Amid Swell of Exempt Offerings, SEC Considers Redefining Accredited Investors

In 2014, something notable happened within the investment community: Issuers using Regulation D exemptions raised over $1.3 trillion in securities offerings, comparable to the amount raised in registered offerings. 

Why is this important? 

The Securities Act requires that investors register the offer and sale of securities with the SEC as a way to ensure that material information is fully and fairly disclosed, allowing investors to make their own investment decisions. Regulation D exemptions, however, which are the most widely used transactional exemptions for securities offerings, are intended to apply to those people whose financial sophistication and ability to sustain risk render certain provisions of the Securities Act unnecessary.

A central component of the exemptions under Regulation D is the “accredited investor” definition, which is intended to define a pool of sophisticated investors who are able to participate in certain unregistered securities sales. Accredited investors are eligible to participate in investment opportunities that are unavailable to other, less sophisticated investors. This definition also plays an important role in other federal and state securities law contexts. 

Current definition

Given the increased relevance and weight of Regulation D exempt investors, as well as new requirements under the Dodd-Frank Act for the SEC to more regularly review its definition of an accredited investor, the SEC is now re-examining its current definition of this group.  

Under the existing definition, an accredited investor is an individual whose:

• Income exceeds $200,000 in each of the two most recent years ($300,000 in joint income with a spouse); or 
• Net worth, excluding primary residence, exceeds $1 million (individual or joint).

In certain cases, a bank, partnership, corporation, not-for-profit or trust may also be considered an accredited investor if it falls into at least one category of provisions as listed under Regulation D. 

SEC-recommended changes

In December 2015, the SEC released a staff report on its review of the definition of “accredited investor.” The staff recommended that the SEC amend or modify the financial threshold requirements for individuals in order to adjust for inflation; consider investment limitations; and/or amend or modify the list-based qualification approach for entities in order to permit otherwise eligible entities that do not fall within a listed category of an “accredited investor” to now qualify.

In particular, the staff recommends a number of options:

• Leave the current income and net worth thresholds as is, subject to investment limitations;
• Establish new income and net worth thresholds, adjusted for inflation, with no investment limitations (For individuals, this is estimated to fall between an income threshold of $200,000 and $500,000, and a net worth threshold of $1 million and $2.5 million, given that the thresholds haven’t been adjusted since 1982.); 
• Index thresholds for inflation on an ongoing basis going forward;
• Permit spouses to pool their finances to qualify as accredited investors;
• Modify the definition as it applies to entities, replacing the $5 million assets test with a $5 million investment test and include all entities, rather than specifically listed entities; and
• Grandfather issuers’ existing investors that qualify based on the current definition with respect to future offerings of their securities. 

Permutations and implications

There are many options and permutations available to the SEC, and therefore many possible implications for the investment industry.

On one hand, should the income or net worth thresholds be raised, the number of qualifying households would shrink considerably—with only 28% of households that currently qualify as accredited investors remaining eligible. Meanwhile, imposing investment limitations would deplete the supply of capital available to investment funds.

Alternatively, should individuals be allowed a minimum amount of investments to qualify as accredited investors, the number of eligible households would increase—with the size of the increase dependent on the limits imposed.

The implications of the newly proposed changes would particularly impact the private investment community. With new regulated crowdfunding rules, which are seen within the industry to be costly and sometimes restrictive, the startup community may continue to turn to accredited investors as their go-to option for raising capital. According to the staff report, under the current definition, 10% of households currently qualify as “accredited investor”-eligible. Should the inflation-adjustment recommendation move forward, this percentage would shrink to just 4%. 

Contention in the industry—and the agency

The possible implications of the recommendations are creating a divide within the investor community: those for the changes and those against. Some are advocating that non-monetary factors, such as one’s education and experience with investing, should be the basis for determining accredited investor status instead of wealth (another option floated within the SEC staff report). 

There appears to be a divide within the SEC itself, with comments from commissioners revealing that there is a debate over whether the definition should remain in place at all. Further, commissioners have questioned whether non-accredited investors should be able to participate in unregistered offerings that carry higher risk as a way to boost their return potential and further diversify their portfolios. 

While changes haven’t moved forward as of yet (the SEC’s public comment period remains open with no indication of a closing date), the SEC will need to carefully balance the opinions of all parties, while ensuring due diligence is applied under Dodd-Frank requirements.