- Lawmakers and federal regulators are contemplating changing the definition of “accredited investor.”
- It determines who can invest in private, unregulated investments, including most startups and VCs.
- Some say the current definition leaves too many people out, but others say it doesn’t go far enough.
There’s a philosophical debate raging in Washington that could transform the multitrillion-dollar capital markets and change the way startups raise money.
In the past month, three bills have passed the House of Representatives that would expand the definition of “accredited investor,” which regulators use to determine who is allowed to buy unregistered securities, or securities that are not subject to normal disclosure requirements.
At the same time, the Securities and Exchange Commission, or SEC, under the current chair Gary Gensler, is reviewing a series of rules that could narrow the definition of “accredited investor” and impose sweeping new regulatory requirements on private markets.
It’s a debate over who should be allowed to risk their money in the shadowy world of private-market and startup investing, away from the well-lit public exchanges where shares in companies like Apple and Google trade with full transparency.
What is an accredited investor?
To some, the definition of “accredited investor” is a relic and a straitjacket that hamstrings growing companies and disproportionately excludes people of color and those with low income. To others, it’s the only thing standing between retail investors and charismatic grifters such as Elizabeth Holmes and Sam Bankman-Fried.
The origins of the definition of “accredited investor” trace back to the Great Depression and the Securities Act of 1933.
Passed in response to the stock-market crash of 1929, the act created the SEC and imposed strict disclosure requirements on any issuer looking to sell securities to the general public. It’s the reason that, to this day, publicly listed companies issue quarterly reports with audited financial statements.
For nearly 50 years, the standards laid out in law governed nearly all of the capital markets. Then, in 1982, with the Wall Street ascendant and President Ronald Reagan preaching the gospel of deregulation, the SEC adopted Regulation D, or “Reg D,” as it’s commonly referred to.
The rule created an exemption allowing issuers to raise an unlimited amount of money without any of the normal disclosure requirements, provided that they only sell securities to accredited investors, which the SEC defined as anyone who has a net worth of at least $1 million or makes at least $200,000 a year.
This distinction is particularly relevant for startups, which generally stick to raising money only from accredited investors to avoid the onerous, and often prohibitively expensive, disclosure requirements of a public offering.
And since the Reg D exemption’s creation, private markets have become the dominant way for most issuers to access capital markets. According to SEC data, between July 2021 and June 2022, nearly $4.5 trillion was raised in the private markets, compared to the $1.2 trillion raised in the public markets during this period. Initial public offerings, once the go-to way for growing companies to raise money, accounted for only $126 billion raised over that same period.
“Private issues are a much more important aspect of the capital markets today than they were in 1982,” Rep. J. French Hill of Arkansas, who sponsored the Fair Investment Opportunities for Professional Experts Act, which passed the house earlier this month, said. The bill would expand the definition of “accredited investor” to include people who don’t meet the financial qualification but who have professional experience related to the investment in question.
“It’s a great way to offer more opportunities to more people, particularly in the Hispanic and African American community, who are concerned with building net worth,” he said.
Rep. Maxine Waters of California, the ranking Democrat on the House Financial Services Committee, reached across the aisle to rally support for Hill’s bill. This put her at odds with some of her fellow Democrats, including Senator Elizabeth Warren of Massachusetts, who told Politico that the bill was “not good for investors and, ultimately, not good for markets.”
The House also recently passed two other bills designed to expand the accredited-investor pool, including the Equal Opportunity for All Investors Act, which would set up an accreditation exam for would-be investors, and the Accredited Investor Definition Review Act, which would give the SEC broad authority to expand the definition as it sees fit.
‘Bad things happen in the dark’
Despite bipartisan support for the bills, not everyone is on board.
“These private markets are dark, there’s little information about them and, you know, bad things happen in the dark,” Micah Hauptman, the director of investor protection at the Consumer Federation of America, said. He argued that without the investor protections of public markets, retail investors would be “sitting ducks” susceptible to scams and deceptive business practices.
Beyond that, he said he worries that these investors won’t be able to compete with institutional investors such as public pension funds and other large asset managers. “The CalPERS and Yale Endowments of the world will always get access to the best deals, whereas somebody with a million-dollar net worth is gonna get the dregs, the bottom of the barrel,” Hauptman said.
According to analysis from the Brookings Institution, in 2020, 13.85% of US households qualified as accredited investors, compared with just 1.8% in 1983.
That rapid expansion is due in large part to the fact that the income and net-worth thresholds established in 1982 haven’t been updated for inflation. Some advocates have called on the SEC to adjust those thresholds to current price levels, which would raise the income requirement to about $645,000 and the net-worth requirement to about $3.2 million
Even that simple change could have an outsized impact on at least one group: angel investors. Marcia Dawood, the chair of the board of the Angel Capital Association, or ACA, which represents over 15,000 accredited angel investors, said indexing to inflation could disqualify more than half of the ACA’s members overnight. She said that this will imperil an important source of funding for fledgling startups.
“Angels are the ones who fuel companies at the earliest stages,” she said. “If angels weren’t around, you wouldn’t see a lot of the in innovation that we have today.”
Dawood also said that angel investing is an important channel for investors who wouldn’t otherwise have access to the startup ecosystem. Women make up nearly 34% of all angel investors compared with just shy of 15% at traditional VC funds.
The ACA has hired a Washington lobbying firm and is pushing Congress and the SEC to expand the definition of accredited investors.
But debate over who is sophisticated enough to wade into private markets misses the point, Tyler Gellasch, a former securities lawyer for the SEC and the current CEO of the Healthy Markets Association, which represents institutional investors such as public pension funds, said.
Rather than police who is allowed to invest in which securities, Gellasch said, a more effective approach would be to require more transparency from the issuers themselves.
“Trying to come up with a test for who should be an accredited investor is a little bit like assigning a driving test to see who’s going to be the best driver while blindfolded. You might be a brilliant investor, but if you don’t have information, you’re gambling,” Gellasch said.
Though it seems unlikely that we would return to a pre-1982 world in which the vast majority of issuers are subject to strictest disclosure requirements, Gellasch said, a move toward more transparency could help alleviate many issues at the heart of the accredited-investor debate.
“There’s a reason why FTX and Theranos were able to happen,” he said. “Had they been public, or at least required to publicly disclose information about the business, they would’ve fallen apart much earlier.”
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