Striking the Right Balance: Revising the Accredited Investor Definition
Individuals holding certain investment designations could automatically qualify as accredited investors under changes the SEC is considering. The agency has proposed to amend the accredited investor definition, which could open the door for eventual recognition of the CFA® charter as a qualifying designation. The accredited investor definition largely determines who is allowed to participate in private markets.[1]
Adding a new category to recognize an investor’s knowledge and experience would improve the current definition, which relies almost exclusively on a test of wealth or income to qualify individuals as accredited investors.[2] In a crucial shortcoming, however, the proposal would fail to shore up the financial thresholds, which have been eroded by nearly four decades of inflation.
In its response to the proposal, the CFA Institute supported the new accredited investor category, but it also urged the SEC to raise and index the thresholds in the interests of investor protection.
These considerations are important because the size of private markets has come to dwarf that of public markets. In 2018, registered offerings accounted for $1.4 trillion of new capital compared with approximately $2.9 trillion through exempt offerings.[3] Yet private markets — which include investments in private companies and offerings by certain hedge funds, private equity funds, and venture capital funds — generally lack the set of robust investor protections of public markets.[4]
As a result, private markets are largely restricted to accredited investors, who are deemed capable of fending for themselves and bearing the financial risks. It takes fine calibration, however, to strike the right balance in defining who is, and who is not, an accredited investor. We think the current definition suffers from two opposing shortcomings: it is overly restrictive in one respect, yet overly inclusive in another. The SEC proposal, if adopted, would fix the first limitation but not the second.
Financial thresholds are a reasonable proxy for an investor’s ability to bear the financial risks of liquidity and loss. (Reasonable, that is if the financial thresholds were maintained to keep track with inflation, as we will discuss.) Financial thresholds, however, fail to consider a person’s investing knowledge and experience. Individuals with an appropriate level of knowledge and experience would fail to qualify as accredited investors if they didn’t meet the financial thresholds.
To fill that gap, the SEC has proposed adding a new category to the accredited investor definition based on an individual’s investing knowledge and experience, as demonstrated by holding certain professional certifications or designations or other credentials. According to the proposed release, the SEC preliminarily expects to recognize three qualifying designations (i.e., the Series 7, 65, and 82 licenses) and could add or remove others over time. The release specifically asks for comments about certain other certificates, including the CFA charter. Even if the SEC adopts the proposed amendments, it would take a separate order to designate the CFA certificate as a qualifying credential.
The proposal, however, would leave in place the financial thresholds, which have been eroded by nearly four decades of inflation. Since they were first set in 1982, these thresholds have been significantly adjusted just once,[5] even as the number of accredited investors has increased dramatically.
According to the SEC’s proposed release, the overall number of accredited households jumped to 16.0 million in 2019, from an estimated 1.31 million in 1983.[6] Over the same period, the share of qualifying households as a percentage of US households leapt to 13.0%, from 1.6%.[7] This dramatic increase suggests that financial thresholds have become overly inclusive, allowing individuals to qualify even if they cannot fend for themselves. And that represents a significant investor protection concern.
The solution is straightforward: raise the thresholds significantly and index them going forward. Unfortunately, the proposal would make the affirmative decision to do neither. We agree with Commissioner Allison Lee, who has warned the SEC not to “codify the toll that 37 years of inflation has already taken” and “arbitrarily freeze in place a 37-year-old rule.”[8]
Then, we also have to consider the impact of the twin Covid-19 and economic crises. Investors are facing a host of newly elevated risks, which exacerbate those already found in private markets. For example, fraudsters are targeting retail investors with scams that aim to take advantage of the coronavirus crisis.[9] Yet state securities regulators have long warned of incidents of fraud in private markets. This makes it all the more urgent to shore up the investor protections of the accredited investor definition.
In conclusion, the SEC’s proposal goes only part way toward
improving the accredited investor definition. On the positive side, the amended
definition would open a new avenue for knowledgeable and experienced investors to
qualify. But by failing to adjust the financial thresholds, the amendments
would lock in place weakened investor protections. More calibration is needed
to strike the right balance.
[1] See SEC, “Amending the ‘Accredited Investor’ Definition,” Proposed Rule, Release No. 33-10734 (18 December 2019), https://www.sec.gov/rules/proposed/2019/33-10734.pdf.
[2] To qualify as an accredited investor, an individual must have either (1) a net worth exceeding $1 million, excluding the value of a primary residence, either alone or with his or her spouse; or (2) an income in excess of $200,000 in each of the two most recent years, or joint income with the individual’s spouse in excess of $300,000 in each of those years, and have a reasonable expectation of reaching the same income level in the current year. In addition, directors, executive officers, and general partners of the issuers also qualify regardless of their wealth or income.
[3] SeeSEC, “Concept Release on Harmonization of Securities Offering Exemptions,” Securities Act Release No. 10649 (18 June 2019), https://www.sec.gov/rules/concept/2019/33-10649.pdf, at 16–19.
[4] These protections include required public disclosures — such as registration statements, audited financial statements, periodic reports, and proxy statements — and rules to level the playing field for all investors. In private markets, these requirements are either reduced or entirely lacking.
[5] According to the proposing release, adjusting the $200,000 income test for inflation would result in a $520,000 threshold, while adjusting the $300,000 joint income test from 1988 dollars to 2019 dollars would require a joint income of $632,000. The thresholds have never been adjusted for inflation, but in 2010, thanks to the Dodd-Frank Act, the calculation of net wealth was changed to exclude a person’s primary residence. See supra note 1 at 75–76.
[6] The accredited investor definition applies to individuals, not households, but the estimates draw on data at the household level. See SEC, “Amending the ‘Accredited Investor’ Definition,” at 27.
[7] SEC, “Amending the ‘Accredited Investor’ Definition,” at 27.
[8] See Commissioner Allison Herren Lee, “Statement on the Proposed Expansion of the Accredited Investor Definition” (18 December 2019), https://www.sec.gov/news/public-statement/statement-lee-2019-12-18-accredited-investor.
[9] See SEC, “Frauds Targeting Main Street Investors — Investor Alert” (updated 6 May 2020), https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-alerts/frauds.
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