Every four years, the United States Securities and Exchange Commission
(SEC) is tasked under the Dodd-Frank Act with reviewing investor definitions.
Investor definitions play a significant role in the capital markets since
they restrict participation in private offerings to those individuals
defined as “accredited.” Although the regulatory agency currently
has two definitions – “accredited” and a higher level
of “qualified purchaser,” neither is tested on their investment
knowledge but merely on their financial status and wealth management.
The Commission’s Investor Advisory Committee has recently opened
the comment period for the review process. This comment period comes after
the December 2015 release of the “Report on the Review of the Definition
of “Accredited Investor.” It is the intention of the SEC review
to determine whether the current definition needs to be modified for either
the protection of the consumer or to adjust for economic conditions. This
report marks the first formal review of definitions since the Dodd-Frank
Act became law back in 2010.
Before issuing the December report, Commissioner Luis A. Aguilar spoke
to the members or the Advisory Committee and said, “The accredited
investor definition is critical for the protection of investors.”
He went on to establish that it is the intentions of the SEC to not only
define those investors who have the financial capability to weather a
bad investment, but to protect them as consumers. He emphasized that notion
by reminding the Committee, “Accredited investors are not only individuals
like Bill Gates or Warren Buffett – but constitute a large pool
that includes a large swath of Americans.”
Current testing thresholds under review restrict who can invest through
the setting of standards. The thresholds uses one of three (3) criteria
in determining accredited status – individual income, joint income,
or net worth. An investor must meet one of the following standards:
Individual Income - $200,000
Joint Income - $300,000
Net Worth - $1,000,000
New recommended thresholds raise the standards through the year 2022. Both
the income requirements and net worth restriction is recommended to be
considerably higher in the coming years. The Committee also recommended
setting minimum “investments-owned” standards to be used in
place of net worth or income testing.
Individual Income - $500,000 | 2018 - $550,000 | 2022 - $600,000
Joint Income - $750,000 | 2018 - $820,000 | 2022 - $900,000
Net Worth - $2,500,000 | 2018 - $2,750,000 | 2022 - $3,020,000
Minimum Investments Owned - $750,000 | 2018 - $820,000 | 2022 - $900,000
Minimum Joint Investments - $1,000,000 | 2018 - $1,100,000 | $1,210,000
Traditionally, investment managers and broker-dealers seek out accredited
and qualified investors because regulatory issues designed to protect
investors who may not be as market savvy, do not bind them. Accredited
investors are only required to pass the means testing of income, net worth,
or investments owned to gauge their knowledge of investing. These standards
have been in place for decades and have not been adjusted to account for
inflation or economic downturns.
The Changing Economy
Accredited investor standards have been a boon to hedge funds who can solicit
investment from an investor class that, due to their financial status,
is exempt from the Securities Act’s regulatory requirements. Some
investment professionals can also be considered accredited investors based
on their understanding of investment markets. A “qualified purchaser,”
on the other hand, would be a person with not less than $5 million in
investments owned, or an investment professional with over $25 million
The new recommendations would more than double the income necessary to
meet accredited status. The SEC claims this is based on statistics that
show that the accredited investor class has grown more than six times
as large over the last decade. Simply adjusting the income threshold for
inflation would more than double today’s standard.
The recommendations are far from set in stone, as the SEC has indicated
they may choose to leave income testing standards alone, and rather put
limitations in place that restrict the amount of money that can be invested.
Another outcome would have the income and net worth thresholds pegged
to an economic indicator that would allow for incremental increases over
a period of years. For instance, as statistics indicate rising incomes
or net worth, the threshold would adjust proportionately. They could also
require that all thresholds be met instead of the current requirement
of only one.
The report states that the Committee has concerns with how accredited status
is determined only through financial means testing and does not test the
sophistication of the investor. While studies have demonstrated that financial
wealth tests have worked well in identifying accredited investors, comments
have shown an interest in creating testing criteria to check the market
understanding of individuals.
Recent studies have shown that nearly 50% of the current accredited investor
pool utilizes financial professionals to help them make investment decisions.
Concerns still linger about the knowledge of the market and investment
strategy of many of these individuals. Some of the increased limits recommended
are done with the feeling that the persons who meet the new thresholds
will have the financial capability to take on additional risks.
The report found that besides the ability to take financial losses, an
accredited investor should be required to understand how their money will
be invested, how unregistered offerings work, and the concepts surrounding
receiving a return on their investment.
A standardized test could include an overview of the markets, with questions
that gauge an investor’s education, details of their profession,
and explore their expertise with investments. Other suggestions indicate
that current investors would be “grandfathered” into the pool.
While some note that this standardized testing may not be a real test of
an investor’s ability to withstand market failures, it may at least
allow the SEC and hedge funds to identify who
should not be considered a “high-net-worth” accredited investor.
As the private investment market continues to grow with the increasing
use of “private offerings,” maintaining a large pool of accredited
investors is key to keeping capital flowing into pre-IPO companies, allowing
them to stay private longer.
Individual investors, who are shown to meet the income requirements and
are capable of managing and protecting their investments, can participate
in this $1.5 trillion marketplace as they see fit. At least that is how
it currently works. What is yet to be seen, is the results of the SEC’s
first ever changes to the standards, and how they will affect the new
pool of accredited investors and the businesses that solicit them.