An advisory committee set up by the SEC, as directed by the Dodd-Frank law, has issued a report with recommendations for changing the “accredited investor” definition used for purposes of determining investor qualifications to participate in Regulation D private offerings. The report correctly identifies the flaws with a system that uses income and net worth as proxies for investment sophistication. It goes on to make a series of recommendations for changes to the system that, in my view, are on the right track.
I wanted to focus for this post on a few specific recommendations that I found particularly noteworthy.
In Recommendation 2, the report advocates relying on more direct measures of financial literacy, such as having securities or financial planning credentials or passing a basic test. There could be challenges in implementing something like this, but clearly we’d rather have a financial planner with a relatively modest income participating in private investments ahead of a 21-year old musician (not that there’s anything wrong with music) who just inherited a $1 million estate.
Recommendation 3 gets into possible limitations on amounts to be invested in private offerings if someone’s income or net worth barely meets the applicable thresholds. This is akin to the limits on investments in the not-yet-enacted Title III crowdfunding rules. This addresses one of the main goals of the securities laws, which is to try to prevent investors from losing a big chunk of their nest egg. If someone who makes $200,000 per year wants to plunk $5,000 in a private investment with a lottery-like risk-reward profile, it may not be the most prudent thing to do, but it’s not going to ruin the investor, so it’s appropriate to regulate it lightly.
Finally, Recommendation 4 promotes third party verification of accredited investor status, which is a somewhat overlooked part of the new rules permitting general solicitation for all-accredited investor offerings. Having trusted third parties in this role helps keep issuers out of the business of sifting through sensitive private financial information of their investors.