The Dodd-Frank Wall Street Reform Act and the SEC: Profound Bits and Pieces (Accredited Investor Standard)

Without much fanfare, the SEC has been instructed to update the definition of accredited investor.  This was designed to provide a safe harbor for the notion of sophisticated investor under Section 4(2) of the Securities Act.  The safe harbor was designed to select out those investors with the financial wherewithal to lose their investment. 

Under Regulation D, accredited investors were not entitled to any specific disclosure before purchasing their securities.  Moreover, under Rules 506 and 505, securities could be marketed to an unlimited number of accredited investors (but no more than 35 non-accredited investors).   Hedge funds and other risky investments could be marketed to accredited investors without needing to register the securities. 

The term accredited investor applied to those making $200,000 a year or with over $1 million in assets.  The definition was inserted into the securities laws in 1982, back when $1 million actually meant something.  See Securities Act Release No. 6389 (March 8, 1982).   The number of households with a net worth of a million dollars or more increased from 2.4 million in 1983 to 6.4 million in 2004.  In short, that level of wealth can be the accumulated equity in a house, hardly the test of sophistication. 

The feeble numbers have ceased, therefore, to be a good measure of sophistication, financial or otherwise.  Over time, the numbers have looked increasingly feeble and not an accurate way of determining those investors who did not need the protections of the disclosure requirements of the securities laws.  Nonetheless, for almost three decades, the numbers have remained unchanged.

In the absence of bureaucratic reform, Congress has stepped in, using Dodd-Frank to mandate an update of the financial standards used for accredited investors.  Specifically, Section 413 requires the Commission to "adjust any net worth standard for an accredited investor" so that the net worth is at least $1 million, "excluding the value of the primary residence."   This had been considered by the Commission back in 1982 but rejected.  See  Securities Act Release No. 6389 (March 8, 1982) ("Some commentators, however, recommended excluding certain assets such as principal residences and automobiles from the computation of net worth. For simplicity, the Commission has determined that it is appropriate to increase the level to $1,000,000 without exclusions."). 

In addition, the provision encourages but does not require the Commission to immediately review the entire definition of accredited investors (for individuals).  According to Section 413, the Commission may "undertake a review of the definition of the term 'accredited investor' . . . to determine whether the requirements of the definition, excluding the requirement relating to the net wolth standard . . . should be adjusted or modified for the protection of investors, in the public interest, and in light of the economy."  Such a review would presumably bring not only the net worth requirements but also the annual income tests under renewed scrutiny. 

The Act does, however, require a review of the definition at least every four years to determine whether any adjustment is appropriate.  While Congress stopped short of dictating standards (except for the $1 million net worth requirement, minus the primary residence, as a minimum), the mere fact that reviews take place on a regular basis is likely to result in higher net worth and income tests over time.

The Dodd-Frank Wall Street Reform Act and a short Summary of the legislation are posted online.  Section 413 is produced below.

SEC. 413. ADJUSTING THE ACCREDITED INVESTOR STANDARD.

(a) IN GENERAL.-The Commission shall adjust any net worth standard for an accredited investor, as set forth in the rules of the Commission under the Securities Act of 1933, so that the individual net wolth of any natural person, or joint net wolth with the spouse of that person, at the time of purchase, is more than $1,000,000 (as such amount is adjusted periodically by rule of the Commission), excluding the value of the primary residence of such natural person, except that during the 4-year period that
begins on the date of enactment of this Act, any net worth standard shall be $1,000,000, excluding the value of the primary residence of such natural person.

(b) REVIEW AND ADJUSTMENT.-

(1) INITIAL REVIEW AND ADJUSTMENT.

(A) INITIAL REVIEW.  The Commission may undeltake a review of the definition of the term "accredited investor", as such term applies to natural persons, to determine whether the requirements of the definition, excluding the requirement relating to the net wolth standard described in subsection (a), should be adjusted or modified for the protection of investors, in the public interest, and in light of the economy.

(B) ADJUSTMENT OR MODIli'ICATION.  Upon completion of a review under subparagraph (A), the Commission may, by notice and comment rulemaking, make such adjustments to the definition of the term "accredited investor", excluding adjusting or modifying the requirement relating to the net worth standard described in subsection (a), as such term applies to natural persons, as the Commission
may deem appropriate for the protection of investors, in the public interest, and in light of the economy.

(2) SUBSEQUENT REVIEWS AND ADJUSTMENTS

(A) SUBSEQUENT REVIEWS.-Not earlier than 4 years after the date of enactment of this Act, and not less frequently than once every 4 years thereafter, the Commission shall undertake a review of the definition, in its entirety, of the term "accredited investor", as defined in section 230.215 of title 17, Code of Federal Regulations, or any successor thereto, as such term applies to natural persons, to determine
whether the requirements of the definition should be adjusted or modified for the protection of investors, in the public interest, and in light of the economy.

(B) ADJUSTMENT OR MODIFICATION. Upon completion of a review under subparagraph (A), the Commission may, by notice and comment rulemaking, make such adjustments to the definition of the term "accredited investor", as defined in section 230.215 of title 17, Code of Federal Regulations, or any successor thereto, as such term applies to natural persons, as the Commission may deem appropriate for the protection of investors, in the public interest, and in light of the economy. 

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