Proposed Changes to the Accredited Investor Rule

Late last year, the Securities and Exchange Commission (SEC) attracted a lot of public attention when it issued a proposal to update the definition of an accredited investor. The definition relates to who can, and who cannot, invest in private, or unregistered, investment offerings. Registered securities, like publicly-traded stocks and bonds, mutual funds, and ETFs are available for investment by the public. Private investment offerings include hedge funds, private equity, venture capital and private real estate funds, and are only available to certain classes of investors. The proposed rule changes impact Greenleaf Trust and our investors, so we are following the developments closely. Below, we summarize the proposed rule changes, the debate about them, and offer our own perspective.

Accredited Investor Rule: Background and Definition

In 1933, Congress passed the Securities Act, now commonly known as the 1933 Act. This Act requires companies that offer or sell their securities to register the securities with the SEC. The registration process can be very time-, labor- and data-intensive. Many companies prefer to avoid this challenging process. As a result, many companies rely on Rule 506 of the Act to gain an exemption from having to register their securities. Rule 506 is only available if the companies only offer the securities to “accredited investors.” Privately held investment companies such as hedge funds can rely on a similar exemption from registering under the Investment Company Act of 1940. Again, this exemption is only available if they solely offer their securities to accredited investors and keep their fund to a limited number of investors.

Who qualifies as an accredited investor and why? An individual qualifies generally as an accredited investor if they have either the wealth or income from which they can be inferred to have the financial resources and sophistication to understand and tolerate the heightened risks associated with private, unregistered offerings.

Institutions or other entities that are specified in the current accredited investor definition generally qualify as an accredited investor when their total assets exceed $5,000,000.

Major Changes Proposed

According to the SEC proposal from December 18, 2019 titled “Amending the ‘Accredited Investor’ Definition”, the purpose of the new proposed rules are “to identify more effectively institutional and individual investors that have the knowledge and expertise to participate in our private capital markets and therefore do not need the additional protections of registration under the Securities Act of 1933.” The net effect of the proposal will be to expand the number of investors who are able to invest in private offerings. The major changes to the accredited investor definition are as follows:

Inclusion of a new “professional knowledge” criterion for natural persons with appropriate professional knowledge, experience or certifications to invest in private offerings. Additionally, “knowledgeable employees” of a company making a private offering will be provided the status of accredited investor with respect to that offering.

Creation of a “catch-all” category of investors that includes any entity owning “investments” in excess of $5 million.

Addition of “family offices” with at least $5 million in assets under management as well as any “family clients” the family office has, regardless of the individual family client’s assets.

Additionally, the rules proposal seeks to update the definition of a qualified institutional buyer, adding a few specific entity types as well as creating a “catch-all” category for entities for the purpose of investing in private markets.

Perspectives on Rule Changes

In reviewing the comments submitted to the SEC on the proposal, there seems to be a broad consensus in favor of some of the proposed changes. In particular, the “catch-all” rules for adding entities are intended to capture certain entities such as tribal entities and certain governmental units that many people agree should have access to private investments. The major changes to the qualified institutional buyer rule have the same impact, with several commenters indicating that this change allows more entities to invest in the large and growing market for unregistered bond offerings.

There also appears to be healthy support for the concept of the “professional knowledge” change, with the debate that exists appearing to be over what criteria to use to indicate sufficient financial sophistication. The SEC’s current proposed guidelines for qualification are based primarily on whether an individual holds the Series 7, 65 or 82 licenses issued by FINRA. This seems to be a relatively straightforward approach based on accepted and transparent criteria for gauging such sophistication.

Despite some agreement on several of the proposed changes, there remains some strong criticism. Some of the loudest is from those who argue that the rule changes weaken investor protections represented by the current accredited investor definition.

There is also very vocal criticism from a different angle: some commenters feel that the SEC is not going far enough in relaxing the accredited investor rules and that significantly more people should have access to private alternatives. Many of these commenters are industry participants with a vested interest in expanding the pool of potential private security investors. There are also some who argue it is simply unfair that only the wealthy may access private markets, which they view as offering investment opportunities that are superior to those available in public markets.

Greenleaf Views on the Proposed Changes

We agree that the accredited investor rule needed a fresh look to address some gaps and inconsistencies with other related rules. Amongst the major changes, the proposed change to allow trained and experienced investment professionals to be considered accredited investors seems sensible. We believe there are some areas of opportunity in private markets, and when investors are able to understand and bear the risks involved, we generally would hope that investors would have the ability to participate.

However, we find it noteworthy that the major investor advocacy groups that have weighed in on the rules changes are opposed to major changes. They note that this bright line represented by the current accredited investor definition, while perhaps a bit of a blunt tool, has worked well to protect less sophisticated investors from the types of fraud that have befallen some private market investors.

Indeed, most investors have difficulty properly assessing private investment opportunities. There are many who do not have a professional advisor like Greenleaf Trust who strives to work “from the client’s side of the desk” to assist them in their assessment. We note that a more significant expansion of the pool of eligible accredited investors might include those who are more susceptible to abuse. As a result, we hope the SEC will move cautiously and err on the side of investor protection when changing any rules.

Ultimately, the debate around these rule changes highlights the fact that rules and laws do not perfectly contemplate every situation facing investors. Investors will always bear the final responsibility in deciding how to invest their wealth. As a result, investors are always well-served to take a step back when contemplating an investment and to ask themselves a couple questions:

Do I feel comfortable that I understand the major risks of the potential investment, and

Is the potential investment sized appropriately so that I could suffer significant losses on it without compromising my ability to meet essential financial goals?

If you have trouble answering these questions, then you should seek out a trusted third party advisor to help guide you through your decision, regardless of what anyone else thinks of your wealth or sophistication.

As the proposed changes evolve, we will continue to evaluate the availability and appropriateness of private investment offerings that may help you reach your financial goals. If you have any questions or would like to discuss this content further, please contact a member of your dedicated client centric team.