February 4, 2007
Given that the income and net worth standards for "accredited investor" status are twenty-five years old, it is more than reasonable that the SEC should revisit these standards and perhaps update them. With the value of the U.S. dollar eroded by half since those standards went into effect, more and more investors are meeting the requirements to be deemed "accredited investors". I strongly suspect that it was not the intent of the SEC in 1982 to permit the fringes of our country's middle class to creep into privately-placed investment eligibility solely by virtue of the decline of our currency's value.
Interestingly, it's more than the value of the U.S. dollar that seems to be driving the discussion about amending the "accredited investor" standard. In 1982, the rationale behind creating an "accredited investor" standard was to limit the pool of investors sought by issuers of privately placed offerings to those capable of understanding, and enduring, the risks of the securities being offered. From a political perspective, the atmosphere was one where the issuers were being constrained, not the investors.
Now that atmosphere has changed, as evidenced by the number of comment letters you've received expressing indignation on the part of non-accredited investors who feel unfairly excluded from most Regulation D offerings. Many of them argue, quite persuasively, that "accredited investor" standards render them second-class financial citizens. The SEC may have ensconced them in a gilded cage, but it remains nonetheless a cage.
So while there may indeed be some correlation between high levels of income or net worth and the knowledge to enable a purchaser to evaluate the merits of a prospective investment in a privately offered security (and to bear that economic risk), that correlation is not perfect. The income and net worth criteria exclude investors who would seem to be more than capable of understanding and bearing the economic risks of these alternative investments. Furthermore, it's quite likely that, despite the standards, "accredited investors" who generate, or have generated, significant levels of wealth in non-investment related endeavors may be in no position to understand the risks of these private placements.
At least one other comment letter includes recommendations to abandon the income and net worth standards in lieu of some form of certification procedure, either through testing or supervision by a licensed professional such as a registered investment advisor, to verify that investors in these instruments are capable of understanding the risks associated with them. While such a certification procedure may be impractical from an administrative perspective, and could be subject to various conflicts of interest problems for registered investment advisors, the idea of positively identifying investors capable of understanding risk is certainly within the spirit of the SEC's rule-making activities as they apply to Regulation D.
As I contemplate the problem of getting investors to understand the risks in the securities they wish to evaluate, I find myself thinking of the "Characteristics and Risks of Standardized Options" brochure published by the OCC. Every broker/dealer in the U.S. is required to verify that an investor has received a copy of the brochure prior to their receiving permission to engage in options trading.
There's obviously a message the SEC would like to get across to investors considering private placements as part of their investment portfolios. Perhaps instead of tweaking the net worth and income criteria criteria for the "accredited investor" standard, the SEC should create a "Characteristics and Risks of Regulation D Offerings" brochure. Form D could likewise be altered with a field for the issuer to check off certifying that they have taken steps to ensure that each investor in the offering has received a copy of the brochure. It would not be a burdensome requirement to have Regulation D issuers affix specific language on the face sheet of their private placement offering memoranda regarding the existence and availability of such a brochure.
We can't be certain that investors would read or even understand the brochure, but we would have at least equipped them with another tool that they would not have otherwise possessed. And so long as the SEC maintains and enforces the advertising and marketing restrictions for private placements, we can at least be reasonably assured that those investors considering private placements have played some active role in seeking out these alternatives and are more motivated to evaluate them carefully.
Even if the SEC were to altogether drop the net worth and income criteria for "accredited investors" there would remain a de facto standard, especially for 3(c)(1) pools. By limiting the number of investors to a 3(c)(1) pool, issuers are forced to impose rather large minimums of their own, which weed out those investors of lesser means. Even without the additional expenses of registration and complying with regulations for publicly-offered securities, the managerial and administrative expenses of these pools make it absolutely necessary that the pool itself be quite sizeable. No one who is serious about managing capital would restrict the size of their fund by setting minimum investment requirements to such a low level where the management of the fund could never be profitable (a fact you might want to point out if you were to pursue a "brochure" approach).
Finally, I'm not sure that attempting to restrict access to these alternative investments to a given percentage of the population is a good public policy goal. It's understandable that the SEC might use the percentage of the 1982 population eligible to invest in hedge funds as a benchmark when it considers alterations to its net worth and income criteria for "accredited investors". However, a more worthy public policy goal, unachievable though it may be, would strive to have 100% of the investors buying privately-offered securities understand their risks AND for 100% of those investors seeking the benefits offered by these alternative investments eligible to consider and purchase them regardless of their current income or net worth.
Thank you for the opportunity to comment on this proposal.
James R. Brownfield