able to fend for themselves or to bear the risk of loss. This became painfully evident upon the crash of the housing market and the obliteration of trillions of dollars of paper wealth during the financial crisis.[6]
In light of this history, what is the best way to supplement the definition of “accredited investor”? The staff of the Division of Corporation Finance and many commenters, including this Committee, have provided thoughtful alternative factors that should be considered. Perhaps it is time for the definition to become more nuanced and to move away from a one-size-fits all approach. For example, should we layer onto quantitative thresholds, qualitative indicia of sophistication, such as professional credentials or experience investing in exempt offerings? Similar to Regulation Crowdfunding and Regulation A+, should we consider investment limitations? How can we gather and analyze data to test the definition to make sure that it continues to be appropriate? To answer these questions, we will need to craft a definition of “accredited investor” that is flexible enough to differentiate between investors. It needs to account for the wide range of investors that exist--from the soon-to-be retiree who is reaching for yield in a low interest rate environment to the angel investor who is seeking to identify the next big “disrupter”.
Finally, I look forward to the second discussion agenda item today--the market for unregistered offerings. We began the discussion about unregistered offerings and Regulation D at the last Advisory Committee meeting. I am interested in hearing about the developments in this market and recent observations. I am particularly interested in your discussion of the usage (or the lack thereof) of Rule 506 (c), which removed the ban on general solicitation.
Thank you.
[1] See Report on the Review of the Definition of “Accredited Investor” (Dec. 18, 2015), available at https://www.sec.gov/corpfin/reportspubs/special-studies/review-definition-of-accredited-investor-12-18-2015.pdf
[2] See Scott Bauguess, Rachita Gullapalli and Vladimir Ivanov, Capital Raising in the U.S.: An Analysis of the Market for Unregistered Securities Offerings, 2009-2014, S.E.C. Division of Economic Risk Analysis White Paper (October 2015) available at https://www.sec.gov/dera/staff-papers/white-papers/unregistered-offering10-2015.pdf
[3] Id.
[4] See 17 CFR 230.501(a)(6). The current threshold for individuals is net income in excess of $200,000 in each of the two most recent fiscal years (or joint income with a spouse in excess of $300,000) and a reasonable expectation of reaching the same income level in the current year. Natural persons with an individual net worth or joint net worth with that person’s spouse in excess of $1 million also qualify as accredited under the rule. 501(a) enumerates the type of entities that qualify as “accredited”, including categories of entities that must have in excess of $5 million in total assets.
[5] The definition of accredited investor was changed in 2011 to exclude the value of a person’s primary residence. The change was made to implement Section 413(a) of the Dodd-Frank Act. See Net Worth Standard for Accredited Investors, Release No. 33-9287 (Dec. 21, 2011).
[6] The United States Government Accountability Office estimated that the cost to the United States economy of the 2008 financial crisis was more than $22 trillion. The paper wealth lost by U.S. homeowners totaled $9.1 trillion. The definition of accredited investor was revised to address the fallout from this crisis by specifically excluding the value of one’s primary residence from the net worth calculation. See US Government Accountability Office, Financial Regulatory Reform: Financial Crisis Losses and Potential Impacts of the Dodd-Frank Act (Jan. 16, 2013) http://www.gao.gov/products/GAO-13-180 ; See also, Net Worth Standard for Accredited Investors, Release No. 33-9287 (Dec. 21, 2011).