Scrap the Accredited Investor Rule
Wednesday, July 20, 2011
The Securities and Exchange Commission (SEC) should make it easier for non-accredited investors to invest in private companies by eliminating the requirement that a person be an “accredited investor” for the company to receive an exemption from registration. The accredited investor requirement does little to protect unsophisticated investors from financial fraud; blocks less wealthy and sophisticated investors from co-investing with, and learning from, their wealthier and more sophisticated counterparts; and reduces entrepreneurs’ access to capital.
The barrier to co-investing with wealthier investors means that people who don’t have the income or net worth to be accredited cannot invest in Facebook today, while it is still a private company. Nor could they have made an angel investment in Google during its pre-IPO years.
The SEC should simply limit the amount of money an outside investor can put into a single private company to no more than 1 percent of the investor’s net worth.
The Securities Act of 1933 compels companies selling financial securities to register that offering with the SEC unless the company can obtain an exemption. An exemption exists for the sale of securities to “accredited investors” under rules 505 and 506 of regulation D. An accredited investor, the SEC explains, is “a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase” or “a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.”
Accredited investors are not necessarily more financially sophisticated than non-accredited ones. Being an accredited investor means having a minimum level of net worth and income not investment knowledge. Kim Basinger, Zsa Zsa Gabor, Wayne Newton, Debbie Reynolds, and Mike Tyson are all examples of people who made enough money to be accredited investors many times over, but still lacked the investment sophistication to avoid financial problems. Because tests of investment knowledge are not required of accredited investors, many non-accredited investors are actually better able to judge the risks of investing in exempt private offerings than more well-off but less financially savvy wealthy people.
Many non-accredited investors are actually better able to judge the risks of investing in exempt private offerings than more well-off but less financially savvy wealthy people.
Accredited investor requirements do little to protect investors from fraud. Having more income or wealth does not help you figure out who is seeking money for a Ponzi scheme or financial fraud. Just ask New York Mets’ owner Fred Wilpon, Massachusetts School of Law Dean Lawrence Velvel, New York Daily News owner Mort Zuckerman, or Dreamworks chief executive Jeff Katzenberg, all of whom were accredited investors who lost money investing with Bernie Madoff. Accredited investors may, in fact, be more at risk of being the target of investment fraud than non-accredited investors, given that many fraudsters adhere to the Willie Sutton school of target selection: go where the money is.
The accredited investor rule blocks poorer people from co-investing with and learning from wealthier investors. If wealthier investors are indeed more sophisticated about investing in private companies than less wealthy investors—a point that the SEC is implicitly arguing by treating income and net worth as a substitute for financial sophistication in determining the rules for information disclosure—then those less well-off are disadvantaged by being precluded from investing alongside those more knowledgeable than them. This situation is exacerbated by the rise of angel groups, which limit involvement to accredited investors to ensure that investment solicitations made to the groups can receive registration exemption under securities laws. The end result is a system that unfairly excludes those with less money from the best investments.
Accredited investors may, in fact, be more at risk of being the target of investment fraud than non-accredited investors, given that many fraudsters adhere to the Willie Sutton school of target selection: go where the money is.
The accredited investor rule makes it harder for entrepreneurs to raise money for their businesses. Non-accredited investors are much more numerous than accredited investors. Analysis I conducted shows that there are nearly four non-accredited angel investors for every one accredited angel. And there are more than 7.5 non-accredited informal investors for every accredited informal investor. By limiting reduced disclosure requirements to fundraising efforts targeted at accredited investors, the SEC makes it more difficult for entrepreneurs to raise money from non-accredited investors, which, in turn reduces the amount of money raised from them. While some entrepreneurs would clearly benefit from tapping accredited investors, particularly if they will need to raise large sums of money or will need follow-on funding from venture capitalists, many would be just as well-served raising money from unaccredited investors, perhaps through processes like crowd funding. Making that process easier would make capital more readily available to private companies.
Rather than restricting investment to accredited investors, the SEC should simply limit the amount of money an outside investor can put into a single private company to no more than 1 percent of the investor’s net worth. By basing the rule on the percentage of net worth invested per company, the SEC could facilitate investment by non-accredited investors, while simultaneously encouraging the diversification necessary to protect investors against the risk of investment failure. By setting the threshold at 1 percent of net worth, the SEC could ensure that any loss incurred would not be devastating to any investors.
Scott Shane is the A. Malachi Mixon III Professor of Entrepreneurial Studies at Case Western Reserve University.
FURTHER READING: Shane has recently written “Are Federal Policies Toward Small Business Contracting Succeeding,” “The Boehner Uncertainty Principle,” “Small Businesses and Big Unintended Consequences,” and “Small Business, Big Regulatory Burden.” Related articles include Kevin A. Hassett and Alan D. Viard’s “How to Think About Taxing Carried Interest” and Alex J. Pollock’s “Ten Ways to Do Better in the Next Financial Cycle.”
Image by Darren Wamboldt/Bergman Group.