COMMENTARY

Redefining the definition of accredited investor

By D.J. Paul
Propellr

Revisiting the definition of accredited

investor has been of interest since the
current definition was first promulgated by
the Securities and Exchange Commission
in 1982. Recently, though, the subject has
taken on significant additional traction.
Various thought-leaders, industry trade
organizations and investor advocacy groups
are now weighing in on the topic anew.

Rule 506(c) which allows for issuers to

advertise their offerings but only accept
funds from verified accredited investors.
Several proposals are making the rounds:

Adjust the current financial test for

inflation.

Jettison the current financial test entirely

and replace it with some kind of test for

An individual investor seeking accredited investor status must

earn $200,000 annually for the past two years ($300,000
for married couples) or have a net worth exceeding $1 million,
excluding his or her primary residence.
Indeed, the definition of accredited investor
was a specific topic for one of the breakout
sessions of the SECs annual Small Business
Forum in Washington on Nov. 20. Moreover,
there are rumblings that the new Congress,
when it convenes in January, may take up the
issue, should the SEC fail to address it in a
timely manner.
Presently, an individual investor seeking
accredited investor status must earn
$200,000 annually for the past two years
($300,000 for married couples) or have a net
worth exceeding $1 million, excluding his or
her primary residence.1
Under Rule 506(b) of Regulation D, which
is the most commonly used securities
registration exemption, only accredited
investors are allowed to legally invest in
private securities offerings. Last year, the SEC
added another exemption under Reg. D

Keep the current financial test in place

but supplement it with an alternative
test based on sophistication and let
potential investors qualify based on one
or the other.

Why the renewed interest in this topic now?

This may be, in part, because a provision
in the Dodd-Frank Act2 of 2010 mandates
that the SEC review the accredited investor
standard every four years. It may also be
because the JOBS Acts Title II specifically
allows general solicitation of accredited
investors by issuers for certain Regulation D
offerings, which makes the issue of exactly
who is an accredited investor even more
important.

D.J. Paul is the chief strategy officer of Propellr, a New York-based real
estate investment crowdfunding platform. He also is the co-chair of the
CrowdFund Intermediary Regulatory Advocates and was recently
appointed as a member of the Securities and Exchange Commissions
advisory committee on small and emerging companies.

2014 Thomson Reuters

SIGNIFICANCE TO THE ECONOMY

sophistication based on an investors

professional credentials or investment
experience.

Further, with the SECs continued delay

in implementing Title III and proper nonaccredited crowdfunding, there has been
a proliferation of accredited investor-only
investment platforms. Over the last 18
months, these would-be crowdfunding
sites have pivoted toward the only business
currently legal for them to pursue:
Regulation D offerings, which are available
to their accredited investors. Because of this,
a new cadre of financial services businesses
suddenly has a stake in the accredited
investor definition.

It would be difficult to overstate importance

of the private placement market in general,
and the Regulation D market in particular, to
American capital formation and the economy
at large. Any significant change in the
current accredited investor standard would
have a profound effect on the Regulation D
market.
This securities class is already enormous
and continues to grow. An SEC report
published in July 2013 found that Regulation
D offerings have been responsible for more
than $3.3 trillion in funding from more than
37,000 discrete offerings between 2009 and
2012.3
Over $1 trillion was raised in Regulation D
offerings in 2013.4 By comparison, the IPO
market raised just under $250 billion in
2013.5
This is even more striking when one considers
that IPOs are, by definition, available to
all investors, but Regulation D offerings
are available only to accredited investors.
Various estimates, including those of the
Government Accountability Office, suggest
the total number of eligible accredited
investors in the U.S. is about 8 million. Of
this number, less than 12 percent actually
invest in Regulation D offerings. So, this
robust market is primarily supported by fewer
than 1 million investors.

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VOLUME 20

ISSUE 15 | 3

HISTORY AND PRECEDENT

Before examining and evaluating the sundry
proposals for modifying, augmenting or
scuttling the current definition, it is worth
reviewing how the current definition came to
be. The Securities Act of 1933 distinguished
between public and private offerings in
Section 4(2), providing an exemption from
registration for nonpublic offerings.
In 1935 the SECs general counsel
promulgated five factors to determine
whether an offering is public or private:

The number of offerees.

The offerees relationship to the issuer.

The number of units of securities

offered.

The size of offering.

The manner of offering.

Despite this, for almost 20 years, the only

test the SEC regularly used to determine
whether an offering was public or private
was the total number of investors offered the
security. The threshold number to make this
determination was often 25.
With the Ralston Purina decision of 1953,6
the U.S. Supreme Court ruled that a private
offering was one made to sophisticated
investors. The court said an offering to
those who are shown to be able to fend for
themselves is a transaction not involving any
public offering.
In 1974 with Rule 146, the SEC provided
that prior to making an offer, the issuer
and any person acting on its behalf had to
reasonably believe that the offeree was either
sophisticated or wealthy. Sophistication,
in this context, meant a person who had
sufficient knowledge and experience in
financial and business matters to make them
capable of evaluating the merits and risks
of the prospective investment.7 Wealthy
suggested a person who was able to bear the
economic risk of the investment.
This all sounds fairly reasonable. The SEC
had implemented a two-pronged standard
that recognized potential investors as able
to fend for themselves, either because they
were smart or rich.
There was a problem, however.
The
broker-dealer community was deeply
concerned about the rather fuzzy notions
of sophistication and wealth. The BDs
were frightened at the potential liability of

4 | WESTLAW JOURNAL

deeming an investor to be sophisticated

enough or wealthy enough without some
kind of verifiable, objective and, ultimately,
defensible standard. The BDs wanted a
bright-line test.
So, the SEC accommodated the BDs
concerns with the simplest solution: Rescind
the sophistication test and establish hard
dollar amounts for what constitutes wealthy
for the purposes of purchasing these
securities.
In 1982 the SEC effectively replaced Rule
146 as it pertained to sophisticated
investors with Regulation D by establishing
the accredited investor test for natural
persons, which remains in use today. An
accredited investor was thereby established
to be someone with a net worth in excess of
$1 million or an annual income of $200,000
(or $300,000 for married couples).

it is needed. Based on the Ralston Purina

decision, it can reasonably be argued that the
court believed Congress intended to protect
only those who need protection.

ANOMALIES
The current standard has created some
odd and inequitable exclusions from the
market of investors who might otherwise
be considered appropriate buyers of private
securities.
For example, a young investment broker who
does not yet make $200,000 per year and
has not accumulated $1 million in net worth
cannot personally purchase Regulation D
offerings. Yet, that same broker, having
passed the Series 7 or 82 examination
administered
by
Financial
Industry
Regulatory Authority, can sell Regulation D
offerings to clients.

Any significant change in the current

accredited investor standard would have a
profound effect on the Regulation D market.
For all practical purposes, the SEC
abandoned the test for sophistication and
has relied primarily on a test of an investors
ability to bear the economic risk of the
investment. This has remained unchanged
but for the statutory exclusion of equity
in a primary residence from the net worth
computation by the Dodd-Frank Act of 2010.

THE CURRENT DEFINITION

AND RALSTON PURINA
It seems pretty clear that, while certainly
functional, the current accredited investor
definition strays rather far from the Supreme
Courts guidance on this issue from the
Ralston Purina decision and from the original
congressional intent that case addressed.
The court used unusually plain language in
describing sophisticated investors as those
who could fend for themselves.8 If the court
had intended the test to be purely financial, it
could have written something like investors
who can take the financial hit, but the court
did not make such a statement.
Furthermore, as the court in Ralston Purina
points out, the legislative history shows
a clear congressional determination that
while some people need to be protected,
that protection is intended to apply where

SECURITIES LITIGATION & REGULATION

The same is currently true of other financial

professionals.
Registered investment
advisers, certified public accountants or
attorneys with wealthy clients may offer
recommendations about Regulation D
offerings, but may not be permitted to buy
these securities themselves because they do
not meet the income or net worth tests.
These examples demonstrate that the
current situation creates the very lack of
alignment between financial advisers and
their clients that much of securities law and
regulation seeks to establish and reinforce.
Furthermore, several of the aforementioned
professionals are trusted by the SEC as
reliable third-party verifiers to confirm
whether an investor is accredited for purposes
of Regulation D Rule 506(c).
It seems paradoxical, if not contradictory,
that a member of one of these professions
can be relied upon to attest to a clients
qualification for Regulation D investment but
cannot be relied upon to attest to his or her
own qualification.
There are certainly many varying opinions
on what shape and form the accredited
investor definition should take, representing
not just different points on the political
2014 Thomson Reuters

continuum, but also distinct world views.

Broadly speaking, the debate centers
around determining the proper role of the
SEC (and of government generally); is it
to protect investors from fraud, or is it to
protect investors from their own imperfect
judgment?

Over $1 trillion was raised

in Regulation D offerings in
2013. By comparison, the
IPO market raised just under
$250 billion in 2013.
THE PROBLEM OF DATA
There does seem to be somewhat of a
consensus with respect to the lack of data
available on this market, despite its size and
import.
A report released in October by the SECs
Investor Advisor Committee9 and a letter
submitted to the SEC from the CrowdFund
Intermediary Regulatory Advocates10 take
very different positions with respect to the
issue. Both point out, however, that there is a
paucity of accurate data on the demographics
of the current active accredited investor base
in the Regulation D market, as well as the
overall market.

Both bodies recommended that the SEC

implement a program facilitating the
collection of such data and disseminate it
publicly before contemplating any change to
the accredited investor definition.

requiring a balance between protecting

investors and meeting the demands of the
market and economy at large. WJ

NOTES
Sec. & Exch. Commn, Net Worth Standard
for Accredited Investors.,17 CFR pts. 230, 239,
270 and 275, which adopts Section 413(a) of the
Dodd-Frank Wall Street Reform and Consumer
Protection Act, available at http://1.usa.gov/
11Qhq7O.
1

CONCLUSION
The current income and net-worth-based
accredited investor definition is the de
facto standard the SEC has enforced for
the past 32 years. Perhaps now that this
standard is being re-examined, there needs
to be a discussion as to whether the current
definition follows congressional intent, as
well as the clear guidelines put forth by the
Supreme Court in 1953 in Ralston Purina.
Should private securities only be sold to
those able to fend for themselves?
Certainly, more data is needed before any
significant change should be made to this
definition. The stakes are incredibly high for
a market that regularly accounts for $1 trillion
of capital formation annually.
Indeed, any attempt to further contract
the limited number of eligible accredited
investors would be disastrous for a variety of
critically important industries that rely on the
Regulation D market, including real estate,
biotech/healthcare, technology and energy.
As with many aspects of securities regulation,
the issue is both nuanced and complex,

Dodd-Frank Act, Title IV, 413.

Vladimir Ivanov & Scott Bauguess, Capital

Raising in the U.S.: An Analysis of Unregistered
Offerings Using the Regulation D Exemption,
2009-2012 (July 2013), available at http://
1.usa.gov/1vFeqZ7.
3

Speech by SEC Chair Mary Jo White, Chair,

Sec. & Exch. Commn, Speech at the 41st Annual
Securities Regulation Institute (Jan. 27, 2014),
available at http://1.usa.gov/11Qhwwg.
4

Ivanov & Bauguess, supra note 3.

SEC v. Ralston Purina Co., 346 U.S. 119 (1953).

Securities Act of 1933, Rule 506(b), 4(a)(2).

Ralston Purina, 346 U.S. at 125.

Sec. & Exch. Commn, Recommendation of

the SEC Investor Advisory Committee: Accredited
Investor Definition (Oct. 9, 2014), available at
http://1.usa.gov/1C5asMb.
9

Letter from David J. Paul, Co-Chair,

CrowdFund Intermediary Regulatory Advocates,
to Elizabeth M. Murphy, Secretary, Sec. & Exch.
Commn (Aug. 25, 2014), available at http://
1.usa.gov/1teI68R.
10

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