“Open Season” on the Accredited Investor Standard: GAO Recommends Alternative Criteria
The Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) mandated that the U.S. Government Accountability Office (GAO) conduct a study on the criteria for individuals to be considered “accredited investors” under Regulation D of the Securities Act of 1933 (the Securities Act). On July 18, 2013, the GAO released its report summarizing the results of this study, which portends significant changes to the accredited investor criteria for individuals under Regulation D.
The GAO report follows on the heels of recent rulemaking by the Securities and Exchange Commission (SEC) which lifted the ban on general solicitation in certain private offerings under Regulation D and imposed new requirements on such offerings. Additionally, in a separate release, the SEC proposed further changes to Regulation D offerings, including various filing requirements. Under the Dodd-Frank Act, the SEC is also required to review the definition of accredited investor in its entirety in 2014, a process which the SEC has indicated is already underway. Accordingly, in its recent Regulation D releases, the SEC specifically requested comments on the definition of accredited investor as it relates to natural persons. In a letter to the GAO, the SEC has also now stated that it will take into account the recommendations of the GAO report as part of its mandated review of the accredited investor definition.
Background. Regulation D sets forth various safe harbors for issuers to conduct securities offerings without registration under the Securities Act. Small businesses, including startup companies, as well as hedge funds and private equity funds, often rely on Rule 506 under Regulation D to issue securities to fund their operations and/or investment activities. Under Rule 506, an unlimited number of “accredited investors” and up to 35 non-accredited (but sophisticated) investors may participate in the securities offering. However, under the new rules, if the issuer engages in general solicitation or general advertising in connection with the offering or does not provide investors with a disclosure document for the offering that provides information similar to the information to be provided in a registered offering, all investors in the offering must be accredited investors. Currently, an individual can qualify as an accredited investor under Regulation D by meeting either of the following two criteria: (a) having a net worth (or joint net worth with his or her spouse) of more than $1 million (excluding the value of the investor’s primary residence) or (b) having had income exceeding $200,000 (or joint income with his or her spouse exceeding $300,000) in each of the previous two years and a reasonable expectation of achieving the same income level in the current year. Generally speaking, these investor net worth and income criteria are seen as indicative of the investor’s financial experience, sophistication, bargaining power, and ability to bear risk, thereby lessening investor protection concerns for these investors in an unregistered securities offering.
GAO Study. In conducting its study, the GAO surveyed 27 participants in the private securities market, including attorneys, investors in private placements, retail investors, broker-dealers and investment advisers.  The GAO solicited the study participants’ views on the existing net worth and income criteria, as well as eight alternative criteria that were derived by the GAO from prior SEC proposals, academic literature and criteria used by foreign regulators for establishing investors’ experience, sophistication and investment wherewithal. The alternative criteria consisted of (i) requiring that a certain amount of the investor’s net worth consist of liquid investments, (ii) limiting the percentage of an investor’s net worth or income that could be invested in any particular private placement, (iii) requiring investors to use registered investment advisers to manage their investment accounts, (iv) permitting investors to self-certify as to their experience and sophistication based on membership in a network of investment groups, employment history or relevant investment experience, (v) requiring investors to obtain a license or certification from a regulator or third party in order to participate in a private offering, (vi) requiring investors to pass a sophistication test following SEC-approved coursework, (vii) allowing investors to qualify based on an advance degree in business or finance or designation as a chartered financial analyst or similar professional and (viii) permitting investors to opt-in to a private placement by signing a waiver of rights to file a complaint seeking compensation for any reason other than issuer fraud.
Survey respondents were asked for their views on adjusting the current criteria and/or implementing any of the alternative criteria, from the standpoints of both investor protection and capital formation, as well as their assessment of the feasibility of implementing such measures. The GAO report includes detailed descriptions of its survey methodology and results.
There were few points of consensus among the survey participants as a whole, except that there was general agreement that utilizing the investor net worth criteria best balances the goals of investor protection and capital formation. Respondents had differing opinions on whether the current dollar thresholds in the existing criteria should be adjusted and whether increasing the thresholds would have a significant impact on investor protection. The GAO observed that a substantial number of respondents thought that raising the thresholds would have no effect on investor protection and most thought that it would limit capital formation. Therefore, the GAO did not, as many had anticipated, recommend an increase in the net worth threshold. Of course, the SEC may still determine to raise the thresholds of its own accord.
Report Recommendations. Based on the information developed in its survey, the GAO report recommends that the SEC should consider alternative criteria, including those listed in the report itself, to determine an individual’s ability to bear and understand the risks of investment in private placements. Among the eight alternative criteria in the study, the GAO noted that a liquid investment requirement [item (i) above] and use of an investment adviser [item (iii) above] were two additional criteria that would balance investor protection and capital formation, as well as be “relatively feasible” to implement.
SEC Comments. In response to a draft of the GAO report, the SEC provided written comments that stated that it will consider alternative criteria (particularly the liquid investment requirement and use of an investment adviser) in completing its mandated review of the accredited investor definition in 2014 and will factor the GAO report into this review.
Based on the GAO Report’s recommendations, and the SEC’s accompanying comments, it seems likely that significant modifications to the accredited investor standard for individuals will ultimately by proposed and implemented by the SEC, which could have a considerable impact on private capital raising by companies and private funds that rely on Regulation D offerings to raise capital.
For more information regarding this Client Alert, please contact Lori Smith (212.714.3075 | firstname.lastname@example.org) or Neil Casey (212.631.4414 | email@example.com) in our New York office or Merritt Cole (215.864.7018 | firstname.lastname@example.org) in our Philadelphia office.
 The GAO report acknowledges that the results of its study are not “generalizable to the population of market participants and only represent the opinions of these 27 individuals.”
 The GAO report noted, for example, that increasing the minimum net worth threshold from $1 million to $2.3 million (to adjust for the effects of inflation) would decrease the number of U.S. households qualifying as accredited investors from approximately 8.5 million to approximately 3.7 million.