Monday, October 7, 2013
In the last 30 years, it has become incredibly important whether or not investors in securities offerings are accredited investors. An issuer can sell securities to accredited investors without registration (and without alternative disclosure requirements) under both Rule 506 and new Rule 506(c) of Regulation D.Accredited investor status also matters in determining whether an issuer is a reporting company under the Exchange Act. A company must register under the Exchange Act only if it has 2,000 record holders of a class of equity security or "500 persons who are not accredited investors." Exchange Act sec. 12(g)(1)(A).
But the SEC may have taken a wrong turn when it defined the term to make individuals "accredited investors" based solely on the absolute level of their net worth or annual income.
The Section 4(a)(2) Exemption
Section 4(a)(2) [formerly, section 4(2)] of the Securities Act of 1933 exempts from registration “transactions by an issuer not involving any public offering.”
The leading case interpreting that statutory exemption is SEC v. Ralston Purina Co., 346 U.S. 119 (1953). In that case, the Supreme Court indicated that the availability of the exemption turns on “the need of the offerees for the protections afforded by registration.” According to the Court, what is now section 4(a)(2) exempts offerings “to those who are . . . able to fend for themselves.”
Since Ralston Purina, the cases analyzing section 4(a)(2) have focused primarily on the sophistication of the offerees and their access to information about the issuer.
The Rule 506 Safe Harbor
Sophistication and ability to fend for one's self are inherently uncertain concepts. In the early 1980s, the SEC adopted a safe harbor, Rule 506 of Regulation D, intended to make the issuer's task a little easier. Offerings that comply with the terms of the Rule 506 safe harbor are “deemed to be transactions not involving a public offering within the meaning of section 4(a)(2) of the Act." Rule 506(a).
Under Rule 506, securities may be sold to investors falling into two categories:
1. Accredited investors (or investors the issuer reasonably believes are accredited investors); or
2. Sophisticated investors. Investors who, either alone or with a representative, have “such knowledge and experience in financial and business matters that . . . [they are] . . . capable of evaluating the merits and risks of the prospective investment.” (There is also a "reasonable belief" clause protecting the issuer with respect to this category.)
The second category is true to Ralston Purina and cases applying Ralston Purina: the investor or someone representing the investor must be sophisticated. And, under Rule 502(b), those non-accredited investors must be furnished with information about the issuer.
Accredited investors do not have to be sophisticated and the issuer is not required to furnish them with the information required by Rule 502(b). Because of this, most Rule 506 offerings are limited to accredited investors.
Rule 506(c), recently added by the SEC pursuant to the JOBS Act, also limits sales to accredited investors. Unlike Rule 506, Rule 506(c) does not allow an issuer to sell to sophisticated, non-accredited investors. And Rule 506(c) imposes no information requirements.
Wealthy Individuals as "Accredited Investors"
The SEC's definition of "accredited investor" strays from the original Ralston Purina idea of investors who do not need the protection provided by registration, particularly with respect to its inclusion of wealthy individual investors.
An individual investor is accredited if, among other possibilities:
(1) her individual net worth, or joint net worth with her spouse, in both case excluding the person’s primary residence, exceeds $1 million (Rule 501(a)(5)); or
(2) the individual’s annual income over a period of years exceeds $200,000 or the joint net income with her spouse exceeds $300,000 (Rule 501(a)(6)).
The Possible Policy Rationales for Including Wealthy Investors
There are a couple of possible arguments for concluding that registration is unnecessary when securities are sold to these wealthy individuals. First, investors in these categories might be sophisticated enough to fend for themselves.
Obviously, not every person with an annual income greater than $200,000 or a net worth greater than $1 million has investment sophistication. For example, if someone just won $5 million in the lottery, there's no good reason to suppose that person is a sophisticated investor. (In fact, if the person is spending money on lottery tickets, the opposite assumption makes more sense.)
It would still make sense to use wealth as a proxy for sophistication if most wealthy investors were sophisticated. The gains in certainty might be worth the overinclusiveness. It's an empirical question, but there's no reason to suppose that most wealthy people are sophisticated investors. Federal securities case law is filled with doctors, dentists, and other wealthy investors making stupid investment decisions.
There's another reason we might conclude wealthy investors don't need the protection of registration: they can afford to lose the money. This alternative argument has at least two problems. First, neither income nor net worth are very good measures of liquidity. If the net worth of a wealthy investor consists primarily of illiquid investments, any loss from an investment in securities could be devastating.
The second problem with this alternative argument is that neither Rule 506 nor new Rule 506(c) limit the proportion of the investor’s net worth or income that may be invested in the offering. Because of that, even if an investor’s assets are liquid, the investor still may not be able to afford the loss.
Assume, for example, that an investor has a net worth of $1 million, consisting of $1 million cash and no liabilities. If the investor invests the entire $1 million in the Rule 506 offering, a loss could bankrupt the investor. The investor clearly cannot afford to lose the money invested in the offering.
A Better Approach?
The recent approach Congress took in the JOBS Act’s crowdfunding exemption is more consistent with the question of whether the investor can afford to lose the amount invested. That exemption places no limit on who may invest; both wealthy and non-wealthy investors may participate in crowdfunded securities offerings (once the SEC adopts the implementing regulations). But the amount an investor may invest is limited to a percentage of the investor’s net worth or annual income.
One may disagree with the percentages Congress chose; I have argued elsewhere those percentages are too high. But the basic idea is sound. If you limit the investor to some percentage of his net worth or annual income, the investor can afford a loss and is therefore less in need of the protection of registration.
The SEC simply took a wrong turn. Its focus on the absolute level of net worth or income doesn’t fit either a sophistication or an affordability rationale.