Revisiting the Accredited Investor Standard by Syed Haq

The current interpretation of the accredited investor standard is misaligned with the courts’ and the SEC’s original intention of protecting those who cannot “fend for themselves”. The SEC should modify the standard with some adjustments implementing sophistication credentials, adjustments to assessments for wealth requirements, and checks on leverage.

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  • Topic Tags

Accredited investor, SEC regulation, sophisticated investors, institutional investors

  • Relevant questions addressed

What is the current interpretation of accredited investor?

Does it protect the classes it is supposed to?

How should it change?

  • Summary bullet points
  • A standard was established in 1933 through the Securities Act to mandate registration of all offerings. Exemptions were made for non-public offerings (especially section 4(a)(2)
    • This need arose out of the speculation throughout the 1920s and the 1929 market crash
    • Subsequent court interpretation set to allow only certain investors to take part in private or unregistered offerings
    • Sophisticated investors don’t need the protection of registered issues and can “fend for themselves” and/or have access to the type of information that would be required in a registered offering
  • To standardize interpretation, the SEC created a standard through a series of regulations.
    • Private placement participants had to qualify through sophistication based on knowledge, experience, capability of evaluating risk and merits and ability to bear economic risks
    • Later, congress introduced the concept of accredited investors, and provided a list of institutional investors it could apply to
    • SEC Regulation D then allowed three additional exemptions to registration requirements (Rules 504, 505, 506), while another Rule (501) defined accredited investors
      • Rule 506 allows to raise an unlimited amount of funds from an unlimited amount of accredited investors
  • Currently, the interpretation is for wealth (and a loss bearing standard) to be a proxy for sophistication
  • Private placement transactions are inherently different than registered offerings
    • In the public markets, unsophisticated investors are protected by the SEC’s disclosure regime and by all other investors, sophisticated and not (when markets are efficient)
    • In private markets, not all investors have the same information and taking advantage of others’ sophistication is difficult. Additionally, assets are less liquid and not priced efficiently. Lastly, because issuers are rarely mature companies they present significant risks.
  • Under the current standard, wealth serves as a proxy for sophistication, which is problematic
    • Even though wealthy individuals can bear economic risks and hire sophisticated representatives
      • It is in contrast with the original intent behind the creation of the accredited investor standard which was based on sophistication
      • In many cases wealth accumulation does not afford people the right tools to analyze investment risk
      • Institutional failures show that even institutions do not always possess the ability to fully analyze risks
      • Behavioral biases for wealthiest investors and methods of wealth accumulation make these investors unable to “fend for themselves” at times
      • The current measures for investors’ ability to bear losses does not take into account investors’ assets’ liquidity or expenses when looking at wealth and income
    • Does not evaluate adequately the loss tolerance of investors, leaving individuals unprotected
      • Especially the elderly, who are more likely to qualify through the financial metrics but less likely to possess the financial literacy to evaluate these investments
  • New standards should take into account multiple factors: sophistication, wealth level, and capital formation
    • Accredited investors in private markets are supposed to have a similar function to regulatory agencies in public markets: monitoring and control, increasing efficiency
    • A new standard should look at investor credentials as a proxy for sophistication and impose sophisticated representation for those that don’t possess them
    • The SEC should change the wealth requirement from a clear cutoff to a waterfall or sliding scale system (as the JOBS Act did for crowdfunding), imposing certain limits and caps
      • Net assets should not include illiquid assets at full value and income should be adjusted for expenses
    • A new standard should also impose consideration on the level of leverage used by investors
  • Follow-up links

Dodd-Frank Wall Street Reform and Consumer Protection Act -

SEC v. Ralston Purina Co., 346 U.S. 119, 125 -