Written By: Phil Feigin
Has the time come to license investors?
Regulators are often called upon to draw regulatory lines. In my experience as a former regulator (some would argue I never left, though it’s been almost 16 years), when called upon to fashion a regulatory scheme, it was a lot easier to flat out prohibit something than to decide how many of something would be allowed and how many would not.
Bright line numeric standards have their advantages. They are clear for all to see, both the regulators and the regulated, but they will all but certainly be set arbitrarily. In an environment where documented justification is required for any regulatory decision, it is all but impossible to find empirical evidence to support a conclusion that 15 is legal but 16 isn’t. It is a fool’s errand to argue the rationale why 15 is lawful but 16 is not. The only response possible is “because we had to draw the line somewhere.”
The “debate” to date against altering the standards in the 1982 definition of “accredited investor” has, in my view, been lacking in discussion of principles and empirical evidence. Consumer groups and state securities regulators have supported raising the standards, if for no other reason than inflation since 1982. Industry representatives, particularly those who have gone all in on the prospects of public solicitation and crowdfunding, have advocated for keeping the numbers where they are (or doing away with them altogether) with all the independence and credibility of a brewery lobbying to lower the legal drinking age. And what of those who would be directly impacted by new and higher standards? There has been no hue and cry, no outrage, no speeches about denial of rights, no taking to the financial streets with placards demanding to be among the “privileged” with access to private placements.
The problem with the whole “raise the standards” argument is that it begs the question, “Were they correct in the first place?” I agree wholeheartedly with those who question whether a net worth of $1 million (excluding principal residence) or two years of $200,000 in annual income (or $300,000 jointly with spouse) was what the Supreme Court had in mind in ruling way back when that private offerings could only be made to “sophisticated investors.” I might be willing to buy that having a million bucks in assets or making $200,000 per might mean a guy has the wherewithal to hire a professional to review an investment opportunity, but it says nothing about his financial sophistication to judge for himself. Far too often these days, that $1 million in assets is totally 401(k) money, built up over a 30 year career, with no pension in sight. It is not just running around money, and losing $50,000 or $100,000 of it is not something an older investor can easily make up once retired or even close to it.
It doesn’t take long as a regulator dealing with victimized investors before you find yourself internally struggling against developing a cynical perspective. You begin to wonder, even if jokingly, whether we’re going about it the wrong way. Instead of registering brokers and regulating issuers, we ought to be licensing investors. Make them take a test before they can invest, and impose continuing education requirements on them to maintain their investor’s license, and presumably, their acumen.
In a crude, indirect way, we sort of do that already, but we make the industry impose the test. Brokers and investments advisers are only allowed to recommend “suitable” investments to their clients. They are required to analyze the client’s financial sophistication, conditions and expectations before recommending investments to them. On the private placement promoter side, the “accredited investor” standards are an even cruder means of sorting those who should and should not be allowed to invest in investments deemed systemically riskier than others. Anyone who has ever fielded investor complaints wonders about the efficacy of the suitability and accredited investor standards, how they are applied, and how often they are ignored.
Assuming we are not going to develop a regulatory regime to license investors, both regulators and industry need another bright line means of identifying “accredited investors.” Whatever they come up with, it must this time be a meaningful indicator of true investment sophistication and the ability truly to withstand a total loss of investment. Advocates for the current “accredited investor standard” (or for no standard at all) have waved the banners of small business being the engine of the economy and job creation, humming God Bless America, but there are there any reliable statistics to support the premise that making it easier to offer private placements creates jobs? At the same time, detractors make the argument that easier private placements mean an increase in floundering businesses and frauds that sap capital from the real economy and cost jobs. Intuitively, both are right, but neither can truly prove it.
Here are my thoughts on revising the accredited investor standards:
- the SEC should get rid of the income test—the accredited investor definition is the only place in federal securities law of which I am aware that includes an income test, and for good reason—ditch it;
- keep the $1 million in assets test but 401(k) and IRA assets should be excluded unless the investment is made through or with the advice of a registered/licensed/family office investment adviser or broker-dealer,
- even then, such an investment should be limited to no more than, say, 10% of total investment assets; and
- people who already have at least, say, 25% of their total investment assets in brokerage accounts or alternative investments that are not held in 401(k) accounts or IRAs would be “accredited” on that basis alone.
These standards would provide for at least a modicum of investor sophistication (or at least potential liability for the people making recommendations) and protection against devastation. If 401(k) and IRA funds are eliminated from consideration, it probably wouldn’t be necessary to adjust the $1 million standard for inflation.
I do not envy the SEC’s task. No matter what they come up with, some people on one side of the line or the other will be unhappy. That’s what happens when you draw lines.