The Securities and Exchange Commission (SEC) recently amended the definition of an accredited investor. This post explores the changes and how they allow more investors to participate in private securities offerings. As a finance education professional, I expect these changes to have a broad impact on how companies raise capital.
Investing in startups and growing companies before they go public was previously relegated to wealthy and institutional investors. The rule change primarily influences who can invest in private sales of unregistered investments, as these often entail significant risk and return potential, with little transparency or SEC oversight.
Most securities sold to investors are subject to a rigorous registration process that the SEC facilitates. Issuers (organizations that sell securities) must disclose a significant amount of information relating to business operations, management, and risks related to the investment being sold to register their securities. The SEC reviews those disclosures and deems registration effective if all necessary information is provided.
The reason for the SEC’s registration process dates back to the early 1900s. Before the Securities Act of 1933, there were few applicable laws that issuers were required to follow when selling securities. Companies could legally sell stock without providing accurate information relating to the company’s business or investment risks. There were many examples of fraudulence, including instances of blatant lies about investments to induce a purchase.
Since the introduction of the Securities Act of 1933, investors purchasing registered securities are offered a significant amount of information. Most of these disclosures are provided in a document known as the prospectus, which is legally required to be delivered to investors purchasing new issues. If the issuer lied or misled investors in the prospectus, the organization and its executives are subject to massive fines and penalties.
Although registering securities has proven to be effective at reducing investment fraud, there’s a considerable cost associated with this process. The issuer must spend significant amounts of money on legal and compliance-related expenses – mainly attorneys, accountants, and compliance officers. If the information disclosed is inaccurate or incomplete, it can result in large monetary losses and liabilities for the issuer. Additionally, issuers can be required to pay registration fees to the SEC in the six-figure range.
With the high cost of registration, the SEC allows some issuers to bypass the registration process. This can be accomplished through a few avenues, with Regulation D being one of the most common. Known as the private placement rule, Regulation D allows the sale of unregistered securities to private audiences. The rule is complex, but unregistered securities can be generally sold to:
In a nutshell, an accredited investor traditionally was a wealthy individual or institution. This is a condensed list of the most common accredited investors prior to the rule change:
In practice, issuers utilizing Regulation D seek to raise capital by primarily engaging wealthy individuals and institutions seeking investment opportunities. Issuers can sell unlimited amounts of unregistered securities to these parties with little SEC oversight or disclosure requirements. The SEC views these investors as “sophisticated,” capable of understanding and withstanding the risks associated with these investments. Up to 35 non-accredited investors can participate in these offerings, but additional disclosure and suitability rules exist for sales to non-accredited investors. Non-accredited investors are not commonly involved in these transactions due to these rules.
The recent update to the accredited investor definition added several new ways to qualify as one. As of late October 2020, these parties will also be considered accredited:
Previously, many organizations and entities with assets over $5 million qualified as accredited investors. The updated rule now includes other entity types that technically fell outside the definition (e.g., Indian tribes, foreign governments, LLCs, and family offices).
Individuals now have several new ways to qualify as an accredited investor. Obtaining the Series 7, Series 65, or Series 82 by passing the appropriate licensing exam is likely the most significant change. While the Series 7 and 82 require company sponsorship (meaning a financial firm must employ the individual), the Series 65 can be acquired without employment in the industry. These are all difficult exams, and the SEC believes individuals passing these tests have the necessary knowledge to determine the risks associated with private investments. There are other ways individuals can qualify, which include being married to an accredited investor or being considered a “knowledgeable” employee of a private fund company.
The SEC’s rule change broadens the field of accredited investors an issuer may pursue when selling unregistered securities. Issuers can raise more capital without the formal registration process and may lead to fewer public offerings that require registration. Individuals and organizations now have several new ways to meet the accredited investor definition, which will lead to more participants in the private securities market.
The consequences of the rule change will be inspected and analyzed over the next several years, but the change certainly benefits issuers raising capital that prefer to avoid registration requirements.