The current definition of an accredited investor—based on an individual’s net worth—hasn’t been modified in any meaningful way since it was enacted via the Securities and Exchange Commission’s regulations governing the sale of unregistered investments in 1982. Some industry observers say a change is long overdue, and that a person’s sophistication, not just their wealth, should qualify them to participate in private placements, a move that would increase access to these kinds of alternative investments.
Just such a provision—a bill that would expand the definition of an accredited investor to include education and job experience as a qualification—is included in a bipartisan package of bills, colloquially called The JOBS Act 3.0, meant to spur capital formation, prompt more initial public offerings and generally expand the public's opportunities to invest. The Financial Industry Regulatory Authority, or an equivalent self-regulatory organization, would oversee that process, the bill says. Anyone licensed as a broker or investment advisor would also be accredited.
Currently, an accredited investor is anyone with income that exceeded $200,000 (or $300,000 with a spouse) in each of the prior two years, or those with a net worth over $1 million (excluding the value of their primary residence).
The JOBS Act 3.0 passed the House of Representatives in July, and Financial Services Committee Chairman Jeb Hensarling (R-Texas) recently urged the Senate to do the same. Washington insiders are confident that it will get passed with some budgetary legislation before the end of the year.
Meanwhile, the SEC is also reviewing the definition; Chairman Jay Clayton recently said a “concept release” is in the works that will seek comments on the current definition to explore if it “is appropriately tailored to address both investment opportunity and investor protection concerns.”
In an interview with WealthManagement.com, Clayton said the current definition was “binary” and that the agency wouldn’t look at raising or lowering the threshold. He said using education and experience as qualifications was a “good idea.”
The move comes just as technology platforms are making it easier for investors to access more sophisticated private placements and other alternative investing strategies beyond what’s available in the public exchanges.
“I think this is moving in the right direction, but it’s been a long time coming,” said Mat Dellorso, co-founder and CEO of WealthForge, a private capital and compliance technology company. Highly paid professionals, like doctors or athletes, or those who get money from an inheritance, have the asset level, but may not necessarily be sophisticated investors. “Wealth might not be the best indicator of your sophistication or your ability to build out an investment portfolio or understand the risk of alternative investments.”
“A group that’s particularly attractive to us is the young and sophisticated but not yet wealthy,” Dellorso says. “So there are a lot of people who are probably earning $125 to $150,000 a year that are sub $1 million of net worth still but have $25,000 or $50,000 a year of disposable income and want to diversify their portfolio. I think that’s a market that opens up. I think our company would be well served.”
“We believe that this is an opportunity for investors to diversify and grow their own portfolio in a way that institutional investors have,” said Kamal Jafarnia, general counsel and chief compliance officer at Artivest, an alternative investment technology firm. Jafarnia is also co-chair of the Policy and Government Affairs Committee of the Institute for Portfolio Alternatives, an industry trade association, and had lobbied for an earlier version of the legislation.
“I think the definitions that exist today are probably the product of a lot of good thinking. They’re probably the common denominator that people came up with to try to ... assume people’s ability to make investments, and to withstand losses as well,” said Lawrence Calcano, CEO of iCapital Network, a tech platform for alternative investments. “But I think people also have to take responsibility for what they’re doing, and that’s a really hard thing to legislate.”
He points out that the number of public companies has shrunk, so it’s harder for investors to find growth companies without looking to the private markets.
And private placements are growing; in 2017, there were 37,785 Reg D offerings (named after the regulations that allow firms to raise capital from investors without the required disclosures of a publicly traded company), accounting for more than $1.8 trillion in new capital raised, according to the SEC. That compares to $1.3 trillion in 2016.
Yet, private placements are also one of the most common areas of abusive sales practices, according to FINRA’s recent examinations report.
“What you don’t want to do is make it easier for abusive salesman of private placements to target vulnerable investors,” says Barbara Roper, director of investor protection at the Consumer Federation of America. Roper is not opposed to the idea of looking at sophistication to be considered accredited, if it’s done right. She believes the current definition—based on income and net worth—makes no sense.
“The thresholds aren’t set at a level to guarantee either that the investor would be able to use their influence to gain special access to information, nor be protected from a harmful impact of losses,” she said.
One idea would be to use a scaled approach, where an individual could invest a modest amount at the first threshold, and then the percentage increases as the thresholds rise, she said. Another idea would be allowing a fiduciary advisor—with no financial stake in the investment—substitute their expertise for the investor.
“We should be looking for a definition that makes regulatory sense and fulfills the regulatory function of identifying a population of people who can protect themselves without the protections afforded in the public market,” Roper says.
Evan Rapoport, CEO of SMArtX Advisory Solutions, a turnkey asset management platform that grew out of alternative investment platform Hedgecovest, doesn’t believe product knowledge is enough to qualify an individual. Rather, investors need to understand the risks of the structure and how to conduct due diligence on the managers running private placements. Simply passing a test, for example, wouldn’t necessarily qualify someone to invest in hedge funds.
“Taking a test is just sometimes studying and regurgitating. That doesn’t mean you’re intelligent and doesn’t mean that you fully grasped the concept,” he said.
And subject matter knowledge won’t necessarily protect an investor from outright fraud. Conducting due diligence on a hedge fund manager’s administrator and auditor is more important, Rapoport says. When he contacted the auditor and administrator the now-imprisoned “pharma bro” Martin Shkreli listed for his hedge fund, for example, the organizations had no idea who Shkreli was.
Andrew Stoltmann, past president of the Public Investors Arbitration Bar Association, believes the bill is “horrific” and agrees that a person’s job experience or background doesn’t necessarily qualify them to assess the risks of private placements.
“It is the continued attempt to expand who can invest in the riskiest, most speculative investments possible, and it’s a bad idea,” he says. “The reason why net worth is used as a proxy for the ability to invest in these deals is because there’s an assumption that, number one, somebody with a high net worth is sophisticated in investments, and number two, if they lose this money, it’s not going to have a cataclysmic result on their overall financial wellbeing.”