On Friday, the SEC announced the issuance of a staff report on the accredited investor definition, a review that, as directed by Dodd-Frank, occurs every four years with the objective of assessing “whether the requirements of the definition should be adjusted or modified for the protection of investors, in the public interest, and in light of the economy.” As described in the report, this review is “focused on changes in the composition of the accredited investor pool since the definition was adopted; the extent to which accredited investors have the financial sophistication, ability to sustain the risk of loss of investment, and access to information that have traditionally been associated with an ability to fend for themselves; and accredited investor participation in the Regulation D market and the market for exempt offerings more generally.” The report examines the history of the accredited investor definition and changes in the economic landscape that might affect the composition of the pool of accredited investors and describes historical comments and recommendations for changes to the accredited investor definition. However, unlike the staff’s 2015 report (see this PubCo post), this report did not make any recommendations regarding changes to the definition and instead simply welcomed public input. Public comment may be particularly impactful this year given that, according to the SEC’s most recent reg-flex agenda, Corp Fin is considering recommending that the SEC propose amendments to Reg D, including updates to the accredited investor definition and to Form D, “to improve protections for investors.” The target date for a proposal is April 2024.
Historically, the SEC has observed that the purpose of the accredited investor definition is “to encompass those persons whose financial sophistication and ability to sustain the risk of loss of investment or ability to fend for themselves render the protections of the Securities Act’s registration process unnecessary.” As stated in the report, the “accredited investor definition provides that natural persons and entities that come within, or that the issuer reasonably believes come within, any of thirteen enumerated categories at the time of the sale of the securities is an accredited investor.” Since its adoption in 1982, the accredited investor definition has been substantively amended four times, with the last amendments, in 2020, expanding the categories to include “natural persons holding in good standing certain professional certifications or designations, among other categories,” irrespective of their income or net worth.
The SEC staff based its assessment primarily on a review of Forms D filed with the SEC, which the staff recognized necessarily means that there are limitations on the extent of information available about the characteristics of the accredited investor pool and whether current market practices are providing sufficient investor protection. The report provides data on the number of U.S. households that would have qualified as accredited investors at various times, estimating that, in 2022, the overall number of qualifying households was 24.3 million, or 18.5% of U.S. households, compared to 1.51 million, or 1.8% in 1983. The staff attributes the increase largely “to the fact that the natural person accredited investor thresholds have not been adjusted to reflect inflation.” If adjusted for inflation, the 2022 numbers would decline to an estimated 8.5 million qualifying households, or 6.51% of U.S. households. The staff estimates that, if “the thresholds are not adjusted for inflation going forward,…31% and 30% of households would qualify as accredited investors by 2032.”
The report points out several changes in the nature of individuals’ assets that likely have affected the pool of accredited investors since 1982 and could have implications for financial sophistication. In addition to the 2011 exclusion of the value of investors’ primary residences from the calculation of their net worth, “changes in market practice with respect to retirement savings have likely affected the pool of accredited investors. Retirement savings are a significant portion of many households’ net wealth,” and the staff believes that it is likely a significant proportion of these assets are held in defined contribution plans and IRAs, not in defined benefit plans as in the past. The staff suggests that this shift “may have created investor protection considerations not present to the same degree at the time of the adoption of the income and net worth thresholds. Specifically, much of the responsibility for the management of retirement investments shifted from employers and professional pension fund managers to individual participants. Those individuals may have little, if any, prior investing experience and may not seek the assistance of professional advisors.” In particular, in the absence of a professional custodian with a fiduciary duty, investment decision-making may rest with individual investors, “who may lack experience in building a portfolio that appropriately allocates risk and ongoing management of investments, including preparing for the illiquid nature of private company.”
“Taken together,” the report states, “the increase in the size of the accredited investor pool over time as a result of inflation and the expanded role of retirement savings in qualifying as an accredited investor, have led some to question the continuing utility of the financial thresholds as a measure of accredited investors’ ability to sustain the risk of loss of investment with respect to accredited investors who are investing for imminent retirement or to provide income in retirement.”
Unfortunately, the report indicates, there is limited information about the financial sophistication of accredited investors. The definition “has historically used wealth—in the form of a certain level of income or net worth—as a proxy for financial sophistication,” but the dearth of information “makes it challenging to assess the effectiveness of the definition’s financial thresholds as a proxy for such sophistication.” The staff also acknowledged that it lacked information about the actual frequency with which information needed to assess the risk of an investment is provided, as well as about the “type, quality, and extent of the information provided,” or “whether investors with increased assets have more bargaining power to request additional information from issuers and funds, and if so, to what extent.”
The report also estimated that “approximately 9.6 million investors participated in Regulation D offerings initiated during 2009 through 2022. Of that total, approximately 99.7% were accredited investors.” The report estimated that “only approximately 27,900 non-accredited investors participated in Regulation D offerings from 2009 through 2022.” Interestingly, although “offerings by small start-up companies still account for a large majority of the offerings under Rules 506(b) and 506(c),…they account for only a small fraction of the capital raised. There were 230,667 Regulation D offerings by operating companies, accounting for an estimated 66% of all Regulation D offerings during 2009-2022, but for only 14% ($2.7 trillion) of the total of $19.8 trillion of capital raised under Regulation D during the same period. Private funds, in turn, accounted for just 119,670 (34%) of all Regulation D offerings, but $17.1 trillion (86%) of total capital raised.”
Although, as noted above, the report offered no recommendations, it did identify a number of previous recommendations, presumably to elicit additional public comment. For example, in connection with the 2020 amendments to the accredited investor definition, the SEC asked for comments on whether to make a one-time inflation adjustment to reflect inflation since 1982. Comments were mixed, and the SEC ultimately did not make an adjustment. At that time, some commenters expressed “concern that the criteria set forth in the accredited investor definition may not be an appropriate proxy for identifying investors that do not need the protections of the federal securities laws.” Other commenters “raised concerns about possible disparate geographic effects of the current financial thresholds, or that certain groups may be less likely to be eligible to be accredited investors under the current definition, due to systemic inequality and racial discrimination.” And “some posited that the accredited investor definition, as it applies to individuals, is under-inclusive because financially sophisticated individuals who are not wealthy may not qualify as accredited investors.” The report added that “many commenters questioned the correlation between wealth and financial sophistication and, as a result, asserted that the income and net worth tests fail to identify correctly those individuals who need or do not need the protections of the federal securities laws.”
The report also observed that the SEC’s Small Business Advisory Committee adopted recommendations in 2022 that the SEC “not increase the current financial thresholds for individual investors to qualify as accredited” but “going forward, [should] consider indexing the financial thresholds for inflation on a periodic basis.” The SEC’s Office of the Advocate for Small Business Capital Formation’s 2022 annual report recommended that the SEC revise the definition to include “additional qualitative professional criteria and offer more opportunities to demonstrate financial sophistication as an alternative to the income and net worth thresholds” and that the SEC “consider the impact any change to the income and net worth thresholds would have on minorities and populations located in rural areas.” Recommendations from other organizations were also discussed.
In conclusion, the staff welcomed public feedback regarding these matters.
