The SEC is considering measures that could increase the investment options available to retail investors by relaxing the definition of accredited investors.
For brokers and advisors, it would mean having a bigger pool of investment products and strategies to offer retail investors who could qualify as accredited investors if the rules change.
However, state regulators warn that relaxing the definition of accredited investors could end up hurting retail investors. Consumer advocates say the SEC’s actions could even lead to conditions similar to those which caused the U.S. stock market crashes of 1929 and 2008.
The measures being considered by the SEC are part of a concept paper, released in June, that explores ways to “simplify, harmonize and improve” the exemptions currently available to certain investors.
The SEC says its goal is expanding investment opportunities while protecting investors and promoting capital formation.
The comment period officially ended last month. The SEC received 142 comment letters as of October 1, with many urging the SEC either to defer or proceed cautiously regarding any measures that would relax the definition of accredited investors.
Who are accredited investors?
The SEC lets accredited investors participate in investment opportunities that are generally not available to non-accredited investors. These include investments in many private issuers and offerings by hedge funds, private equity funds and venture capital funds.
Under SEC rules, individuals are classified as accredited investors if:
- Their income exceeds $200,000 in each of the two most recent years (or $300,000 in joint income with a person’s spouse) and they reasonably expect to reach the same income level in the current year;
- Their net worth exceeds $1 million (individually or jointly with a spouse), excluding the value of their primary residence.
The accredited investor definition also includes — among others — a bank; registered broker-dealer firm; insurance company; registered investment company; an employee benefit plan under the Employee Retirement Income Security Act (if a bank, insurance company, or registered investment advisor makes the investment decisions, or if the plan has total assets in excess of $5 million) and a tax-exempt charitable organization, corporation, or partnership with assets in excess of $5 million.
The key questions the SEC is asking in the concept paper include:
- Should we change the definition of accredited investor or retain the current definition?
- Should we revise the financial thresholds requirements for natural persons to qualify as accredited investors and the list-based approach for entities to qualify as accredited investors?
- Should we revise the accredited investor definition to allow individuals to qualify as accredited investors based on other measures of sophistication?
States want to remain cops of markets
William Galvin, Secretary of the Commonwealth of Massachusetts, is concerned that the SEC could pre-empt the authority of states to regulate exempt transactions.
“We urge the Commission to preserve the roles of the states as the local cops in these markets to help protect investors, particularly retail investors, from abusive practices and high-risk offerings in an unregulated market,” he says in his comment letter.
Rather than ease the accredited investor definition, Galvin believes it should be strengthened.
Galvin says net worth and income standards for accredited investors are outdated. “Those standards were established in 1982 and have been severely eroded by inflation,” he says.
Galvin also believes that a measure of sophistication should be imposed on accredited investors.
“Because the current accredited investor definition does not describe a category of investors who can fend for themselves in the financial markets or sustain the loss of their invested funds, the definition poses great risks to retail investors and savers,” he says. “The greatest risks are to the elderly and to those saving for retirement.”
Meanwhile, the attorneys general of California (Xavier Becerra), the District of Columbia (Karl Racine), Massachusetts (Maura Healey) and Oregon (Ellen Rosenblum) say the SEC hasn’t provided data on the impact on retail investors of expanding the accredited investor definition.
The SEC “focuses almost exclusively on issuers’ access to capital from an undifferentiated population of investors,” they say in their joint comment letter.
The attorneys general also support the following “sophistication” criteria for accredited investors:
- They should have enough sophistication and power to demand and receive material information from issuers.
- They should have enough wealth or income to tolerate illiquidity and withstand losses from their investments.
If the SEC allows less-sophisticated investors to become accredited investors, the attorneys general say issuers should be required to provide them with disclosures of material information.
Meanwhile, the Consumer Federation of America says the “sweeping” concept paper “lays out a framework that would actually further expand the ability of companies to raise capital from the general public without meeting the basic transparency and accountability requirements of the federal securities laws.”
“As such, it threatens to recreate conditions that led to the stock market crash of 1929 and contributed to the 2008 financial crisis,” the consumer advocacy group adds.
Fifteen law professors who focus on teaching securities regulation shared their concerns about the potential harm to “small-dollar investors.”
They include professors from Columbia Law School, Loyola Law School, Stanford Law School, Georgetown Law, UCLA School of Law, Cornell Law School, Duke University School of Law and the University of Colorado Law School.
“Such proposals would have the primary effect of allowing small-dollar retail investors to invest directly in private securities,” they say.
“Yet investing in private securities would pose considerable additional risks for retail investors, relative to investing in public securities, and existing research suggests that these additional risks would not be sufficiently offset by higher expected returns,” they add.
The law professors say retail investors would unlikely gain access to the same issuers and investments in the private markets as institutional investors, so they would mainly have access to leftovers.
“The private issuers that seek out direct investment from small-dollar retail investors are likely to be the smallest issuers with the worst prospects — the product of severe adverse selection, if not outright fraud,” they say.
“It would be ill-advised to steer retail investors towards these firms, when decades of research in financial economics suggest that they would be poor investments for retail investors,” they add.