Ariel Micah Blask
SEC Chairman Jay Clayton recently proposed altering the Accredited Investor standard governing individual investment in private securities. The SEC’s Regulation D, promulgated in 1982, sets out that companies can raise an unlimited amount of capital in private placement securities so long as such securities are only offered to “Accredited Investors.” Individuals with annual incomes exceeding $200,000 or a net worth (not including the value of the primary home) exceeding $1,000,000 may be considered Accredited Investors under Regulation D. While Chairman Clayton did not specify what specific change or changes the SEC is actually considering, he insinuated that any proposed rulemaking would either lower the income and wealth threshold or otherwise alter the qualifying criterion so that more Americans can invest in private securities and benefit from the wealth generated by young, fast-growing companies. While lowering the threshold is certainly a step in the right direction, a more equitable solution might be doing away with the Accredited Investor category entirely. Allowing all Americans, regardless of income or wealth, to invest in private securities would help solve the problem of inequality in access to investments. Moreover, a full repeal would remove the paternalistic assumption that average investors require protection that wealthy investors do not need from securities regulation.
What’s at Stake
The Accredited Investor standard and other private placement regulations structure private securities markets by governing the quantity of capital available in private markets and thereby the firms that may seek to access capital in these markets. Firms benefit from issuing private offeringsrather than to public offerings by being exempted from certain registration, disclosures and continual reporting requirements. A Price Waterhouse Coopers study found that most CFO’s of publicly traded companies report that initial filing costs of IPOs and annual reporting costs both exceed $1 million. By contrast, private placement fees range from a 6% commission on an offering of less than $1 million to only 2% for offerings of more than $50 million. Additionally, disclosures mandated pursuant to an IPO or as part of quarterly reporting provide information that may be of strategic value to competitors. Firms therefore have a strong incentive to stay private so long as they can meet their funding needs without issuing publicly traded equity or debt securities.
The amount of capital available in private markets has the ‘08 financial crisis for a few reasons. First, the income and wealth thresholds defining an Accredited Investor are fixed nominal values, so the number of Accredited Investors has increased with inflation. Second, online secondary trading increased the liquidity of private securities, thereby increasing the general attractiveness of these assets to investors. Before online secondary trading, SEC regulations made it difficult for holders of private securities to sell the securities to anyone besides other Accredited Investors whom the sellers knew personally. Finally, the Sarbanes Oxley Act increased the complexity and cost of quarterly reporting and shifted the calculus of firms’ public v. private decisions. Should the Accredited Investor standards be loosened, more potential investors will have access to these secondary markets, which will continue to increase liquidity and decrease the cost of capital in these private capital markets.
As a result of the private market’s growth, capital markets have morphed into a parallel private-public system. Both private and public markets allow firms to exchange fungible securities among a deep pool of investors. But private markets allow firms to sell securities at a lower cost, with fewer disclosures and in less time to a pool of investors that likely have the capital to make large scale purchases. Therefore, securities of fast-growing, large, young companies are staying private for longer and specialized financial assets, like shares in hedge or private equity funds, are only available on private markets—which are largely inaccessible to the majority of Americans, who are not Accredied Investors—and therefore only available to wealthy investors.
This current dynamic of a public market available to all investors and a private market available to only the wealthy would likely not have been foreseen by the framers of the Securities Act, which contains the statutory provision exempting privately issued securities from the registration requirement. The driving idea behind that law was to fix information asymmetries in the securities market by instituting a mandatory disclosure regime. The private placement exemption complemented that regime by offering a de-minimis exemption for smaller offerors. Unfortunately, the Supreme Court’s decision in SEC v. Ralston Purina Co., 346 U.S. 119 (1953), interpreted the private placement exemption as catering towards highly sophisticated investors capable of making investment decisions without the aid of corporate reports. The Regulation D Accredited Investor regime is consistent with the Ralston Purina holding in that it uses wealth as a proxy for sophistication. But its effects in creating a tiered capital market is certainly inconsistent with the spirit of the Securities Act, which intended to democratize capital markets by providing a common informational baseline for financial sophisticates and average Americans alike.
A Lower Threshold or Complete Repeal?
As previously discussed, the SEC has not released any details regarding its announced plan to reform the Accredited Investor standard, but commenters expect that the proposed reform will increase the number of Accredited Investors without doing away with the standard itself. Such a reform proposal could simply lower the income and wealth requirement, or allow individuals who work in the financial industry or have pursued advanced education relevant to finance and economics to obtain accredited status. Increasing the number of Accredited Investors would expand access to private securities and reduce the proportion of private securities held by the economic elite. But at the same time, the underlying problem of a two-tiered capital market would necessarily not be fixed so long as the accredited standard exists in some form.
An alternative solution is simply doing away with the Accredited Investor standard entirely. A full repeal would completely fix what Professor Usha Rodrigues calls “securities law’s dirty little secret,” namely that the wealthy have access to assets that the rest of America are legally barred from investing in. A full repeal would also fit the civil libertarian ideal of freely choosing individuals having complete discretion over how to spend their own money, and would end the absurdity of the “investor protection” logic which presumes that individuals without a wealth buffer should not invest in potentially high yielding investments when they are free to spend their entire life savings on consumer goods or lottery tickets.