2015 was a watershed year for equity financing in general and real estate financing in particular. $2.57 billion of real estate was financed through crowdfunding while two major SEC rulings—Title IV (or Reg A+) and Title III of the JOBS Act—were finalized, directly addressing the structure and accessibility of security offerings. People who previously could not invest in equity offerings are on their way to doing so. Now that it’s 2016, investment professionals get to examine the early results of those two rulings and adjust accordingly, while awaiting further SEC actions.
Revising the definition of accredited investors is among the most pertinent changes being discussed. As the SEC and congress review the decades-old definition in light of the JOBS Act, will the status of “accredited investor” soon apply to many more people? Will accredited investors remain the most lucrative and powerful force in equity investing, or has the tide swung toward non-accredited investors?
Changing the Definition
The current definition of “accredited investors” hasn’t been fully updated since 1982—and even the greenest investor knows the financial world of 2016 bears little resemblance to that of the early Reagan years. Of course, other SEC measures predating that definition are still in the books. But because the stakes are higher with higher net worth individuals, the SEC should more judiciously monitor their interests. As we’ll discuss, it appears our post-Recession regulatory environment, along with the internet, has prompted regulators to finally re-examine old definitions.
In the most basic sense, accredited investors are those whom the SEC has deemed financially sophisticated enough to invest in security offerings with less government protection. The SEC has established income and net worth requirements based on its interpretation of “sophistication”. If the meaning of that word sounds ambiguous to you here, you’re not alone—regulators have become increasingly preoccupied with what “sophistication” entails and how it should be measured. At this year’s Annual Securities Regulation Institute, SEC Chairwoman Mary Jo White said:
“I don’t think…that the net worth and income criteria by themselves are a very good ...proxy for who doesn’t need the protections, who can fend for themselves in the marketplace. There are number of alternatives that are discussed in [the SEC staff study on accredited investors] that are being considered as, again, proxies for sophistication and being able to fend for yourself depending on your background, your professional qualifications, how much you have been involved in investing.” (ThinkAdvisor)
White is pointing to certain questions that financial professionals are asking, such as: Does having a net worth of at least $1 million or individual income of at least $200K necessarily mean you are a “sophisticated” investor, especially if you’ve never invested before? Does having a smaller net worth mean you are an unsophisticated investor, even if you have a diversified investment portfolio? And what are those alternative criteria for sophistication that White alluded to?
“Report on the Review of the Definition of ‘Accredited Investor’”
In December 2015, the SEC published their “Report on the Review of the Definition of ‘Accredited Investor’”. The report cites criticism that the definition is over-inclusive because the financial thresholds are unadjusted for inflation and the net worth calculation controversially includes certain assets such as retirement accounts. Additionally, the report cites criticism that the definition is under-inclusive because sophisticated investors who do not meet earnings requirements may not qualify.
Furthermore, the report includes the following recommendations for revising the accredited investor definition:
- Establish a new income threshold of $500k, a joint income threshold of $750k, and a net worth threshold of $2.5m.
- Permit individuals with a minimum amount of investments to qualify as accredited investors.
- Consider professional credentials, such as Series 7 or 82 licenses, in determining whether an investor meets sophistication standards.
- Permit individuals with particular experience investing in exempt or related offerings to qualify.
- Develop an investor examination for individuals to qualify as accredited investors, which would enable financially sophisticated investors to be included regardless of wealth.
- (i) persons who are licensed in the securities industry (such as a registered broker or investment adviser) with the Securities and Exchange Commission (the “SEC”), the Financial Industry Regulatory Authority (“FINRA”), or the securities division of a state or an equivalent state division; and
- (ii) persons whom the SEC determines by regulation to have demonstrable education or job experience to qualify such persons as having professional knowledge of a subject related to a particular investment, and whose education or job experience is verified by FINRA or an equivalent self-regulatory authority. (see TREFIS)
- who is a licensed or registered as a broker investment adviser with the Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA), or a state level equivalent division;
- who is licensed attorney in good standing under the laws of the jurisdictions in which he or she is admitted to practice law;
- who is a registered CPA in good standing under the laws of the place of his or her residence or principal office;
- who has retained and used the services of any person referred to in numbers 1-3 above to make an investment decision relative to the subject investment being offered; or
- who has passed an examination administered by FINRA to qualify as an accredited investor. (see Crowdfundinsider)
Only the first provision of the above list made it into the final bill, which is currently in limbo between the House and the Senate. According to GovTrack.Us, the bill has only a 21% chance of being enacted if it were to ever reach the Oval Office.
Accredited or Non-Accredited: Who are the Investors of the Future?
In choosing to register under either Reg A+ or Title III, real estate crowdfunding platforms must acknowledge two conflicting facts: 1) that accredited investors have more money to spend, both individually and as an investment demographic that includes institutional investors; and 2) that there are potentially many more non-accredited investors than accredited, and many of them like the idea of passive investing. If you operate a real estate crowdfunding platform with the end goal of maximizing revenue, getting bought out by a bank, or going public, then accredited/institutional investors are still your most valuable prospects. From a liability standpoints it’s also easier to collect funds from accredited investors. However, some platforms value the investment initiative of everyday people, and are best served to cultivate local investors with local real estate, with the knowledge that high net worth investors are necessary to sustain growth. These companies strive—in the words of Victoria Silchenko, Founder & CEO of Metropole Capital Group—to “fill the essential gap [left by accredited equity crowdfunding] in entrepreneurial finance...” (Huffington Post) Moreover, crowdfunding platforms are finding ways to offer investments to both accredited and non-accredited investors, as with REITs, which we’ll explore in another post. Both accredited and non-accredited investors are positioned to make an impact on the financial industry this year and beyond. Non-accredited investors benefit from an unprecedented explosion of opportunity, while accredited investors stand to gain from current available opportunities—as well as a more nuanced SEC definition if regulators keep their eye on the ball.