One of my fondest memories of high school is All-State Orchestra, which brought together serious high school musicians from throughout the state. Every fall, students auditioned for a seat in the orchestra, and the orchestra met for a long weekend in the spring for an intensive orchestra experience under the baton of an esteemed visiting conductor.
When I participated, the student had to be in grades 10-12, enrolled in orchestra at their high school, that they prepare the required audition music, and show up in person in the state capital for auditions. Plus, the school orchestra director had to be a member of the state music teachers’ association (Association).
All-State, therefore, was open only to a limited number of high school students–even if they played their instruments at a high level. If a student’s school didn’t have an orchestra or they were home-schooled, or couldn’t audition on the prescribed date, or they didn’t have transportation to the audition, or their orchestra director didn’t join the Association, they were out of luck.
Since I was in high school, states have implemented practices to expand the opportunity for an All-State experience to more students. In addition to the high school All-State Orchestra, some states have a middle school option for students in grades 7-9.
Some states allow home-schooled students, unheard of when I was in high school, to participate if their private teacher is a member of the Association. Paradoxically, some states no longer require the school orchestra to be an Association member for the student to participate. Plus, to make the process more accessible, rather than requiring students to audition in person, some states have modernized their requirements to require a video audition.
Access to invest in private placement securities reminds me of All-State Orchestra. Private placements provide unique investment opportunities that can help investors diversify their portfolios. Yet, most private placements are available only to a limited group of “accredited investors,” based upon a standard originally adopted in 1982.
Recently, however, the Securities and Exchange Commission (SEC) proposed a rule change which would qualify more people as accredited investors. If adopted, this rule would expand and modernize the opportunity to invest in private placements.
Why is Accredited Investor Status Important?
The Securities Act of 1933 (1933 Act) requires that all securities be registered with the SEC unless they fit into an exemption. Section 4(2) of the 1933 Act, known as the “private placement exemption,” exempts the sale of securities by the issue from registration if the sale is not part of a “public offering.”
In 1982, the SEC adopted Regulation D (Reg D) under Section 4(2). Rule 506(b) of Reg D establishes a safe harbor for issuers wishing to rely upon the private placement exemption. In Rule 506(b), the SEC limits sales of securities to no more than 35 non-accredited investors, provided the non-accredited investors receive disclosure and financial statements (usually audited) similar to those required of registered securities offerings. Although all investors must receive accurate disclosure of material information, the requirements are relaxed if an offering is sold only to accredited investors. Because it can be costly to provide the extent of disclosure in a registration, this requirement effectively limits the availability of smaller offerings only to accredited investors.
Who Currently Qualifies as an Accredited Investor?
Under Reg D, several categories of investors qualify as accredited investors. These categories included investors deemed able to look out for themselves and who also were believed to be able to afford the loss of their investment.
Banks, investment companies, employee benefit plans, business development companies, and small business investment companies are accredited investors. Corporations, partnerships, charities, and trusts with more than $5 million in assets also are accredited investors.
Individuals are accredited investors if they fall into one or more of these categories:
Have a net worth with a spouse of more than $1 million, not counting net equity in their primary residence
Have an income of at least $200,000 (or joint income with a spouse of at least $300,000) in each of the two most recent calendar years and reasonably expect the same level of income in the current year
Are a director, executive officer, or general partner of the securities issuer
Business enterprises in which all equity owners are accredited investors also may be accredited investors, as are grantor trusts (usually trusts where the grantor is both the trustee and beneficiary) controlled by accredited investors.
What Changes are in the Proposed Rule?
The SEC’s proposed rule proposed rule appears to continue the focus on investors able to look out for themselves and can afford the loss of their investment. However, if adopted, the rule would modernize the accredited investor definition to reflect current social and market realities.
The proposed rule would extend the opportunity to invest in private placements to additional entities:
Any entity owning investments (as defined in the Investment Company Act (ICA) over $5 million, unless the entity was formed for the specific purpose of investing in the securities being offered. Indian tribes are specifically mentioned in this category.
Family offices and their family clients (as defined in the ICA).
Limited liability companies (LLCs) with more than $5 million in assets, not formed solely for investment in the securities being offered.
Registered investment advisors.
Rural business investment companies.
The proposed rule also would require that entities trace ownership back to the individual, human owners (warm bodies) to determine whether they are entirely owned by accredited investors.
New categories of individuals also would qualify as accredited investors under the proposed rule:
“Knowledgeable employees” of the private fund being offered for sale, provided they are involved in the management of the fund in other than purely clerical or administrative areas.
Individuals with certain professional certifications or designations requiring an examination that demonstrate a background and understanding of securities and investing.
Individuals could pool finances with a “spousal equivalent” to attain the $300,000 annual income level or $1 million net worth required to be accredited.
What the Proposed Rule Wouldn’t Do
Although the SEC proposed expanding accredited investor availability to individuals with professional certifications, the SEC proposed using SEC orders, rather than rulemaking, to establish what certifications would qualify. The SEC indicated that initially, it might limit access to individuals with Series 7, 65, or 82 licenses. But it didn’t rule out the possibility that eventually, investment advisor representatives, certified public accountants, MBAs, and even attorney with securities industry experience, might qualify.
The biggest surprise from the proposed rule is the SEC’s decision not to recommend inflation adjustments to the accredited investor definition’s net worth, income, and total assets thresholds, which have been in place since the 1980s. Because the standards haven’t been adjusted for inflation, the SEC estimated that 13% of U.S. households currently qualify as accredited investors, as opposed to 1.6% of households when the standard was first adopted.
The SEC posited that the increased availability of information and technological advances, combined with the absence of reports of abuses, supported retaining access to private placements at the current income and net worth levels. And the SEC expressed concerns that a significant reduction in eligible investors could disrupt the private placement market, which would limit the availability of venture capital and could have a ripple effect in the U.S. economy as a whole.
The proposed rule isn’t the first expansion of access to private placements in recent years. In 2012, Congress adopted the Jumpstart our Business Startups Act (JOBS Act), which made it easier for startups and small business to raise capital. Rule 506(c), which allows “private placement” sales to be advertised if sold only to accredited investors, followed, as did equity crowdfunding. JOBS Act also spawned other changes, including Reg A+, which allows companies to raise up to $50 million using an abbreviated securities registration process.
Technology and a changing educational landscape in part appear to have fueled expanded access to All-State orchestras. Similarly, the proposed accredited investor rule is a much-needed modernization and reflects changes in the ways people invest and the ways information flows in current society.
© 2020 by Elizabeth A. Whitman
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