As most readers of this blog know, one of the key concepts in securities law compliance for private offerings is the definition of “accredited investor” in Regulation D. Although it is possible to include non-accredited investors in private offerings (e.g., Rule 506(b) permits offerings to up to 35 non-accredited investors), many issuers choose to limit their offerings to accredited investors only, which can simplify the offering from a documentation perspective.
Several of the categories of accredited investor are non-controversial, for example, a bank or an executive officer of the issuer. However, the categories that apply to most individual investors — based on income or net worth — have come under increasing attack. The numerical thresholds ($200,000 annual income for a single filer or $1,000,000 in net worth not including primary residence) have been in place for years, not indexed for inflation. However, the more important question, in my view, is not what the thresholds should be, but why income and net worth are the sole determinants of accredited investor status for individuals.
This short and readable letter from the SEC’s Advisory Committee on Small and Emerging Companies points out that “[t]he Committee is not aware of any substantial evidence suggesting that the current definition of accredited investor has contributed to the ability of fraudsters to commit fraud or has resulted in greater exposure for potential victims. The connection between fraud and the current accredited investor thresholds seems tenuous at best.” In other words, high net worth individuals are often defrauded (see Madoff, Bernie), and conversely, a low-paid adjunct professor who teaches about money management is excluded.
The Committee’s conclusion is to expand the pool of accredited investors by allowing in those who fall into my latter example – people who can demonstrate investment sophistication. I think this would be an improvement over the current system, but I would more radically overhaul it by completely scrapping the simple thresholds. Instead, I would steal an idea from the not-yet-effective crowdfunding rules under Title III for the JOBS Act, and allow anyone to participate in a private offering, so long as the total amount invested in all private offerings does not exceed a specified percentage of the investor’s income or net worth. Under the current standard, an investor with a net worth of $1.1 million can invest $1 million in a single private investment, which is obviously insufficiently diversified and a recipe for financial ruin. But if an investor, of any income, was allowed to invest, say, no more than 5% of annual income per year in private offerings, mathematically the investor could nprivate investment, which is obviously insufficiently diversified and a recipe for financial ruin. But if an investor, of any income, was allowed to invest, say, no more than 5% of annual income per year in private offerings, mathematically the investor could not be wiped out financially if the investment decisions are bad.