The debate over who can invest isn’t over yet.
Two weeks ago, the SEC approved the final rules implementing Title III of the JOBS Act. These new rules will open up equity crowdfunding to non-accredited investors when the rules take effect in mid-2016. Title III crowdfunding offerings will contain strict investment caps for both accredited and non-accredited investors, and skeptics worry that the required compliance measures will make Title III difficult to use.
While we’re optimistic about Title III, there’s no question that crowdfunding platforms will continue to rely upon both the existing Title II regime and the new Title III rules. Expect to see platforms listing Title II offerings (open only to accredited investors) alongside separate Title III offerings (open to both accredited and non-accredited investors). Given the $1 million offering size limit for Title III, larger deals will have no choice but to rely upon Title II.
That again raises the issue of who can invest in these offerings. As we’ve mentioned, Title II crowdfunding offerings are currently open only to accredited investors. Over the past year, though, there have been a number of proposals to change the definition of an accredited investor. While the Title III rules have now been settled, the debate over the definition of an accredited investor is just getting started.
Who is Accredited?
The current definition of an accredited individual investor is based solely on wealth or income. It originates from the 1933 Securities Act, as subsequently interpreted by the Supreme Court and the SEC. Accredited investors are supposedly better able to withstand losses from private investments in which the available information is less than what would be disclosed in the prospectus of a public investment. Under Rule 502(a) of Regulation D, natural persons are accredited if:
- They earn at least $200K a year for each of the last two years (or $300K for joint filers) and reasonably expect to continue meeting the income requirements in the current year, or
- Have at least $1M in net wealth, excluding a primary residence.
This primary residence exclusion, introduced by the Dodd-Frank Act, is important, because it places emphasis on an investor’s liquid assets, the kind that could be used to help withstand substantial losses on an investment without forcing investors to sell securities they would rather hold. As we will see, the limitation placed only on a primary residence is one of the criticisms leveled against the current definition of accredited investors.
Beyond the ability to withstand losses, the current definition of accredited investors is often cited as a proxy for investor sophistication and for the ability to obtain, through negotiation, the disclosure of sufficient information to properly evaluate private placement offers. Criticisms from many quarters, including Congress, challenge all three assumptions as to whether these assumptions are necessary to provide the intended protections without unnecessarily restricting capital formation.
In response to the Dodd-Frank Act and the JOBS Act, the SEC has made several regulatory changes:
- On September 23, 2013, the SEC lifted the ban on general solicitation for private investments offered under Rule 506(c) of Regulation D, provided that the issuer takes “reasonable steps” to verify that all investors participating in the offering are accredited.
- On October 9, 2014, the SEC Investor Advisory Committee (IAC) issued a set of recommendations regarding changes to the definition of accredited investor.
- On March 25, 2015, the SEC modified Regulation A (dubbed Reg. A+) to allow non-accredited investors to invest in certain publicly offered private investments of up to $50M per year.
- On October 30, 2015, the SEC voted to adopt rules fully implementing Title III of the JOBS Act. The rules will take effect in mid-2016.
Many states (including Illinois) have also implemented intrastate equity crowdfunding rules allowing non-accredited investors to participate in purely intrastate offerings. These offerings are only available to residents in that particular state, though, and the overwhelming majority of equity crowdfunding offerings are governed on the federal level via the SEC.
On April 30, 2015, Representative Schweikert introduced H.R. 2187, a bill that would expand the definition of accredited investor to include natural persons who certify that they are a registered broker-dealer, licensed attorney, CPA or SEC-registered investment adviser. It also includes individuals who hire one of these types of professionals and individuals who pass a new licensed-accredited-investor test administered by Financial Industry Regulatory Authority (FINRA). The bill is currently in committee.
On June 16, 2015, a House subcommittee held a hearing about widening the definition of accredited investor, and the proceedings discussed the IAC recommendations. Several participants at the hearing noted that the accredited investor income (over $200,000, or $300,000 together with a spouse) and net worth (over $1 million) amounts have not been updated since 1982. The only change in that time has been to eliminate the value of an investor’s primary residence from the net worth calculation. Updated for inflation over the past 33 years, the income threshold would increase to just under $500,000 ($740,000 for a married couple), and the net worth criteria would increase to almost $2.5 million.
The House Investor Education Subcommittee has issued five recommendations with supporting rationales regarding alternate approaches to the current definition of accredited investor that are meant to remove constraints on capital supply. The subcommittee recommended that:
- The SEC should review whether individuals that meet the current definition of accredited investor are actually capable of protecting their own financial interests. The committee points out weaknesses in the current financial thresholds. For example, non-liquid properties other than a primary house, such as a family farm or retirement plan, may allow persons to pass the wealth test but not necessarily be able to absorb large losses without forced sale of the investment. IAC questions whether raising the thresholds because of inflation would constrain capital supply without providing any real benefit.
- The SEC should re-examine situations in which non-accredited individuals have the personal knowledge, experience or sophistication needed to fend for themselves when making private investments. Certain credentials, examinations or professional experience would attest to an individual investor’s sophistication.
- If the SEC maintains the financial threshold approach, it should alter it to limiting private investments to a percentage of investor assets or income.
- The SEC should allow alternate means to verify accreditation status, such as using reliable third parties.
- To better ensure against conflicts of interest, the SEC should strengthen the protections applied to non-accredited investors who invest in Rule 506 investments through reliance on sophisticated representatives.
The committee also expressed support for four overriding goals:
- Enable natural persons to qualify as accredited investors based on their financial sophistication.
- Consider whether financial thresholds need to be adjusted for inflation.
- Evaluate alternative approaches to setting financial thresholds.
- Strengthen protections for non-accredited investors who rely on recommendations from purchaser representatives to qualify as sophisticated.
Since Title III was adopted last month, much of the mainstream media attention has focused on the idea of non-accredited investors being able to participate in equity crowdfunding. There’s no doubt that there will be numerous Title III offerings available to these investors come mid-2016, but some non-accredited investors may be disappointed to see other (Title II) offerings that they are unable to participate in. As we have discussed, it’s ironic that quite a few attorneys, advisers and brokers who make a living advising clients on investments are themselves unable to invest in equity crowdfunding offerings. Title III will partially address this, but the discussion on the accredited investor definition will continue.