SEC may change identity of angels
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Potential Changes.

Accredited investors have long been critical participants in private financing transactions, and the success of most private financings is largely determined by the participation of these investors and the availability of their capital. State and Federal securities laws have been written or amended to foster and facilitate investment by these accredited investors. Based on recent developments, the standards for qualification as an accredited investor may be changing, and these changes could pose problems for companies seeking financing.

The current requirements for accredited investor status are contained in Rule 501(a) of the 1933 Act. The most commonly used standards for individual investors are a $200,000 annual income (or $300,000 combined income with a spouse) or a $1,000,000 net worth (excluding the value of the investor’s primary residence). Other than the exclusion of the investor’s primary residence (which became effective in 2012), these standards have been in place since 1982 without any changes to reflect the effects of inflation during that period.  

Based on these current standards, observers estimate that there are approximately 8.5 million accredited investors in the United States. Some critics have asserted that this number is far higher than it should be, and that many of these people only qualify as accredited investors because they are subject to 1982 standards which do not reflect the considerable inflation and other factors that the United States economy has faced over that 32 year period. From the standpoint of companies seeking financing, however, this is a distinct advantage since it considerably increases the available accredited investor pool. Devin Thorpe’s post contains a good summary of this situation along with some interesting comments from sources in the crowdfunding community.

This criticism clearly has some validity, but the bigger problem here is what to do about these outmoded standards. It would be easy enough to just raise these quantitative standards to adjust for the inflation rate over the past 32 years. This is a quick fix, but it could quickly have a substantial negative effect on the availability of private financing for many companies because of the significant reduction in the number of accredited investors. Some observers believe that an adjustment of these standards to fully reflect these 32 years of inflation would reduce the number of accredited investors by as much as 2/3.

The Dodd Frank Act requires the SEC, among many other things, to review these accredited investor standards on a regular basis (currently every four years). It’s now time for this review process, and accordingly the SEC’s Investor Advisory Committee (the group charged by the SEC to, among other things, review these accredited investor standards) met on July 10 to discuss the accredited investor standards and possible changes. Here is a video link to the Committee’s meeting. The Committee  discussed a number of interesting items such as increases in the income and net worth amounts as described above, limits on the percentage of a person’s net worth that can be invested in private financings, and the possible development of a qualitative “investment sophistication” test that could be used to evaluate a potential investor’s investment acumen and experience.

The Committee did not issue any formal reports or recommendations at this stage, but will likely issue some recommendations on potential changes to the accredited investor standards when it meets again in October. In any case, the SEC commissioners are not bound by the Committee’s recommendation so the final status of any changes is difficult to predict now.

It will be interesting to see how this goes down. This is a very critical decision that could negatively affect the ability of many companies to obtain much needed private financing. This would be unfortunate from many perspectives, especially since the private financing markets are finally showing some positive activity. My biggest concern is that the Committee and then the SEC will take the easy way out and just adjust the standards based on some inflation index. This would be a mistake because it would make private financing transactions more difficult to do because of the smaller numbers of accredited investors that would result. The use of a “sophistication” test has a lot of appeal, but this may be very difficult to enact from a practical perspective due to the subjectivity of such a test and the probable wide divergence of opinion on what constitutes “sophistication” in this arena. Some commentators have suggested that certain investors, such as CPAs or CFAs, automatically be considered accredited investors. There may also be some combination of these items that could be a viable solution. Of course, the SEC could always decide to not change the accredited investor standards, but I believe that at least some changes are coming in October. Stay tuned on this one.

Helpful guidance.

In another development in the accredited investor area, the SEC issued some helpful guidance regarding the confirmation of accredited investor status under Rule 506(c). Rule 506(c) allows the use of general solicitation in a private offering under Rule 506 if all purchasers are accredited investors. The challenge here has been how to confirm or certify that a purchaser is an accredited investor.

The SEC attempted to provide some clarification in this area by the issuance of six new Compliance and Disclosure Interpretations (CDI’s):

            CDI 255.48 relates to the exchange rate to be used to determine an investor’s annual income when it is not reported in U.S. dollars.

            CDI 255.49 confirms that, for purposes of the net worth test, an investor may include property jointly held with a non-spouse to the extent of the investor’s ownership interest.

            CDI 260.35 relates to the restrictions on the availability of the safe harbor in connection with verification of the investor’s qualification under the annual income test where the investor’s tax returns for the most recently completed year are not available.

            CDI 260.36 relates to the restrictions on the availability of the safe harbor in connection with verification of the investor’s qualification under the annual income test where the investor is not a U.S. taxpayer and non-U.S. tax forms are used.

            CDI 260.37 relates to restrictions on the availability of the safe harbor where tax assessments more than three years old are used in connection with the verification of an investor’s net worth.

            CDI 260.38 relates to restrictions on the availability of the safe harbor where reports issued by non-U.S. consumer reporting agencies are used in connection with the verification of an investor’s net worth.