Saturday, July 14, 2018

Should All Accredited Investors Be Wealthy?

            Instead of undergoing the expensive process of conducting a public offering of securities, companies have continually relied upon Regulation D to conduct private placements of securities. Among other requirements of Regulation D, companies are limited to selling their securities only to the “accredited investors” (with some exceptions).

            Rule 501 of Regulation D defines an accredited investor (as it pertains to individuals) as any one of the following: (i) a director, executive officer, or general partner of the issuer of the securities being offered; (ii) a natural person whose individual net worth, or joint net worth with that person's spouse, exceeds $1,000,000 (excluding the value of the primary residence); or (iii) a natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person's spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.

Accredited investors are presumed to have a higher level of financial sophistication and financial wealth that enables them to conduct proper due diligence and withstand a total loss of their investment. Also, it is presumed that, if accredited investors are lacking financial savvy, they can afford to hire financial advisers.  Indeed, often the most relevant parts of the definition of an accredited investor are in determining the investor’s net worth or annual individual or joint income. But the idea that wealth alone is some measure of financial sophistication is misleading.

Consider a successful doctor or a wealthy actor. It would be reasonable to assume that these individuals do not necessarily possess the financial sophistication needed to make smart financial investments.  On the other side, consider financial analysts or investment advisers who, while working daily with securities and investments, do not meet the “accredited investor” minimums.  Yet, it will be the doctors and the actors who, in our hypothetical, will be accredited investors.

There have been suggestions for reform. Pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act, the U.S. Securities and Exchange Commission (“SEC”) is required to review the accredited investor definition as it relates to natural persons every four years to determine whether the definition should be modified or adjusted. The last review occurred in December 2015, which means we are still one year away from the second report. But that has not stopped the U.S. House of Representatives from proposing legislation to expand the definition in December 2016, and SEC Chairman Michael Piwowar from speaking on the need for reform of the definition in February 2017. The most common suggestion is to expand the definition of accredited investor to include individuals with a securities license and those who have passed a securities examination.

In our opinion, expanding the definition of accredited investor would increase the pool of potential investors and help facilitate the flow of capital into the startup economy.  It would lead to an increase in jobs and the growth of the U.S. private sector.  On the other hand, the need to protect investors is paramount, and the criteria for accredited investors need to remain simple and straight-forward to apply.  Given these considerations, it would be desirable to expand the definition to include non-financial criteria, such as knowledge in the securities and investment areas, as evidenced by the passing of Series 7, Series 65, 82 and CFA examinations and equivalents.  The definition should also be expanded to include individuals who work in finance-related fields and who obtain a letter or certification regarding their financial acumen from their direct superiors.  However, the amount of investment by such individuals should be limited to no more than 25% of their annual income. 

All we can do is wait another year until the next review of the accredited investor definition in the hope that the definition will include those who have the qualifications needed to knowingly participate in the investments in the early-stage companies.

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its authors, Andrew Silvia and Arina Shulga.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

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