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I'm a partner in the New York office of Mayer Brown and am a co-head of the firm's capital markets practice. I devote much of my time to counseling issuer's, counseling placement agents, underwriters, and other financial intermediaries when they are thinking about or structuring a financing transaction – that might be a private placement to accredited investors or institutional accredited investors, or it may be a public offering. In short, securities offerings are an important component of what I do.
The JOBS Act obviously is something that made some significant changes to securities law. I think people focus too much attention on the JOBS Act and its effect on the IPO market and neglect to talk about the JOBS Act and its effect on exempt offerings both on private placements, Rule 506(c), matchmaking platforms, Reg A crowdfunding and probably even more importantly, just the ability for private companies to stay private longer which obviously is now something that we read about almost daily when we commiserate about the declining number of US public companies and the relatively small number of U.S. IPOs.
The Accredited Investor Standard
The worries of, for example, Commissioner Piwowar who I think was one of the first to suggest it that about perhaps doing away with the accredited investor standard. Or the more recent comments that Commissioner Peirce made regarding accredited investors. It all derives from the same sort of public policy concern right. Do we need this standard? The accredited investor standard. Is it helpful? Is it still serving its purpose or, if you were to take the other view, if you were to take the commissioner Piwowar view, if companies are staying private longer and companies are experiencing more of their growth these days while they're private instead of in the years that immediately follow their public offerings, are we essentially doing a harm by not allowing a greater percentage of the investing public to participate in those offerings. I think it's interesting to look at it from both angles.
Unlike Commissioner Piwowar, I think there is merit in having an accredited investor standard There is good reason to have an accredited investor standard. I think that the current standard which includes some institutions – and I don't think that many people have quibbles about the prongs of the accredited investor definition that include that include non-natural persons – I think that's fine. What many have looked at is whether the two prongs that we now have for natural persons, the net worth test and the net income test, are still appropriate and whether those are good proxies for sophistication, for financial sophistication.
Dollar Amounts as Proxies
In the securities laws we have lots of instances where we use dollar amounts, assets as a proxy for identifying the kinds of individuals that can fend for themselves. For example, if you look at the definition of qualified client or if you look at the definition of qualified institutional buyer, qualified purchaser, any number of investor standards that we have sprinkled throughout the securities laws. We've always sort of resorted to having these dollar thresholds be a proxy for getting at whether somebody has the wherewithal to bear some investment risk or could, if an investment goes sour, it could withstand the loss. There's nothing wrong with that. It's important to have bright line net worth and net income standards. That's very helpful because it provides legal certainty because there are crisp answers that you and I can identify – we know what those are, we know what those mean. They're not subject to judgment. They're easy to verify. For broker dealers for investment advisers having that clarity and legal certainty is important.
Obviously, the Dodd Frank Act required that the SEC periodically review the appropriateness of the accredited investor standard. The SEC did deliver a report on the accredited investor standard. There were some recommendations which are sensible ones that certain individuals having securities brokerage licenses or certain designations like a CFA designation be able to be considered an accredited investor regardless of net worth or net income. There's a fairness to that because they are sophisticated. There's an ascertainable standard. The CFA designation is conducted over a period of time by an independent organization. FINRA administers the securities licensing exams. That's sensible. Things get murky and complicated with suggestions that there be some test that gets administered that then becomes the basis for assessing whether somebody is or isn't financially sophisticated. That’s troublesome.
Education vs. Net Worth or Income
Indeed, education and income or networth are not necessarily equivalent. Net income or net worth suggests that a person is probably going to be able to take certain financial risks. There may be a little bit of a paternalistic quality to that regulation i.e. deciding that we should only let those who can withstand risk of loss make an investment. However, it's important to have some proxies even if they're imperfect and net worth and net income are imperfect but there is merit to the notion that you can substitute net income and net worth. These are people who probably could withstand the fact that their investment in a startup amounted to zero; that they lost it all.
Keeping in mind that the accredited investor standard was promulgated in 1982 it may be a reasonable approach to index the standard to inflation, for example. We have inflation indexes written in to a variety of other thresholds and, perhaps, there's a lot of common sense appeal to that. Of course, applying an inflation index to the standard would, however, reduce the numbers of eligible investors so to contemplate such a change, one might go back to some of those interesting public policy issues that are now coming about. There'd be some reluctance to limit the overall number of investors that are able to or that may participate in in private placements. This is because private placements have a more significant role in capital raising than they did historically. Then again, another way to go about things would be to require more disclosure in connection with certain private placements. You could attack the problem in any number of different ways.
For and Against Retaining the Accredited Investor Standard
The notion of our securities regulatory scheme is premised on there being investment decisions that are made when disclosure is provided. Section 5 of the Securities Act is disclosure based if there is a public offering, with disclosure requirements being relaxed in the case of certain private offerings or certain exempt offerings based on the theory that you're offering to investors that are sophisticated, that can fend for themselves, that have the ability to ask questions regarding the investments that are being offered to them, and that have the ability to have those questions answered. It presumes that we're not going to impose disclosure requirements or we're going to impose lighter disclosure requirements in instances where we're selling to certain types of more sophisticated investors or investors who can, at least, bear a risk of loss. That's a powerful argument for keeping the accredited investor standard for similar such standards and it's kind of built in to how we think about the securities framework.
Disclosure Requirements
Another alternative would be to modify or review some of the disclosure requirements that we currently have in offerings that are made to non-accredited investors. In 506(b) transactions or 504 transactions there are certain disclosure requirements but, one wonders, are those still current? It’s hard to know but that's another way to skin the cat.
Now for those that are in favor of just setting the accredited investor standard aside there is a good story to tell and that is that the capital markets have changed a great deal particularly in the last 10/15 years. We now have private companies with the ability to go out to a broader universe of investors and to conduct successive rounds of financing and to become Unicorn's and essentially to become household names and have some dispersed ownership while still remaining private. A lot of the wealth that's being built and a lot of that explosive growth that's being experienced by these companies is only open to institutional investors and accredited investors because, in order to avoid disclosure requirements, most private placements are limited to accredited or institutional accredited investors or equivalent. Wouldn't it make sense, from a public policy perspective, just as we once encouraged retail participation in IPOs to encourage broader participation in some of these exciting private placements? That's the argument that would be made.
Gambling Has Only an Age Hurdle
People understand when they take their seat at the craps table that they may walk away with a significant return. Or they may walk away with empty pockets. Meanwhile it's all too easy for investors to hear about a startup with what they think is a promising business venture and to assume or perhaps be led to think that at least some portion that it's an investment that some portion of the money that they're putting up is not subject to complete risk of loss.
Process for Change
In the Treasury report on capital markets, one of several reports that was issued in response to the recent Trump presidential order, a number of suggestions were made, but it is only within the SEC's domain to evaluate whether the definition ought to be changed or not. Obviously the SEC has done its work. The SEC has completed its study. The study's been done for some time. There have been comments solicited from the public and submitted on the standard.
The SEC's investor advisory committee has weighed in on the standard and the takeaway from all of that is that most people would like to keep the net worth and net income measures, maybe with some indexation, maybe with some changes in the numbers, but also want to see added individuals who have certain designations. There is another recommendation to add knowledgeable employees to the standard which makes a lot of sense. The collective wisdom of the commenters, the Investor Advisory Committee, the SEC report, is to keep it intact but make some changes.
For any changes to occur, the SEC would have to propose changes to the definition and on the SEC's published agenda, the Reg-Flex agenda, one of the actions in the long-term category is consideration of proposed changes to the accredited investor definition, perhaps bringing it to the top of the agenda in no less than six months or so.
SEC staff would come to the commission with a proposed rule. The commission would take a vote on releasing the proposed rule for comment. There'd be a comment period and then presumably after a time the rule after giving weight to the comments the rule would be adopted modifying the definition in Rule 501.
Anna believes that the Standard will stay substantially the same, maybe with these added categories. It is unlikely that there will be any reduction the number of people who qualify, rather, if anything, it's going to be increased.