Securities and Exchange Commission: Alternative Criteria for Qualifying As An Accredited Investor Should Be Considered
Published: 2013-07-18T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Accredited investors who meet certain income and net worth thresholds may participate in unregistered securities offerings. GAO determined that the intended purposes of the accredited investor standard are to (1) protect investors by allowing only those who can withstand financial losses access to unregistered securities offerings and (2) streamline capital formation for small businesses. To qualify as accredited, SEC requires an investor to have an annual income over $200,000 ($300,000 for a married couple) or a net worth over $1 million, excluding a primary residence. The thresholds were set in the 1980s and 2010. The Dodd-Frank Wall Street Reform and Consumer Protection Act mandates GAO to study the criteria for qualifying individual investors as accredited.
This report examines market participants' views on (1) the existing criteria for accredited investor status and (2) alternative criteria. To address these objectives, GAO conducted a literature review, examined relevant data, and interviewed domestic and foreign regulators and industry representatives to identify alternative criteria. GAO also conducted structured interviews of 27 market participants (including broker-dealers, investment advisers, attorneys, and accredited investors).
section_title: What GAO Found
paragraphs: Of the existing criteria in the Securities and Exchange Commission's (SEC) accredited investor standard, many market participants identified net worth as the most important criterion for balancing investor protection and capital formation. For example, two market participants said the net worth criterion, more so than income, likely indicates the investors' ability to accumulate wealth and their investment knowledge. Others noted that some parts of the market might not accept adjustments to the thresholds. For example, an association of angel investors--accredited investors who invest in start-up companies--told GAO that they would be resistant to increased thresholds because it would decrease the number of eligible investors. GAO analysis of federal data on household net worth showed that adjusting the $1 million minimum threshold to approximately $2.3 million, to account for inflation, would decrease the number of households qualifying as accredited from approximately 8.5 million to 3.7 million.
While citing net worth as the most important criterion, several market participants GAO interviewed said that alternative criteria related to an investor's liquid investments and their use of an investment adviser also could balance investor protection and capital formation. GAO obtained views on eight alternative criteria that focus on investors' financial resources and their understanding of financial risk--criteria that SEC or industry groups previously proposed or that foreign regulators use. Among the financial resources criteria, market participants with whom GAO spoke most often identified a liquid investments requirement--a minimum dollar amount of investments in assets that can be easily sold, are marketable, and the value of which can be verified--as the most important for balancing investor protection and capital formation. Among the understanding financial risk criteria, market participants most often identified the use of a registered investment adviser. Beginning in 2014, SEC must review the accredited investor definition every 4 years to determine whether it should be adjusted. This study provides a reasonable starting point for SEC's review. Specifically, SEC will have the views of market participants about how existing and alternative qualifying criteria could help determine an investor's ability to bear and understand risks associated with unregistered securities offerings.
section_title: What GAO Recommends
paragraphs: SEC should consider alternative criteria for the accredited investor standard. For example, participants with whom GAO spoke identified adding liquid investments and use of a registered adviser as alternative criteria. SEC agreed with GAO's recommendation.

section_title: Letter
paragraphs: Small businesses rely on capital to start and expand their businesses.  Some small businesses often satisfy capital needs by asking friends and  family members, or by seeking bank loans. Small businesses (like start- up companies) that exceed these resources, or have additional capital  needs, may seek to sell shares of ownership or securities convertible into  shares of ownership in the business to raise needed cash to be used in  operations. Businesses and public companies can seek capital through  public offerings or nonpublic offerings (private placements).
The Securities Act of 1933 (Securities Act) requires companies that are  publicly offering securities for investment to register the offering of the  securities with the Securities and Exchange Commission (SEC) and  provide investors with all material information necessary to make an  investment decision. The Securities Act contains exemptions from  registration and authorizes SEC to provide, by rule, additional  exemptions.
In particular, Rule 506 under SEC Regulation D exempts offerings from  registration if the issuer conducts a limited offering and restricts sales to  accredited investors and up to 35 nonaccredited investors. Within  Regulation D, SEC sought to facilitate capital formation while protecting  investors—consistent with its mission to protect investors; maintain fair,  orderly, and efficient markets; and facilitate capital. While Regulation D  originated as an effort to assist small businesses with capital formation,  various types of companies rely on registration exemptions in Regulation  D. According to SEC staff, in 2011, the estimated amount of capital raised  in these types of exempt offerings was just over $1 trillion, which is  comparable to the amount of capital raised in registered offerings in that  year. Further, pooled investment vehicles (hedge fund, private equity,  venture capital, and other investment funds) are among the top issuers  under Regulation D, accounting for 29 percent of such offerings in 2011.
Under Regulation D, SEC defines individual accredited investors as  meeting certain income and net worth thresholds. Based on information  we reviewed, this type of investor is generally a securities purchaser who  possesses knowledge and experience in finance and business matters to  evaluate the risks and merits of prospective investments or one who the  issuer reasonably believes meets this description. On the basis of the  legislative history of the accredited standard, SEC’s mission statement,  and academic literature, we determined that the intended purposes of the  accredited investor standard are to protect investors (by allowing only  those who can withstand financial losses to have access to private  placements) and streamline capital formation for small businesses. SEC’s  thresholds for individual accredited investors were established in the  1980s. The thresholds for income and net worth were intended as a  buffer to protect the investor from potential economic loss of investing in  private placements. Section 415 of the Dodd-Frank Wall Street Reform  and Consumer Protection Act (Dodd-Frank Act) requires us to study  appropriate criteria for qualifying as an accredited investor.
This report examines market participants’ views on (1) the existing criteria  for qualifying for accredited investor status, and (2) alternative financial  and other qualification criteria. To address these objectives, we reviewed  SEC’s current definition of and legislative history for the accredited  investor standard. We also reviewed SEC’s proposed changes to the  accredited investor standard since 2006, market participants’ comment  letters to SEC on these proposals, academic literature related to  accredited investors and unregistered securities offerings, and applicable  criteria used by foreign regulators. To estimate the impact of changing the  minimum net worth and income thresholds on eligible households, we  analyzed data from the Survey of Consumer Finances (SCF) issued by  the Board of Governors of the Federal Reserve System (Federal  Reserve). We found the Federal Reserve data to be sufficiently reliable to  evaluate household income and net worth levels. We interviewed staff  from SEC and other federal financial regulators, lawyers knowledgeable  about accredited investor issues, and trade associations to discuss  current and alternative criteria for accredited investor status. In addition,  we interviewed officials from the Ontario (Canada) Securities Commission  and United Kingdom Financial Services Authority about their investor  standards, and others with standards similar to the U.S. accredited  investor standard.
Compiling information from SEC’s proposed changes, academic  literature, and criteria used by foreign regulators, we identified eight  alternative criteria. We grouped these criteria under two categories— financial resources and understanding financial risk. To obtain the views  of market participants on existing and alternative criteria, we conducted  structured interviews with a judgmental sample of 27 market participants,  whom we categorized in four groups of different segments of the  accredited investor population: (1) attorneys who have experience in  private placement transactions, (2) accredited investors who invest in  private placements, (3) retail investors who meet the current accredited  investor criteria but do not necessarily invest in private placements, and  (4) broker-dealers and investment advisers who work with accredited  investors. The results from the structured interviews are not generalizable  to the population of market participants and only represent the opinions of  these 27 individuals. See appendix I for additional information on our  scope and methodology.
We conducted this performance audit from June 2012 to July 2013 in  accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: Small businesses, such as startup companies, may choose to raise  capital through a nonpublic offering, also called a private placement,  when their capital needs exceed what might be available through other  channels (such as bank loans, personal credit cards, or loans from friends  and family). Public companies also may raise capital using private  placements to benefit from lowered transaction costs and raise funds  more quickly than in the public market.
Private placements generally involve issuers, placement agents or  finders, qualifying accredited investors, and regulators.
Issuers. Issuers include private and public companies, and pooled  investment vehicles such as hedge, venture capital, or private equity  funds.
Placement agent or finders. Issuers may employ placement agents  (who are registered with SEC, the Financial Industry Regulatory  Authority, or states) and finders (who are unregistered with regulators)  to access accredited or other qualified investors.
Qualifying accredited investors. Qualifying accredited investors can  be individuals or institutions. Some individual accredited investors,  called angel investors, invest in early-stage start-up companies with  high growth potential. Other qualifying accredited investors, such as  venture capital funds that invest in start-ups at later stages of  development, are institutional accredited investors.
Regulators. SEC and state regulators have some oversight over the  offering and sale of private placement securities. SEC generally limits  its enforcement activity to fraud and does not conduct reviews of  offering materials or verify accredited investor status. State regulators  play a role in investigating potential fraud in private placements and  enforcement after the securities have been sold in their state for  certain exempted securities.
subsections: section_title: Regulation D
paragraphs: Regulation D defines accredited investors and describes certain terms  and conditions of offers and sales of private placements securities.  Under Regulation D, accredited investors consist of institutional entities  and individuals. Institutions that qualify as accredited investors include  certain regulated financial institutions and certain entities with total assets  of $5 million or more. Individuals who qualify as accredited investors are  directors, executive officers, and general partners of the securities  issuers, or persons who have a minimum annual income in excess of  $200,000 ($300,000 with spouse) or net worth in excess of $1 million  excluding primary residence (see fig. 1). The focus of this report is on  individual accredited investors.
Regulation D establishes registration exemptions, with the exemptions  differing in the size of offerings, the number and type of investors, or both.  These exemptions are described in Rules 504, 505, 506.
Under Rule 504, the maximum dollar amount of the offering is $1  million in any 12-month period and no limit is set on the number of  investors.
Under Rule 505, the maximum offering is $5 million in any 12-month  period and unlimited number of accredited investors and up to 35  nonaccredited investors may invest.
Under Rule 506, there are no offering dollar limits and an unlimited  number of accredited investors and up to 35 nonaccredited  sophisticated investors may invest.
Offerings made in reliance on the rules cannot solicit investors through  any form of general solicitation or general advertising. SEC staff has  indicated that an issuer would not contravene the prohibition against  general solicitation if the issuer had a preexisting and substantive  relationship with the investor. Of the three rules, Rule 506 is the most  widely used exemption because there is no limit on the size of the offering  or the number of accredited investors. Further, according to a GAO  report, complying with state securities registration requirements for other  exemptions may play a role as to why issuers rely more on Regulation  D.
SEC data show that businesses make more Regulation D offerings than  registered public offerings (see table 1). Regulation D is designed to (1)  eliminate any unnecessary restrictions SEC rules place on small business  issuers, and (2) achieve uniformity between state and federal exemptions  to facilitate capital formation consistent with investor protection.
The accredited investor standard, which is used to adjust exemptive  conditions under Regulation D, has undergone several changes since its  adoption in 1982. As shown in figure 2, the qualifications for investment in  private placements securities went through several interpretations and  changes. For example, in 1953 the Supreme Court ruled that the  applicability of registration exemptions depended on whether the  purchasers of securities could “fend for themselves.” In 1974, SEC  adopted Rule 146, a predecessor to Rule 506, which stated that investors  were financially sophisticated enough to be offered or purchase private  placement securities based on their knowledge and experience, capability  of evaluating the risk and merits, and ability to bear the economic risk of  investment. In 1982, Regulation D—the goals of which included  facilitating capital formation and promoting investor protection—replaced  previous rules, including Rule 146. The income and net worth thresholds  established in Regulation D were intended to serve as proxies for  financial experience, sophistication, and adequate bargaining power.  Since 1982, SEC twice revised the individual accredited investor  standard: it added the $300,000 threshold for joint income in 1988, and  excluded the value of primary residence as part of the net worth  calculation in 2011 as required by the Dodd-Frank Act.
In recent years, market participants and a regulator have proposed  several changes to the accredited investor standard for individuals. The  proposals were generally based on concerns for investor protection and  capital formation, and consist of adjustments to income and net worth and  alternative ways of measuring investor knowledge. For instance, two  consumer advocacy groups, an investment company association, SEC,  and North American Securities Administrators Association (NASAA) have  expressed concerns that the number of those eligible to be accredited  investors has grown significantly since the thresholds were established.  According to SEC, when the standard was first created, 1.87 percent of  households qualified as accredited investors. SEC staff estimate that 9.04  percent of households would have qualified as accredited investors under  the net worth standard in 2007; we estimate that removing the primary  residence from households’ net worth, as required in the Dodd-Frank Act,  dropped the percentage to 7.2 percent (based on 2010 data). SEC and  NASAA say that because private placement offerings are generally  illiquid, complex, and not reviewed by state or federal regulators, the risks  of investing in private placement offerings are high and a higher level of  protection may be necessary to protect accredited investors. In contrast,  the angel investor community has expressed concerns about how any  proposed changes could affect capital formation for start-up companies.
Noting concerns about investor protection, SEC proposed several  changes to Regulation D during the 2000s. In December 2006, SEC  proposed a new standard for individuals with the goal of providing  additional protection to accredited investors investing in certain pooled  investment funds, including hedge funds. An investor would have to meet  either the existing income or net worth criteria and also own at least $2.5  million in investments at the time of the purchase of the securities. SEC  stated that with this proposal, it sought to ascertain that an individual  likely would have sufficient knowledge and experience to evaluate the  merit and risk of certain private placement investments or be able to hire  someone able to do so. In their comment letters on this proposal, some  market participants suggested that SEC adjust the income and net worth  standards for inflation, while others suggested these standards be  lowered or eliminated. Some commentators suggested that SEC use a  percentage of the net worth standard for certain investments. Others  agreed with the proposal but made suggestions such as decreasing the  required investments owned. This proposal was never finalized because,  according to SEC officials, it received competing demands and mixed  comments during the comment period.
In July 2007, SEC proposed other changes to align its rules with modern  market practices and communications technologies without compromising  investor protection. First, SEC proposed to create a new exemption for  offers and sales for a new category of investors to be designated as  “large accredited investors.” Under this standard, individuals would have  to own $2.5 million in investments or have an annual income of $400,000  (or $600,000 for married couples). Second, SEC proposed an alternative  criterion for the accredited investor standard (to include $750,000 of  investments owned) and adjusting the dollar-amount thresholds for  investments owned, income, and net worth to reflect future inflation.  According to SEC, it did not finalize its proposals due to, as stated before,  competing demands and the mixed comments it received during the  comment period.
There are pending changes to Regulation D as a result of the passage of  the Dodd-Frank Act and the Jumpstart Our Business Startups Act (JOBS  Act).
First, Section 926 of the Dodd-Frank Act directs SEC to adopt a rule  that would make the Rule 506 exemption unavailable to securities  offerings in which “felons or other bad actors” were involved. SEC  proposed a rule in 2011 defining bad actors and prohibiting them from  using the Rule 506 exemptions if they have been convicted of, or are  subject to court or administrative sanctions for securities fraud or  other violations of specific laws. The SEC commission adopted the  final rule in July 2013 which prohibits bad actors, which include the  issuer, certain issuer, officers, significant owners, general partners or  managing members of the issuer, whose actions occurred after the  rule’s effective date from using Rule 506. Actions which occurred  before the effective date must be disclosed but do not act as a  prohibition against using Rule 506.
Second, the Dodd-Frank Act also requires SEC to review the  “accredited investor” definition in its entirety beginning in 2014 and  every 4 years thereafter and to conduct rulemaking as SEC deems  appropriate after each review. As a result, criteria within the standard  could change. According to SEC officials, they are conducting their  review of the entire definition in 2014, after we publish our report on  market participants’ views relating to existing and alternative criteria  for qualifying as accredited.
Third, the JOBS Act directs SEC to implement a rule that would permit  companies to use general solicitation and advertising to offer  securities under Rule 506 of Regulation D. In August 2012, SEC  proposed a rule permitting companies to advertise and market such  securities offerings provided that the issuer takes reasonable steps to  verify the purchaser’s accredited investor status. Currently, Rule 506  does not specifically require that the issuer verify that accredited  investors meet the requirements. The comment period to the  proposed rule closed in October 2012. On July 10, 2013, the SEC  adopted the final rule which permits issuers using Rule 506 to utilize  general solicitation and advertising when all the purchasers are  accredited investors.
section_title: Net Worth Identified as Most Important Criterion for Qualifying as Accredited Investor
paragraphs: Among existing criteria, market participants whom we interviewed said a  net worth criterion was most important for balancing the goals of  protecting investors and facilitating capital formation. While market  participants offered varying viewpoints on how adjusting the existing  thresholds for net worth and income would impact investor protection,  they tended to agree on how adjustments would impact capital formation.  In particular, many argued that increasing the thresholds would limit  capital formation. Our analysis of Federal Reserve consumer finance data  indicates that increasing the existing thresholds would contribute to  limiting the pool of the eligible investors. Market participants said  adjusting the existing net worth and income criteria is feasible, but market  acceptance would depend on the extent of the adjustments.
subsections: section_title: Market Participants Said Net Worth Best Balances Goals of Investor Protection and Capital Formation
paragraphs: Seventeen of 27 market participants said that net worth was the most  important criterion for balancing investor protection and capital  formation. Nine of the 17 market participants said that net worth alone  was the key criterion for balancing investor protection and capital  formation. The other 8 participants stated that net worth with other criteria  was important to balance investor protection and capital formation. Two  market participants told us that net worth demonstrated an investor’s  ability to accumulate wealth over time. One market participant also  thought it indicated an investor’s understanding of financial risk and  having experience with investment decisions. A few market participants  and an industry expert said that a high net worth provided a cushion  against risky investments—that is, having enough assets to bear the loss  of the investment should a start-up company fail. However,  representatives from an industry association and a broker-dealer firm  cautioned that net worth is not easily identifiable or verifiable because  they have to rely on information from the investor. For example, net  liabilities—a component of net worth—are a complex measure to  calculate and net worth can be subject to manipulation.
Of the two existing qualifying criteria, most market participants did not  think income was the best criterion to balance investor protection and  capital formation. One of the 27 market participants identified income  alone as the most important criteria. However, one market participant said  that it was more probable that an investor’s income could decline  compared with net worth, and net worth tended to be a better indicator  than income of an investor’s knowledge of the markets. For example, a  wealthy professional would not necessarily have a guarantee that his or  her income would remain the same or have the investment experience or  financial wherewithal, depending on his or her profession, to invest in  private placements. Nonetheless, an athlete or a doctor, for example, will  qualify under the income standard, but it is unclear whether he or she  could afford to hold the private placement for an indefinite period and  whether he or she could afford a complete loss.
section_title: Views on Potential Implications for Investor Protection and Capital Formation of Adjusting Net Worth and Income Thresholds
paragraphs: Market participants had differing opinions on whether the thresholds for  the existing criteria should be adjusted, citing various advantages and  disadvantages associated with balancing investor protection and capital  formation. Some market participants (13 of 27) said the thresholds should  be adjusted, two believed that the current thresholds should be increased,  but differed on how much they should be increased. To better protect  investors, some participants thought the levels should be increased to  adjust for inflation—thus focusing on the original subset of the population  that was targeted when the standards were first implemented. For  example, officials from one industry group said that SEC designated the  existing thresholds to identify a subset of the population that does not  need SEC’s regulatory investor protection and therefore the thresholds  should be readjusted periodically to ensure that the thresholds only  capture the intended population. Others suggested the thresholds are  very outdated and should be raised even higher than inflation.
However, almost an equal number of market participants (11 of 27) said  the current thresholds should not be adjusted. For example, a number of  participants commented that the net worth threshold already had been  significantly adjusted because the primary residence is no longer  considered as part of the net worth calculation. In addition, officials from  an investor association said that regulators should take into account  regional differences when considering changes to the thresholds as they  represent a significant dollar amount in certain states with lower average  income levels. Thus, adjusting the existing criteria could negatively affect  some regions more than others. For example, in a rural state increased  thresholds could negatively affect investors’ ability to qualify under the  standard and make it harder for local start-up companies to seek  investors and capital inside the state, according to an investor  association.
Market participants had differing views on the impact of increasing the  thresholds on investor protection (see fig. 3). Some thought that investor  protection would be strengthened, and a similar number responded that  increasing the current qualification criteria would have no effect on  investor protection.
Thirteen of the 27 individuals we interviewed said that increasing the  minimum annual income requirement would strengthen investor  protection. Ten of the 27 said it would have no effect, 3 said it would  weaken, and 1 said they did not know.
Similarly, 13 of the 27 market participants said that increasing the  minimum net worth requirement would strengthen investor protection.  Twelve said it would have no effect and 2 said it would weaken.
Investor and industry associations that we interviewed separately did not  support adjusting the thresholds of the existing criteria to increase  investor protection. An investor association and an academic  acknowledged the importance of establishing thresholds to protect  investors who may not have the knowledge or ability to protect  themselves against making risky investments. Regardless of the  thresholds, a representative from an investor association said that its  investors completed due diligence on potential investments to protect  their financial portfolio. Furthermore, industry associations representing  attorneys and financial advisers involved in private placement generally  agreed that the current qualification criteria were adequate. They said that  any changes to the thresholds might provide only marginal increases to  investor protection.
Market participants’ views were more similar on the impact of increasing  the income and net worth thresholds on capital formation for businesses  (see fig. 4). Specifically, most said that increasing the thresholds would  limit capital formation.
Eighteen of the 27 individuals said increasing the minimum annual  income requirement would limit capital formation. Eight of the 27 said  it would have no effect and 1 said it would promote capital formation.
Fifteen of the 27 individuals said increasing the minimum net worth  requirement would limit capital formation. Ten said increasing the net  worth requirement would have no effect on capital formation and 2  said it would promote it.
Representatives from associations representing start-up companies and  angel investors said that raising the current thresholds would limit capital  formation. Specifically, the representatives said that raising the thresholds  would reduce the current number of angel investors—a type of accredited  investor who invests in start-up companies—and other eligible accredited  investors. A representative of a venture capital association told us that  removing the primary residence from the net worth calculation was a  significant adjustment to the current standard and that any further  changes would further limit the pool of accredited investors, discourage  angel investing, and ultimately hinder the ability of start-up companies to  access capital. For instance, a representative of a network of angel  investors said that he knew other accredited investors in the network who  no longer qualified because of the 2011 change in the net worth  calculation. However, according to an official from the North America  Securities Administrators Association (NASAA) and a former regulator,  start-up companies have other avenues to access capital such as new or  expanded capital formation programs in the JOBS Act. As a result, the  officials said that increasing the minimum thresholds would not limit a  start-up company’s ability to access capital.
According to SEC staff, it does not have a list of accredited investors  because maintaining such a list would be impractical because there are  so many accredited investors and could raise privacy concerns. If  maintaining such a list were possible, the costs of doing so would likely  outweigh the benefits. Therefore, determining the potential impact of  changes to the existing thresholds on the pool of accredited investors is  difficult. To estimate such impacts, we analyzed Survey of Consumer  Finances data, the data that SEC also uses for these purposes. These  data show that changing the thresholds for net worth and income would  affect the pool of eligible accredited investors. Specifically, we found  that increasing the minimum net worth or income thresholds would  decrease the number of eligible household investors. Our analysis of  federal household net worth data showed that adjusting the minimum  thresholds to account for inflation from $1 million to approximately $2.3  million—the inflation adjusted amount—would decrease the number of  households qualifying as accredited from approximately 8.5 million to  approximately 3.7 million. Table 2 illustrates how further adjusting the  thresholds affects the number of eligible investors.
Market participants with whom we spoke said adjusting the thresholds  upward for the existing net worth and income criteria would be feasible,  but market acceptance would depend on how much the thresholds were  adjusted.
The majority of market participants (25 of 27) said it would be feasible  to increase the income requirements and 24 of 27 said it would be  feasible to increase the net worth thresholds.
Sixteen of 27 market participants said the market likely would accept  increasing the minimum annual income requirement, and 17 said the  market likely would accept increasing the minimum net worth  requirement.
The extent to which the market would accept increased thresholds would  depend on which part of the market is considered. For example,  according to four representatives from associations, the small business  and investor communities would be resistant to increased thresholds  because this would limit the pool of investors. However, according to  NASAA, and an a consumer advocacy group they would support  increased thresholds because it would bolster investor protection. One  market participant noted that increasing the thresholds could be a  problem for some existing investors if they no longer qualified under the  new thresholds, and consideration would have to be given to their existing  investments.
In our other interviews, market participants said that the current  thresholds provide certainty and said while it is feasible to adjust them  because they have not been adjusted, it would increase costs and  therefore not be well received by all market participants. For example,  one industry expert and two representatives from investor associations  said that the current criteria have the advantage of providing certainty for  the industry, which encourages investments in start-up companies.  However, the industry expert also thought the standard was overinclusive  because of the increased number of people who can now meet the  thresholds compared with the numbers eligible when the thresholds were  first put into effect. Two representatives from industry associations also  said that adjusting the thresholds upward would increase costs by  changing internal systems and procedures for assessing investors’ status,  making the adjusted thresholds less accepted.
section_title: Market Participants Identified Alternative Criteria SEC Could Use in the Investor Standard
paragraphs: In addition to asking about the existing criteria, we asked market  participants about eight alternative criteria related to investors’ financial  resources and their understanding of financial risk. We identified these  alternative criteria from previous SEC proposed changes to the  accredited investor standard, relevant academic literature, and criteria  used by foreign regulators. While citing net worth as the most important,  market participants indicated that using criteria for financial resources (25  of 27) and understanding of financial risk (22 of 27) could both be  important to determine accredited investor status. Among the financial  resources criteria, market participants thought a liquid investments  requirement (that is, a minimum dollar amount of investments in assets  that can be easily sold, are marketable, and the value of which can be  verified by a financial institution) was the most important for balancing  investor protection and capital formation. Among the understanding of  financial risk criteria, market participants selected the use of a registered  investment adviser as most important (see fig. 5).
Market participants offered varying views on alternative criteria, citing  advantages and disadvantages of either replacing criteria related to an  investor’s financial resources or adding criteria related to an investor’s  understanding of financial risk.
Liquid investments requirement. Many market participants told us  that the liquid investment criteria could either replace the current  criteria or be added to it. A liquid investment requirement would  require an investor to have a minimum dollar amount of investments  in liquid assets, such as assets that can be easily sold, are  marketable, and the value of which can be verified by a financial  institution. As shown in figure 6, 13 of 27 market participants said  that replacing the existing criteria with a new requirement related to an  investor’s liquid investments would strengthen investor protection;  however, 16 said it would limit capital formation. Many market  participants thought that the liquid investments requirement should be  considered as an addition to the existing accredited investor criteria.  Three market participants said it was indicative of cumulative  investment experience or an investors’ understanding of financial risk.  Three market participants additionally commented that it was  important for investors to have liquid assets because securities that  are liquid could be easily liquidated to cover setbacks in investments.
Most market participants (17 of 27) said it would be feasible to replace  the existing accredited investor standard with a liquid investment  requirement. However, they were divided about whether it was likely  to be accepted by the market (13 likely to accept, 13 unlikely to  accept). Another association commented that a liquid investments  requirement would be straightforward to implement. However, a few  others said that investment portfolios might be difficult to verify and  that asking financial institutions to verify investments would make this  criterion less feasible. Two market participants as well as a  representative from an industry association said that clearly defining  liquid investments was important and that the definition would affect  whether the criterion would be feasible.
Fixed-percentage investment. Only one-third of market participants  told us that the fixed-percentage criterion would strengthen investor  protection (9 of 27).  Few market participants told us that fixed- percentage should be considered as an addition to the current criteria  (5 of 27). A fixed- percentage investment would require an investor to  limit their investments in a single, nonpublic securities offering to a  certain percentage of their individual net worth or income. Many  market participants said replacing the current standard with fixed- percentage investments would have no effect on investor protection  (14 of 27) and that it would limit capital formation (15 of 27). Five of  27 market participants thought that the fixed-percentage requirement  should be considered as an addition to the current standard. Two  market participants noted that this criterion would help to promote  diversification in an investor’s portfolio and could promote investor  protection. For example, one representative from an industry  association told us that an individual’s investment portfolio would  better approximate financial resources than net worth or income and  another representative from an industry association said it would help  to minimize risk posed to investors.
However, in general, market participants thought that replacing the  existing criteria would not be feasible (18 of 27) and not likely be  accepted by the market (19 of 27). Two market participants  commented that it would be difficult to implement and it might be  burdensome to update and monitor the percentage figure.  Furthermore, one market participant said that if an investor is only  able to invest a small amount due to the fixed-percentage limit  entrepreneurs might not find that small amount helpful.
Market participants also offered a range of views on alternative criteria  related to an investor’s understanding of financial risk. Figure 7  summarizes participants’ views on these alternatives.
Registered investment adviser requirement. Of the six alternative  criteria related to an investor’s understanding of financial risk,  participants most often said that the registered investment adviser  criterion should be added to the existing criteria. That is, the criterion  would require an investor who wishes to invest in a private placement  offer to use the services of a registered investment adviser to manage  their investment accounts. A majority of market participants (14 of 27)  thought that adding a registered investment adviser criterion to the  current standard would strengthen investor protection but were  divided about its effects on capital formation (see fig. 7). Some  market participants and an industry association we interviewed noted  that advisers examined the financial needs of their clients. As a result,  they determined this requirement would promote investor protection.
In addition, most market participants (21 of 27) said that having a  registered investment adviser criterion would be feasible to implement  and that the market would be willing to accept it. For example, two  market participants told us that this criterion could be feasible to  implement because advisers were already vetted (registered and  subject to regulation). Another market participant said that having an  adviser would be a practical and objective way to approximate  understanding of financial risk. However, one market participant said  that this standard represents a new cost to investors because they  would have to pay for the services of a registered adviser. In addition,  representatives from an investment adviser firm and an angel investor  group said that investment advisers might not recommend private  placements because of their asset management role and  compensation structure. That is, investment advisers buy and sell  assets on behalf of their clients and generally base their fees on the  assets managed. Because investments in private placements would  be illiquid, investment advisers would not be able to manage the asset  to generate greater return. As a result, the compensation structure for  investment advisers would not readily accommodate private  placements.
Self-certification investor designation. While market participants  were divided on the impact of adding a self-certification criterion on  investor protection, they generally agreed on the impact on capital  formation. Through a self-certification process the investor would  self-certify based on standards, such as membership in a network of  investment groups, work experience (director of a company), or  investment experience. Ten market participants told us a self- certification process would weaken investor protection; 11 said it  would have no effect. However, the majority (17 of 27) said it would  promote capital formation. One market participant expressed  concerns that individuals could self-certify to become an investor  without actually meeting the qualification criteria. Another said that  self-certification based on being in an investment group or being a  director would not approximate understanding of financial risk.  Another market participant commented that having a self-certification  option would emphasize to potential investors that they should not  take investments in private placements lightly.
Market participants had favorable views about the feasibility and likely  market acceptance related to a self-certification criterion. A majority of  market participants said that self-certification was feasible (19 of 27)  and that the market would be willing to accept it (23 of 27). One  market participants said that self-certification was similar to the  current process in which investors self-certify that they meet either  income or net worth thresholds. Moreover, representatives from an  investment company association said that investment and work  experience would demonstrate an individual’s ability to analyze  investments. However, a representative from NASAA cautioned that  the standards for qualifying work experience would have to be  specific.
License and certification standard. Market participants had  conflicting views about the effect of adding a new licenses and  certification requirement to the existing criteria. Under such a criterion,  an investor would have to demonstrate knowledge of financial risks  related to private placement investments to receive a license from  regulators or authorized third parties. About the same number of  market participants said that adding such a requirement would  strengthen, weaken, or have no effect on investor protection (10, 8,  and 9, respectively). Furthermore, 12 of 27 participants said it would  promote capital formation and 10 of 27 said that it would have no  effect. Five participants said the requirement would limit capital  formation. A market participant said that having a license and  certification requirement would encourage unscrupulous companies to  develop and issue certification without appropriately making  assessments. Another market participant told us that having a license  might not mean that these investors could absorb the loss.
Many market participants (15 of 27) did not think it would be feasible  to add a license and certification requirement. Three market  participants and two representatives from associations raised a  number of issues including that some investors might be unwilling to  take the steps to be licensed. Nevertheless, 16 of 27 market  participants thought the market would accept it.
Investor sophistication test. Many market participants told us that  adding the sophistication test criterion to the existing criteria would not  likely be accepted by the market. With this criterion, an investor would  complete SEC-approved investor education classes and pass a test  that would qualify them as accredited. About the same number of  market participants said that adding an investor sophistication test  would either strengthen or have no effect on investor protection.  Furthermore, 11 of 27 participants said that there would be no effect  on capital formation; the remaining were split on whether the test  would promote or limit it.
While many participants (16 of 27) thought that the market would  accept the addition of a test, market participants were split on whether  a test would be feasible. Representatives from two industry  associations suggested that investors could take the investments  segment of the examination for stockbrokers. However, two market  participants raised questions about whether investors would be willing  to take the test or spend time to prepare for it and take a test to  become a certified sophisticated investor. Furthermore,  representatives from another association said the test could quickly  become overly complex given the variety of investments available and  the frequency of changes in investment products. Also,  representatives from associations questioned who would administer  the test and where the resources to administer the test would come  from.
Education standard. Under this criterion, an investor would qualify  as accredited based on an advanced degree in business or finance,  or a chartered financial analyst credential or similar designation. While  14 of 27 market participants told us that an education criterion would  have no effect on investor protection, 11 of the participants said  education would promote capital formation. For example, one  market participant said that the education criterion would allow  younger people who might not have financial resources but  understood financial risks to invest in private placement offerings.  However, two market participants said that having an advanced  degree, such as in business, would not necessarily give an investor  the necessary knowledge to invest wisely. A majority of market  participants said that an education criterion would be feasible (23 of  27) and that the market would be willing to accept it (18 of 27).  Representatives from one industry association we interviewed said  verifying education would be a simple process. However, one market  participant said that market acceptance would depend on the  documentation that would be required of the investor.
Opt-in provision. Market participants’ views were divided about the  inclusion of an opt-in provision. With an opt-in provision, the investor  would sign a statement that waives significant rights to file a complaint  to seek compensation unless there is fraud on the part of the issuer. A  majority (17 of 27) of market participants said that the provision would  decrease investor protection. One market participant commented  that the provision would decrease investor protection because it would  take away the burden of proof from an issuer in relation to fraud. An  equal number of participants said that it would promote or have no  effect on capital formation. Market participants had more favorable  views about the feasibility and likely market acceptance of a new opt- in criterion. A majority of market participants said that it would be  feasible (17 of 27) and that the market would be willing to accept it (21  of 27). For example, one market participant said that an opt-in form  would be easy to implement. However, two market participants noted  that state securities regulators would object strongly to the addition of  this criterion because it decreased protection for investors.
section_title: Conclusions
paragraphs: The intended purposes of the accredited investor standard are to protect  investors and streamline capital formation for small businesses. However,  beyond excluding an investor’s primary residence in the calculation of net  worth in 2010, the standards for qualifying as an individual accredited  investor have remained unchanged since the 1980s. As a result, some  market participants and policymakers have raised concerns about  diminished investor protection as the numbers of individuals able to  qualify as accredited has increased over the years. Of the existing criteria  for qualifying as an accredited investor, most market participants with  whom we spoke said that net worth was the most important criterion for  balancing investor protection and capital formation. However, these  participants also identified alternative criteria that could also achieve  these goals. Specifically, market participants we spoke with most often  supported adding an investment requirement or use of an investment  adviser as an alternative criterion that would balance investor protection  and capital formation, be relatively feasible to implement, and have some  level of acceptance by the market. SEC must review the definition of  accredited investor every 4 years beginning in 2014. Our report on market  participants’ views on the existing and alternative qualification criteria for  accredited investor status will be published in July 2013. By examining  the potential effects of the existing and alternative criteria when it  conducts its review in 2014, SEC could help ensure that it is using the  most appropriate ones for qualifying investors as accredited.
section_title: Recommendation for Executive Action
paragraphs: To further advance the goals of balancing investor protection and capital  formation in its accredited investor standard, SEC should consider  alternative criteria, including those in this report, to help determine an  individual’s ability to bear and understand the risks associated with  investing in private placements. For example, market participants that we  spoke with identified adding a liquid investment requirement or use of an  investment adviser as alternative criteria that would balance investor  protection and capital formation, be relatively feasible to implement, and  have some level of acceptance by the market.
section_title: Agency Comments
paragraphs: We provided SEC a draft copy of this report for their review and  comment. SEC provided written comments that are reprinted in appendix  IV. SEC also provided technical comments that were incorporated as  appropriate.
In its written comments, SEC agreed with our recommendation.  Specifically, SEC noted that the Dodd-Frank Act requires the agency to  review the definition of accredited investors four years after the law’s  enactment. SEC said that it would consider alternative criteria  (particularly, adding liquid investments and the use of a registered  adviser) when it completes its mandated review.
We are sending copies of this report to the Chairman of the Securities  and Exchange Commission, the appropriate congressional committees,  and other interested parties. In addition, the report will be available at no  charge on GAO’s website at http://www.gao.gov.
If you or your staffs have any questions about this report, please contact  me at (202) 512-8678 or clowersa@gao.gov. Contact points for our  Offices of Congressional Relations and Public Affairs may be found on  the last page of this report. GAO staff who made major contributions to  this report are listed in appendix V.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: This report examines market participants’ views on (1) the existing criteria  for qualifying for accredited investor status, and (2) alternative financial  and other qualification criteria.
For both objectives, we reviewed the Securities and Exchange  Commission’s (SEC) current definition and legislative history of the  standard. We reviewed SEC’s proposed changes to the accredited  investor standard since 2006, market participants’ comment letters to  SEC regarding these proposals, and academic literature related to  accredited investors and private placements. We interviewed and asked  officials from the SEC, Financial Industry Regulatory Authority (FINRA),  and North American Securities Administrators Association (NASAA) for  their views about the current and proposed accredited investor standards.  We asked SEC, FINRA, NASAA, the Department of Treasury, Commodity  Futures Trade Commission, and Consumer Financial Protection Bureau  about any financial literacy efforts directed at individuals who qualify as  accredited investors and they told us that they were not aware of any  relevant financial literacy efforts that we could consider. We interviewed  officials from the Ontario (Canada) Securities Commission and United  Kingdom Financial Services Authority to obtain information about their  investor standards, especially those similar to the U.S. accredited investor  standard. We conducted interviews with academics; lawyers  knowledgeable about accredited investor issues; other securities market  and investment experts; trade associations representing investors, capital  formation groups, small businesses, and private equity groups. These  associations included the Securities Industry and Financial Markets  Association, Angel Capital Association (ACA), National Venture Capital  Association (NVCA), American Association of Individual Investors (AAII),  Investment Adviser Association (IAA), National Small Business  Association, SecondMarket, and the Investment Company Institute.
To examine market participants’ views on the existing criteria for  accredited investor status, and the potential effects of changes to the  standard on investor protection and capital formation, we conducted  structured interviews by telephone with a judgmental sample of 27 market  participants whom we categorized in four groups intended to represent  different segments of the accredited investor population: (1) attorneys  who have experience in private placement transactions, (2) accredited  investors who invest in private placement securities, (3) retail investors  who meet the current accredited investor criteria but do not actively invest  in private placement securities, and (4) investment advisers and broker- dealers who work with accredited investors. We asked the participants of  the structured interviews (market participants) about the feasibility,  likelihood of market acceptance, and impact on investor protection and  capital formation of adjusting the existing criteria. We worked with  associations to identify market participants to interview. We identified  seven associations that represent the types of individuals in the four  groups described above. These associations are the American Bar  Association, the Securities Industry and Financial Markets Association,  the Financial Services Institute, ACA, AAII, IAA, and NVCA. We selected  these groups from a broader list of organizations we previously identified  as knowledgeable about accredited investors or that were recommended  by others. These organizations then recruited members to participate in  the interviews. We also asked participants for referrals to other individuals  who might be interested in participating.
Our sample of 27 market participants consisted of 11 attorneys, 5  investment advisers, 5 angel investors, and 6 retail investors who qualify  as accredited investors but do not actively invest in unregistered  securities. We asked them demographic questions to learn more about  their backgrounds and help put their responses in context.
We interviewed 11 attorneys, of whom 1 had more than 4 years of  experience with Regulation D transactions, 1 had more than 11 years  of experience, and 9 had more than 20 years. They represented  accredited investors, issuers, and placement agents and practiced in  different cities throughout the United States, although 5 were located  in New York City or Washington, D.C.
We interviewed 5 broker-dealers or investment advisers: 3 said they  recommended Regulation D investments to clients at least once a  week; 1 said once a month; and 1 said several times a year. The size  of their firms ranged from less than 50 employees to 5,000 employees  or more. We did not ask the advisers about their geographic location.
We interviewed 5 angel investors, 1 of whom had 4 more than 10  years of experience investing in private placements, and 4 who had  more than 11 years of experience. They invested in industries  including information technology, biotechnology, health care, energy,  medical devices and equipment, and energy. The companies in which  the group members invested were primarily located in the Midwest,  but two individuals invested in start-up companies throughout the  United States.
We interviewed 6 retail investors over the age of 55, all of whom had  at least a bachelor’s degree and 1 of whom occasionally used the  services of an investment adviser. They resided in different regions of  the United States.
We conducted the structured interviews from February through March  2013. One team member asked the questions while a second recorded  the responses in a web-based questionnaire. We took steps to minimize  errors, such as difficulties interpreting a particular question, by pretesting  the interview questions with one member from each of the groups in  January 2013. We conducted pretests to make sure that the questions  were clear and unbiased and that they did not place an undue burden on  respondents. An independent survey specialist within GAO also reviewed  a draft of the questions prior to their administration. We made appropriate  revisions to the content and format of the questionnaire after the pretests  and independent review. The results from the structured interviews are  not generalizable to the population of market participants and only  represent the opinions of these 27 individuals. However, as described  above we took steps to obtain opinions from a diverse group of market  participants.
Because the population of accredited investors is unknown, we performed  an additional analysis to suggest how changing the thresholds for net  worth and income would affect the pool of eligible investors. We used  data from the Survey of Consumer Finances (SCF), which the Board of  Governors of the Federal Reserve System (Federal Reserve) issues  every 3 years, to examine how changing the thresholds would affect the  pool of eligible households represented by survey respondents. For the  purposes of this analysis, a household refers to the primary economic unit  within a household (to which the SCF refers as a family). We used net  worth and income as defined in a Federal Reserve publication about the  SCF. For net worth, we excluded home equity. We did not attempt to  determine the appropriate threshold based on a household’s marital  status. For the estimates in table 3, we followed SCF guidance and  estimated the standard errors (which appear in parentheses). We found  the data to be sufficiently reliable to evaluate household income and net  worth levels.
To examine market participants’ views on alternative financial and other  qualification criteria, we identified accredited investor criteria that market  participants and others proposed, and identified relevant criteria used by  the Ontario (Canada) Securities Commission and the United Kingdom  Financial Services Authority to qualify similar types of investors. From the  list of proposed and foreign regulator criteria, we identified a list of criteria  that was consistent with the intended purpose of the accredited investor  standard and that could be used to qualify individual investors as  accredited. We grouped these criteria into two categories: investors’  access to financial resources and their understanding of financial risk.  (1) Investor’s financial resources
Liquid investments requirement. Investors would have to have  a minimum dollar amount of investment in liquid assets (that is,  assets that can be easily sold, are marketable, and the value of  which can be verified by a financial institution).
Fixed-percentage investment. Investors would be limited in their  investments in single, nonpublic securities offerings to a certain  percentage of their individual net worth or income.  (2) Investor’s understanding of financial risk
Licenses/certification. Investors would have to demonstrate  knowledge of financial risks related to private placement  investments to receive licenses from regulators or authorized third  parties.  Investor sophistication test. Investors would complete SEC- approved investor education classes and pass a test that would  qualify them as accredited.
Self-certifying as a sophisticated investor. Investors would self- certify based on standards such as membership in a network of  investment groups, work experience, or investment experience.
Education. Investors would qualify as accredited based on an  advanced degree in business or finance, a chartered financial  analyst credential, or similar designation.
Opt-in provision. Investors would sign a statement that waives  significant rights to file a complaint or seek compensation unless  there is fraud on the part of the issuer.
Registered investment adviser requirement. Investors who  wished to invest in private placement offerings would have to use  the services of registered investment advisers to manage their  investment accounts.
We asked the 27 market participants if the current standard (income and  net worth) should be adjusted and to identify the most important criteria  for balancing capital formation and investor protection from the two  respective categories. We asked the market participants three different  lines of questions: (1) the effect of increasing or decreasing the minimum  income or net worth thresholds; (2) the effect of replacing the current  standard with an alternative criterion for financial resources; (3) the effect  of adding a criterion for understanding financial risk to the current  standard. By replace, we meant that potential investors must qualify  under the alternative criterion. By add, we meant if potential investors did  not qualify under the current standard, they could qualify under an  alternative. For each criterion, we asked about the effects on feasibility,  likelihood of market acceptance, and impact on investor protection and  capital formation. We did not ask about the effects of adding alternative  financial resources criteria to the current standard or replacing the current  standard with criteria for understanding financial risk. However, we asked  market participants if the current standard should be added with a  criterion for financial resources and if any criterion for understanding  financial risk should be replaced to the current standard. Appendix III  includes the questions that we asked market participants and our results.
We compared response patterns between the four types of market  participants that we interviewed and found that generally, there were little  differences in those patterns. A response pattern is the variability in  response options chosen. For example, all 11 lawyers responded that the  education standard was feasible, whereas other groups responded that it  was feasible (12) or somewhat or not feasible (4). However, we cannot  conclude that the differences indicate a statistical difference in opinion  because of the small and varying sample sizes of each group and the fact  that they are not statistically representative samples.
We conducted this performance audit from June 2012 to July 2013 in  accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.
section_title: Appendix II: Summary of Rules for Exemption from Registration under Regulation D
paragraphs: The Securities Act of 1933 generally requires securities issuers to register  securities offerings with SEC. However, the act exempts certain offerings  from registration, which SEC has implemented by regulation when it  determines that the registration procedure is not required for investor  protection. Regulation D, adopted by SEC in 1982, describes terms and  conditions that qualify a securities offering for an exemption from  registration. Regulation D contains multiple rules, which include  definitions of terms, general conditions applicable to the offerings,  requirements for exemptions, and deadlines for notices of claims of  exemptions. Table 4 summarizes Rules 504, 505, and 506, which  establish registration exemptions.
section_title: Appendix III: Summary of Results from Our Structured Interviews
paragraphs: We conducted structured interviews to determine the potential impact on  investor protection and capital formation of replacing or adding alterative  criteria to the existing criteria for determining accredited investor status.  We also asked market participants’ opinions about the potential impact on  investor protection and capital formation of marketing and advertising  securities offerings under Regulation D, Rule 506. We interviewed 27  individuals representing different segments of the accredited investor  population: 11 attorneys who represent issuers of private placements, 5  investment advisers, 5 individuals who are active investors in private  placements, and 6 individuals who meet the current criteria for accredited  investor status but are not active investors. The interviews were  conducted from February through March 2013. For more information  about our methodology for designing and conducting these interviews,  see appendix I.
section_title: Appendix IV: Comments from the Securities and Exchange Commission
section_title: Appendix V: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the individual named above, Triana McNeil (Assistant  Director), Benjamin Bolitzer, Jeremy Conley, William Chatlos, Katherine  Bittinger Eikel, Elizabeth Jimenez, Jill Lacey, Angela Messenger, Marc  Molino, Barbara Roesmann, Jessica Sandler, and Weifei Zheng made  major contributions to this report.