The Securities Act of 1933 makes it illegal to sell securities unless the offering is registered with the Securities an
Section 4(a)(2) of the Securities Act exempts “transactions by an issuer not involving any public offering.” There is no definition in the statute or, for that matter, in the securities regulations of a “public offering” or, conversely, of what is not a public offering. The leading Supreme Court case interpreting this statutory provision is SEC v. Ralston Purina Co. In that 1953 case, the court held that “the applicability of §4(1) [now §4(a)(2)] should turn on whether the particular class of persons affected needs the protection of the Act. An offering to those who are shown to be able to fend for themselves is a transaction ‘not involving any public offering.’” An offering that is not a public offering is generally called a private placement or private offering, and section 4(a)(2) is usually called the private placement or private offering exemption.
Regulation D and Rule 506
The SEC adopted Regulation D in 1982 during the Reagan Administration. Regulation D creates a safe harbor such that an issuer that complies with the requirements of Regulation D will be treated as exempt pursuant to the private-offering exemption from the registration requirements of the Securities Act. Regulation D achieves this by creating three exemptions (Rule 504, Rule 505, and Rule 506). According to SEC data, in 2014, registered (public) offerings accounted for $1.35 trillion of new capital raised, compared to $2.1 trillion raised in private offerings. Regulation D accounted for $1.3 trillion (62 percent) of private offerings in 2014. Regulation D is of central importance to the ability of businesses to raise the capital they need to launch or grow.
Under Rule 506, a company may raise an unlimited amount of money. It may sell securities to an unlimited number of “accredited investors” and up to 35 non-accredited yet sophisticated investors. Under Regulation D an “accredited investor” is, generally, either a financial institution or a natural person who has an annual income of more than $200,000 ($300,000 joint) or a residence exclusive net worth of $1 million or more.
The Sophisticated-Investor Problem in Regulation D
The problem is that the regulatory definition of what constitutes a sophisticated investor is highly amorphous. It hinges on whether the investor has such “knowledge and experience in financial and business matters” that the investor “is capable of evaluating the merits and risks of the prospective investment.” The risk to an issuer of selling to an investor whom the issuer deemed sophisticated, but whom a court or regulator later deems unsophisticated, is the risk of having the issuer’s entire offering disqualified or being subject to rescission demands by investors in subsequent litigation. Accordingly, many issuers are very reluctant to rely on the sophisticated-investor provisions of Regulation D. In fact, only 10 percent of Regulation D offerings have any non-accredited investors, and they typically account for a minor portion of the capital raised.
What this means in practice is that sophisticated investors without high incomes or net worth are unable to invest in the companies with the most profit potential. People who fall in this category are disproportionately young. It also means that young entrepreneurs seeking to raise capital from their non-wealthy peers find it more difficult to raise capital.
The Solution: Bright-Line Tests to Determine Sophistication
The solution is for Congress to broaden the definition of an accredited investor for purposes of Regulation D to include persons who have met specific statutory “bright-line” tests for whether an investor has the “knowledge and experience in financial and business matters” and whether the investor “is capable of evaluating the merits and risks of the prospective investment.” For example, Congress could provide that someone is an accredited (or sophisticated) investor for purposes of Regulation D who has (1) passed a test demonstrating the requisite knowledge, such as the General Securities Representative Examination (Series 7), the Securities Analysis Examination (Series 86), or the Uniform Investment Adviser Law Examination (Series 65), or a newly created accredited investor exam that tested for investment knowledge; (2) met relevant educational requirements, such as an advanced degree in finance, accounting, business, or entrepreneurship; or (3) acquired relevant professional certification, accreditation, or licensure, such as being a certified public accountant, chartered financial analyst, certified financial planner, or registered investment adviser.
The Fair Investment Opportunities for Professional Experts Act
In February, the House passed, by a vote of 347 to eight, the Fair Investment Opportunities for Professional Experts Act (H.R. 2187), introduced by Representative David Schweikert (R–AZ). This bill would amend the statutory definition of accredited investor and increase the number of investors who can legally invest in private placements offered pursuant to Regulation D. It would enable certain people who do not have a high income or high net worth to invest in promising-but-high-risk companies. Because it leaves so much discretion to financial regulators, its impact may be large or small.
Probably the most important step the bill takes is to statutorily set the monetary tests for individuals to become accredited investors at their current levels and index them for inflation going forward. There has been a major push by liberal interest groups to radically raise the accredited investor monetary thresholds, potentially reducing the number of people who can invest in private offerings by 60 percent to 70 percent. In December 2015, the SEC released a Dodd–Frank-mandated study of the issue. In that study, the SEC calculates that adjusting the accredited investor thresholds from their current levels for inflation since 1983 to $600,558 in joint income or $2.5 million in residence exclusive net worth would reduce the percentage of households who are eligible to invest in private offerings from 10.1 percent of households to 3.6 percent of households. Put differently, the adjustment would bar over 8 million households from investing in private offerings. By specifying the thresholds statutorily, the bill would prevent the SEC from adopting revised rules, raising the threshold and potentially preventing millions of investors from choosing to invest in private offerings.
The bill would also treat as “sophisticated,” and therefore able to invest in private offerings, registered brokers, registered investment advisers, and “any natural person the SEC determines, by regulation, to have demonstrable education or job experience to qualify such person as having professional knowledge of a subject related to a particular investment, and whose education or job experience is verified by the Financial Industry Regulatory Authority.”
This aspect of the legislation is less than ideal for two reasons. First, the definition is too narrow. Congress should specify by statute that any person who passes a test demonstrating the requisite knowledge should be eligible. It should not be limited to only financial professionals. Congress should also specify the educational, licensure, or accreditation attainment that would make a person eligible. If these requirements are met, no further action from regulators should be required. For example, if Congress indicated that certified public accountants (CPAs) were to be deemed sophisticated, no action by the SEC or the Financial Industry Regulatory Authority (FINRA) should be required in order for a CPA to invest in a private Regulation D offering. Congress should also allow, as the bill does, financial regulators to broaden the definition of a sophisticated investor by, for example, providing a list of private accreditations (as a certified financial planner, for example) that would meet the requirement.
Second, the bill effectively delegates the decision about whether a person is sophisticated for purposes of Regulation D to FINRA, by requiring that FINRA verify the person’s “education or job experience.” FINRA is a so-called self-regulatory organization (SRO). It is a private organization that is not adequately accountable to the industry, the public or the SEC. It is not subject to the rule-making safeguards built into the Administrative Procedure Act (APA). It would be highly preferable for Congress to write the primary rules itself. Congress has become much too willing to effectively delegate law-making authority to the executive branch. But should Congress decide to delegate the power to write the rules about who qualifies as a sophisticated investor, it should delegate it to the executive branch—in this case the SEC—not to FINRA, because the SEC is subject to the basic protections built into the APA, such as the requirement to provide notice of the rule-making, provide the public the opportunity to comment on proposed rules, and to make the decision to promulgate the rule in a public meeting.
The SEC should write rules such that most of the requirements are self-effectuating and require no verification by FINRA. Investors should not have to go to FINRA, pay a fee, prove they are a CPA or have a particular degree or certification, and obtain FINRA’s approval before they can invest in a private offering. The only exception to this should be FINRA-administered exams, such as the General Securities Representative Examination (Series 7), the Securities Analysis Examination (Series 86), the Uniform Investment Adviser Law Examination (Series 65), or a newly created accredited investor exam that tests for investment knowledge.
Regulation D is a key means that companies use to raise the capital they need to launch and grow. It accounts for over $1.3 trillion in new capital annually. Under current Regulation D rules, sophisticated investors without high incomes or net worth are often unable to invest in the companies that offer the greatest opportunity but often with greater risk. People who fall in this category are disproportionately young people. Current rules are amorphous and have demonstrably limited the pool of people from whom businesses can raise capital. Only 10 percent of Regulation D offerings have any non-accredited investors, and they typically account for a minor portion of the capital raised. Congress should address this problem by providing bright-line rules for determining who is sophisticated and therefore eligible to invest in Regulation D private placements. This would increase the number of people who are allowed to invest in private firms, broadening the options available to investors and helping entrepreneurs to raise capital.
The House-passed Fair Investment Opportunities for Professional Experts Act would have a positive impact on both investors and entrepreneurs. By statutorily setting accredited investor income and net-worth thresholds at current levels, the legislation prevents a substantial increase in those thresholds by the SEC, which is a serious possibility and would be a very adverse development. The legislation should, however, be improved by broadening the definition of who would qualify as sophisticated by specifying the educational, licensure, or accreditation attainment that would make a person eligible, while allowing financial regulators the option of further broadening who qualifies. It should also minimize the role of FINRA.
—David R. Burton is Senior Fellow in Economic Policy in the Thomas A. Roe Institute for Economic Policy Studies, of the Institute for Economic Freedom and Opportunity, at The Heritage Foundation.