Unsophisticated wealth: reconsidering the SEC's "accredited investor" definition under the 1933 Act.

AuthorFinger, Wallis K.
  1. INTRODUCTION

    Paris Hilton almost certainly can purchase unregulated securities issued by hedge funds or other private investment vehicles. Although her training and sophistication in the field of high-stakes financial transactions may be limited, the Securities and Exchange Commission (the "SEC" or the "Commission") would leave her to her own devices if she chose to invest in private offerings. On the other hand, assume Sheryl has an M.B.A. from Harvard and is a graduate of one of the country's leading Ph.D. programs in financial systems analysis. After all of this schooling, Sheryl is long on debt and short on assets. She has several offers to work at the nation's most prestigious investment brokerages. But if Sheryl wants to invest in a private offering, the SEC regulations will not allow it. Sheryl is barred from investing in private offerings because, unlike Paris Hilton, Sheryl does not have sufficient income or net worth to be an "accredited investor." Though ironic, this hypothetical contrast demonstrates the current state of securities law in the United States. The apparent incongruity of this example warrants a closer examination of the SEC's accredited investor definition and raises the question: is there a better way?

    The SEC regulates and oversees the purchase and sale of securities. (1) Under Section 4 of Securities Act of 1933 (the "1933 Act") (2) or Regulation D, (3) promulgated under the 1933 Act, certain securities offerings are exempt from registration requirements, so long as certain offering conditions are met. (4) One such condition is that investors participating in private offerings generally must be accredited. (5) Under the current definition, an accredited investor is one "whose individual net worth, or joint net worth with that person's spouse, at the time of his purchase exceeds $1,000,000," or alternatively, one "who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person's spouse in excess of $300,000 in each of those years, [with] a reasonable expectation of reaching the same income level in the current year." (6) Hedge funds, along with other private investment vehicles such as private equity funds, typically sell securities to accredited investors as one way of maintaining their exempt status. (7)

    On December 27, 2006, the Commission released proposed revisions to its accredited investor definition. (8) The SEC drafted the proposed revisions with an eye toward providing additional investor protections in light of the increased number of investors who have achieved accredited investor status. (9) To meet this goal, the Commission proposed a new category of accredited investor called the "accredited natural person," which would apply to persons transacting in private investment vehicles under Regulation D (10) and Section 4(6). (11) The Commission specified that the accredited natural person had to meet "either the net worth or income test specified in rule 501(a) or rule 215 [sic], as applicable, and [own] at least $2.5 million in investments." (12)In connection with its December 27, 2006, release, the SEC issued a call for comments on the accredited natural person standard. (13) In response, the SEC received numerous comment letters, (14) both in support (15) and in opposition. (16)

    On August 3, 2007, the Commission proposed additional revisions to the accredited investor definition. (17) The SEC's proposal included adding an "investments-owned standard" as an alternative means of establishing accredited investor status. (18) Under this investments-owned standard, individuals and spouses with $750,000 in investments would be deemed accredited. (19) The SEC also continued to consider its proposed accredited natural person definition. (20) Similar to the earlier December 27, 2006, release, the Commission issued a call for comments and again received comment letters in support of (21) and in opposition to its proposal. (22)

    In light of this disagreement among commentators over how to revise the current accredited investor definition, a reexamination of the definition is necessary. Reconsideration is also relevant given legal criticisms of the current standard, (23) as well as the perceived deficiencies in proposed scholarly alternatives to the current accredited investor definition. (24) Finally, the need for this review is heightened by the tremendous growth of the hedge fund industry over the past two decades (25) and the projection that hedge fund assets will likely exceed $1 trillion in the next five to ten years. (26) This Note reexamines the current accredited investor definition and proposes a licensing scheme to supplement the current definition.

    Part II of this Note provides a history of the 1933 Act, Regulation D and the accredited investor standard. Part II also details the need for change in the current accredited investor standard by explaining the evolving financial landscape, presenting scholarly criticisms of Regulation D, and examining proposed alternatives to the current definition. Part III surveys the problems with the current wealth-based accredited investor regime and details the shortcomings of existing scholarly alternatives. Ultimately, Part IV proposes a licensing scheme which would supplement the current accredited investor definition. This system incorporates two different licensing exams: one for those natural persons who are accredited investors under the current definition, and one for those natural persons who are currently unaccredited.

  2. BACKGROUND

    1. The History of Regulation D

      Congress passed the 1933 Act in the aftermath of the Stock Market Crash of 1929, during the early years of the Great Depression. (27) With the 1933 Act, Congress attempted to regulate the offer and sale of securities, which previously had been regulated by a patchwork of state laws. (28)

      The purpose of the 1933 Act, as stated in its preamble, is "[t]o provide full and fair disclosure of the character of securities sold in interstate commerce and foreign commerce and through the mails, and to prevent frauds in the sale thereof, and for other purposes." (29) The legislative histories of the 1933 Act and the Securities Exchange Act of 1934 (the "1934 Act") (30) reflect concerns that investors participating in the financial markets were not sufficiently protected against inadequate disclosure, misrepresentation, and manipulative schemes. (31)Congress feared that if investors were victimized as a result of insufficient market safeguards, they would lose confidence in the financial markets. (32) The Commission attempted to implement safeguards to prevent loss of investor confidence and provide investors with adequate disclosure by implementing the mandatory use of registration statements for securities sold to the public. (33)

      The 1933 Act delineates two types of securities offerings: public offerings and private offerings. (34) Public offerings of securities must be registered and approved by the Commission. (35) In contrast, certain private offerings of securities are exempt from the 1933 Act's registration requirements. (36) The 1933 Act's legislative history details that the private offering exemption allowed "an issuer to make a specific or an isolated sale of its securities to a particular person," and was directed at transactions "where there [was] no practical need for [the bill's] application or where the benefits [were] too remote." (37) Initially, exemptions were determined by examining a number of factors, such as the number of offerees and their relationship to each other and the issuer, the number of units offered, and the manner of the offering. (38)

      In 1953, the Supreme Court decided Securities and Exchange Commission v. Ralston Purina Co. (39) The SEC brought suit against Ralston Purina because the company sold unregistered common stock to its employees. (40) Ralston Purina claimed that its employee stock sales were exempt because the offerees were key employees. (41) The Court recognized that the private offering exemption was ill-defined and attempted to clarify its scope. (42) The Court looked to the 1933 Act's legislative history regarding the private offering exemption, and held that "[s]ince exempt transactions are those as to which 'there is no practical need for [the bill's] application,' the applicability of [the exemption] should turn on whether the particular class of persons affected needs the protection of the Act." (43) After Ralston Purina, a private offering was "[a]n offering to those who are ... able to fend for themselves." (44)

      In the 1970s, financing via private offerings expanded, (45) and the SEC and the judiciary struggled with the practicality and efficiency of determining investor suitability on a case-by-case basis. (46) In response, the SEC enacted Rule 146 in 1974 to create an objective means to determine investor suitability. (47) Under Rule 146, an issuer had to meet three requirements for an offering to be exempt from registration requirements. (48) First, the issuer had to have a reasonable belief that the offeree was sophisticated, which was generally demonstrated by wealth or knowledge. (49) Second, prior to completion of the sale, the issuer had to have a reasonable belief that the purchaser could assess the risks and merits of the offer, or that the purchaser had consulted a financial advisor and could bear the financial risks of the offer. (50) Third, the issuer had to provide the offeree with the type of information that would be provided in a registration statement. (51)

      Rule 146 was not the panacea that the Commission hoped it would be. (52) The rule resulted in compliance problems for small issuers who were uncertain whether the private offering exemption was available, (53) primarily because investor suitability was determined by subjective criteria. (54)

      In 1980, the SEC replaced Rule 146 with Rule 242. (55) With the promulgation of Rule...

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