August 15, 2016 | Backgrounder on Economy
The Securities and Exchange Commission’s Regulation D accounts for more than $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 opportunities (often with greater risk). People who fall in this category are disproportionately young. Current rules are amorphous and have demonstrably limited the pool of people from whom businesses can raise capital. Congress should provide bright-line rules for determining who is financially sophisticated, and therefore eligible to invest in Regulation D private placements. This would increase the number of people 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. It should, however, be improved by (1) broadening the definition of who would qualify as a sophisticated investor, and (2) minimizing the role of the Financial Industry Regulatory Authority.
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.
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 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 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.
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.
 The Securities Act of 1933, P.L. No. 73–22, 48 Stat. 74, 15 USC §77a et seq. (as amended through P.L. No. 112–106, April 5, 2012), http://www.sec.gov/about/laws/sa33.pdf (accessed May 11, 2016).
 Ibid., §5.
 Proposed Rules, “Crowdfunding,” Federal Register, Vol. 78, No. 214 (November 5, 2013), p. 66509 (col. 2), http://www.gpo.gov/fdsys/pkg/FR-2013-11-05/pdf/2013-25355.pdf (accessed May 11, 2016).
 The Securities Act of 1933, §4(a)(2), 15 USC § 77d(a)(2). Prior to the 2012 Jumpstart Our Business Startups (JOBS) Act, P.L. No. 112–106, the exemption was in §4(2).
 Investors and their attorneys must rely on various court cases, SEC interpretive releases, SEC concept releases, SEC policy statements, SEC staff interpretations, SEC staff legal bulletins, and SEC “no action” letters to make judgments about what will be deemed a public offering.
 346 U.S. 119 (1953), http://caselaw.lp.findlaw.com/scripts/getcase.pl?court=US&vol=346&invol=119 (accessed May 11, 2016).
 This “fend for themselves” formulation is highly suspect, since whether an offering is “public” is analytically unrelated to whether the investors in the offering can “fend for themselves.” For example, an offering to one utterly unsophisticated person wholly incapable of fending for himself with whom there is a substantial pre-existing relationship is not public in any meaningful sense (such as the CEO’s never-employed son who was a poetry major in college is the sole offeree). Conversely, an offering limited to those demonstrably able to “fend for themselves” (by whatever measure) conducted on national television and with whom there was no pre-existing relationship is certainly public in the ordinary sense of the term (and the authors of the Securities Act of 1933 undoubtedly intended for it to be treated as such).
 “Revision of Certain Exemptions from Registration for Transactions Involving Limited Offers of Sales” (Release No. 33-6389), Federal Register, Vol. 47 (March 16, 1982), p. 11251. Regulation D is found at 17 CFR §230.500 through §230.508. For the original proposed rule, see “Revision of Certain Exemptions from the Registration Provisions of the Securities Act of 1993 for Transactions Involving Limited Offers of Sales” (Release No. 33-6339), Federal Register, Vol. 46 (August 18, 1981), p. 41791.
 Rule 504 replaced Rule 240. Rule 505 replaced Rule 242. Rule 506 modified rule 146. Rules 504 and 505 are rarely used because Rule 506 offerings, unlike Rule 504 and Rule 505 offerings, are exempt from state “blue sky” registration and qualification requirements, which involve substantial expense and delay.
 Scott Bauguess, Rachita Gullapalli, and Vladimir Ivanov, “Capital Raising in the U.S.: An Analysis of the Market for Unregistered Securities Offerings, 2009–2014,” U.S. Securities and Exchange Commission, October 2015, https://www.sec.gov/dera/staff-papers/white-papers/unregistered-offering10-2015.pdf (accessed May 11, 2016).
 The statutory basis for the use of accredited investor in Regulation D is §2(a)(15) of the Securities Act, 15 USC §77b(a)(2). 17 CFR §230.501(a) defines accredited investor for purposes of Regulation D.
 Rule 501(e) excludes all accredited investors from the calculation of the number of purchasers. Rule 506(b)(2)(ii) requires that “each purchaser who is not an accredited investor either alone or with his purchaser representative(s) has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment, or the issuer reasonably believes immediately prior to making any sale that such purchaser comes within this description.” The shorthand for this requirement is that the purchaser must be a “sophisticated investor.”
 Rescission is the right of an investor to “undo” the transaction and get his or her money back. Obviously, such demands are only made if the investment turns out to have been a poor investment.
 Vladimir Ivanov and Scott Bauguess, “Capital Raising in the U.S.: An Analysis of Unregistered Offerings Using the Regulation D Exemption, 2009–2012,” U.S. Securities and Exchange Commission, Division of Economic and Risk Analysis, July 2013, http://www.sec.gov/divisions/riskfin/whitepapers/dera-unregistered-offerings-reg-d.pdf (accessed May 11, 2016).
 Such a provision would be a safe harbor. It would not exclude other means of meeting the existing requirement.
 FINRA, “Series 7 Exam–General Securities Representative Examination (GS),” http://www.finra.org/industry/compliance/registration/qualificationsexams/qualifications/p011051 (accessed May 11, 2016).
 Final Results for Roll Call No. 46, H.R. 2187, February 1, 2016, http://clerk.house.gov/evs/2016/roll046.xml (accessed May 11, 2016).
 Text of H.R. 2187 as passed by the House, https://www.gpo.gov/fdsys/pkg/BILLS-114hr2187eh/pdf/BILLS-114hr2187eh.pdf (accessed May 11, 2016).
 David R. Burton, “Don’t Crush the Ability of Entrepreneurs and Small Businesses to Raise Capital,” Heritage Foundation Backgrounder No. 2874, February 5, 2014, http://www.heritage.org/research/reports/2014/02/dont-crush-the-ability-of-entrepreneurs-and-small-businesses-to-raise-capital, and Rachita Gullapalli, “Accredited Investor Pool,” presentation to the Forum on Small Business Capital Formation, November 20, 2014, http://www.sec.gov/info/smallbus/sbforum112014-gullapalli.pdf (accessed May 11, 2016). The number of accredited investors is estimated by Gullapalli to decline from 12.2 million to 4.3 million households (by 65 percent) when adjusted for inflation since 1983.
 “Report on the Review of the Definition of ‘Accredited Investor,’” U.S. Securities and Exchange Commission, December 18, 2015, https://www.sec.gov/corpfin/reportspubs/special-studies/review-definition-of-accredited-investor-12-18-2015.pdf (accessed May 11, 2016).
 The impact of inflation on the thresholds is miscalculated by the SEC in its December 2015 report. The ratio between the new and old thresholds for individual income and for net worth is 2.45, and 2.00 for joint income. The ratio should be the same (2.45). Thus, the joint-income figure adjusted for inflation should be $735,000, not $600,558. The current level is $300,000.
 “Report on the Review of the Definition of ‘Accredited Investor,’” Tables 4.1 and 4.2.
 Hester Peirce, “The Financial Industry Regulatory Authority: Not Self-Regulation after All,” Mercatus Center Working Paper, January 2015, http://mercatus.org/sites/default/files/Peirce-FINRA_0.pdf (accessed May 11, 2016).
 P.L. 79–404 (1946); 5 U.S. Code 551 et seq.
 FINRA, “Series 7 Exam–General Securities Representative Examination (GS).”