The SEC is set to come out with further revisions to the definition of accredited investor this month

[July 2014].
Under Rule 506 of Regulation D under the Securities Act, issuers can raise unlimited funds from
accredited investors in private offerings. When the SEC last reviewed the definition of accredited
investor exactly two years ago, the definition was revised to exclude the value of a persons primary
residence in the calculation of such persons net worth for purposes of meeting the minimum $1
million net worth test. The Government Accountability Offices July 2013 report and market survey
(titled Alternative Criteria for Qualifying as an Accredited Investor Should Be Considered, herein the
GAO Report) notes that this revision resulted in certain investors no longer qualifying as
accredited investors.
What the SEC has in store this time is noteworthy.
Under the current definition set forth in Rule 501 of the Securities Act, an individual is an
accredited investor if such person (i) has a net income in excess of $200,000 (or $300,000 with a
spouse) in each of the prior two years and reasonably expects the same for the current year or (ii) has
a net worth in excess of $1 million (either alone or with a spouse), excluding the value of such
persons primary residence.
These thresholds have been largely unchanged since the 1980s.
Any changes to the accredited investor definition must balance the SECs two primary albeit
competing goals of protecting investors and encouraging small business capital formation. One
proposal has been to simply adjust the thresholds in the definition for inflation. For example, the
GAO Report noted that adjusting the $1 million net worth threshold for inflation to $2.3 million
would decrease the number of qualifying households from approximately 8.5 million to 3.7 million.
Some commentators have opined that such a reduction in the number of eligible accredited investors
would have a very negative impact on private offerings. It seems likely that a 60 percent decrease in
eligible households would result in a decrease in funds provided by accredited investors. This ignores
the reality that smaller accredited investors have historically provided a disproportionately smaller
percent of capital raised. Still, many have argued that existing thresholds are sufficient, ignoring the
already occurring rise in investor fraud in the private placement market, evidenced by the states
securities regulatory web sites.
Though the GAO Report cites net worth as the most important criteria for determining accredited
investor status, the report did list other possible modifications to the definition that the SEC may
consider, including, among others, (i) a liquid investments requirement (i.e., a minimum dollar
amount of investments that can be easily sold and whose value can be verified), (ii) use of a
registered investment adviser, and (iii) self-certification, licensing or other education standards to
establish investor sophistication (e.g., attorneys and certified public accountants may be deemed to
be accredited investors).
The report notes, similarly, that requiring $250,000 of a persons net worth to be liquid would
certainly protect investors by making sure they can better absorb potential losses, but would come at
the cost of reducing the number of eligible accredited investors and thus available capital. Requiring
use of a registered investment adviser or establishing other sophistication criteria (in the absence of
other financial requirements) may result in more eligible accredited investors and available capital,
but may result in investors participating in private placements who are unable to withstand
significant losses.
Small businesses should keep in mind the coming final rule for Regulation A+ should increase the
cap from $5 million to $50 million as a middle road for private companies to raise larger amounts of
capital without going public.
Finally, it should be noted that hedge funds often make use of the exemptions afforded by Sections
3(c)(1) and 3(c)(7) of the Investment Company Act of 1940, which rely on a funds ability to use the
private placement exemption under the Securities Act, usually by way of Rule 506.