Some of our fondest childhood memories occurred at the amusement park. The anticipation of riding the roller coaster was so intense we could barely contain ourselves. We waited in line for what seemed to be an eternity and when it was finally our turn we were confronted by a sign that read, "You Must Be This Tall to Ride."
Those of us who didn't meet the height requirement were emotionally devastated. Reluctantly, we left the park and went home. The next year we returned, even more enthusiastic because we knew the rules of the rollercoaster and, more importantly, were three inches taller. We stood confidently and pressed our backs against the plywood height marker, knowing that our heads were well above the line that separated despair from happiness. Victory was ours.
We then immediately exercised our constitutional right to pursue some happiness. It was a good day.
Now imagine coming back the year after that, and just as you were about to strap into your seat on Space Mountain someone callously informed you that the height requirement had increased by five inches.
You were once again prohibited from riding the rollercoaster even though you rode it the prior year and were none the worse for wear. You understood the safety protocol, adhered to the rules, and even possessed bonafide experience, but now taller children without experience were permitted to ride while you were sidelined.
The same thing could be happening right now in the financial world, so to speak.
All offers and sales of securities must either be registered with the SEC under the Securities Act of 1933 (the "Securities Act") or be subject to an available exemption to registration. The purpose of registration is to provide investors with full and fair disclosure, allowing them to make informed investment decisions.
When creating the registration and exemption requirements, Congress and the SEC recognized that not all investors needed the protection of public registration and not all situations possessed a practical need for formal registration. These exempt offerings merely require a rudimentary investor disclosure document, are not subject to ongoing federal reporting requirements, and their respective offering documents are not reviewed by the SEC. Due to these abbreviated standards, exempt offerings carry a much greater degree of risk and are intended for sophisticated, accredited investors.
Regulation D provides the most commonly used registration exemptions. Approximately $1.3 trillion was raised under Regulation D in 2014 alone. The definition of accredited investor provides the backbone to the Regulation D exemptions and is intended to protect unsophisticated and low-net-worth investors from participating in high-risk, technical offerings that possess an inherently greater probability of financial loss.
The first definition of accredited investor was established in 1982 and has not been comprehensively re-examined since. However, in 2011 the Dodd-Frank Act narrowed the definition to exclude an individual's primary residence from the net worth calculation.
Presently, a person qualifies as an accredited investor if they either have a net worth that exceeds $1 million (not including their primary residence), or if they have an annual income in excess of $200,000 for the past two years, or joint income with their spouse in excess of $300,000, and a reasonable expectation that the same income level will continue.
Although the SEC has yet to memorialize actual proposed changes, they have published an extensive report on potential changes and have requested public comment. The SEC staff recommends a complete revision to the definition of accredited investor that includes the addition of investment limitations to the current income and net worth thresholds and the creation of higher thresholds that would not have investment limitations. Moreover, the SEC staff suggests indexing the thresholds for inflation.
The SEC is considering these changes to protect unsophisticated investors from losing money they can't afford to lose in high-risk scenarios that they don't really understand.
Qualifying as an accredited investor is the essential criterion that must be satisfied in order to participate in an exempt offering. Equally vital is the issuer's ability to confidently rely upon the rules that govern exemptions from registration as well as the corresponding definition that determines who is genuinely accredited.
Should the accredited investor criteria become more exclusionary investors who meet the current accredited-investor standard, and who actively invest in sophisticated high-risk investments, may be limited from doing so in the future. When the Dodd-Frank Act amended the accredited investor definition to exclude a person's primary residence from the net income calculation, the new criteria were put into effect immediately. Due to the manner in which this previous modification was implemented, it is unlikely that there will be any type of grandfather policy attached to a revised accredited investor definition.
So as to counterbalance this narrowing effect, the SEC staff does suggest adding sophistication credentials that may reclassify currently unaccredited investors as accredited. In early 2015 the SEC Advisory Committee on Small and Emerging Companies suggested that any changes made to the definition of accredited investor should have the effect of increasing, not decreasing, the quantity of accredited investors. The Committee reiterated this view in a meeting held on May 18, 2016.
Since a high net worth is not necessarily an indicator that an investor truly understands the inherent risks of exempt offerings, investment experience and other intellectual qualifiers may prove to be more effective criteria.