In 2016, U.S. businesses raised about $1.7 trillion in capital by means of private offerings. Because companies are going public much later than in the past, those who invest in private offerings generally receive a higher share of returns generated by successful entrepreneurial ventures than those who invest in relatively late-stage public companies. Yet the securities laws restrict who can invest in private offerings to the most affluent 7 percent to 10 percent of U.S. households. Congress should democratize access to these private offerings so that they are available to more investors.
The House has passed legislation sponsored by Representative David Schweikert (R–AZ) that could be a small step in this direction, although it contains a significant drafting error that needs to be corrected if it is to have its intended effect. Senator Thom Tillis (R–NC) and Senator Catherine Cortez Masto (D–NV) have introduced better-drafted legislation that would make more substantial, although still modest, reforms to increase access to private offerings. Both of these bills are called the Fair Investment Opportunities for Professional Experts Act.
The Securities Act of 1933 makes it generally illegal to sell securities unless the offering is registered with the Securities and Exchange Commission (SEC). Making a registered offering (often called going public) is a very expensive proposition and well beyond the means of most small and start-up companies. In addition, the costs of complying with continuing disclosure and other obligations of being a registered, public company are quite high. The Securities Act, however, exempts various securities and transactions from this requirement. The exemption of the greatest importance to entrepreneurs is the exemption for private offerings. The primary means of implementing this exemption is Regulation D.
The SEC adopted Regulation D in 1982 during the Reagan Administration. Although private offerings do not necessarily have to be in compliance with Regulation D, Regulation D provides a regulatory safe harbor such that if an issuer meets the requirements of Regulation D, the issuer will be treated as having made a private offering (often called a private placement). As discussed below, Regulation D investments are generally restricted to “accredited investors,” who are affluent individuals or institutions. The vast majority of Americans are effectively prohibited from investing in Regulation D securities.
Under Rule 506 of Regulation D, a company may raise an unlimited amount of money and sell securities to an unlimited number of “accredited investors,” and up to 35 non-accredited but sophisticated investors. Under Regulation D, an “accredited investor” is, generally, either a financial institution or a natural person who has an income of more than $200,000 ($300,000 joint) or a residence-exclusive net worth of $1 million or more. Unlike under Rule 505, under Rule 506 all non-accredited investors, either alone or with a purchaser representative, must be “sophisticated.”
SEC data show that 90 percent of offerings involve only accredited investors and even those that are not exclusively composed of accredited investors are composed overwhelmingly of accredited investors. Thus, in practice, sophisticated investors without high incomes or net worth are unable to invest in the companies with the most profit potential. People that 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.
Congress Should Increase Access to Private Offerings
Congress, or the SEC on its own initiative, should change the definition of “accredited investor” for purposes of Regulation D to include persons who have met specific statutory bright-line tests that determine whether an investor has the “knowledge and experience in financial and business matters” to be “capable of evaluating the merits and risks of the prospective investment.” Specifically, Congress should provide that someone is an accredited investor for purposes of Regulation D who has:
- Passed a test demonstrating the requisite knowledge, 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 testing for substantive investment knowledge;
- Met relevant educational requirements, such as an advanced degree in finance, accounting, business, or entrepreneurship; or
- Acquired relevant professional certification, accreditation, or licensure, such as being a certified public accountant, chartered financial analyst, certified financial planner, registered representative, or registered investment advisor representative.
The Fair Investment Opportunities for Professional Experts Act
On November 11, 2017, the House passed the Fair Investment Opportunities for Professional Experts Act (H.R. 1585), introduced by Representative Schweikert. This legislation would codify the current income ($200,000 single; $300,000 joint) and net worth (residence exclusive $1 million) thresholds. It would provide the SEC authority that it already has to deem as accredited “any natural person the Commission 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.” Lastly, it would provide that “any natural person who is currently licensed or registered as a broker or investment adviser” is an accredited investor. (Emphasis added.)
This last provision is a drafting error. People often refer to their “stock broker” by which they mean the individual they speak to at the brokerage firm. However, as a matter of law, the “broker” is the firm, not an individual or “natural person” who works at the broker-dealer. In 2017, there were 3,726 securities firms (brokers) that employed 630,132 registered representatives (natural persons). Broker-dealers are legal entities, usually corporations or limited-liability companies. Currently, there are no natural persons who are brokers. What the bill’s authors undoubtedly intend is for licensed individuals who work for brokers to be treated as accredited. Those individuals are registered representatives, not brokers. There are over 13,000 investment advisers registered with the SEC. All, or virtually all, of them are firms not natural persons.
Thus, unless changed, the “broker” and “investment adviser” provisions in the bill will accomplish nothing because there are no brokers who are natural persons and no, or virtually no, investment advisers who are natural persons. Instead of, or in addition to, using the term “broker,” the bill should use the term “registered representative,” and instead of, or in addition to, the term “investment adviser,” the bill should use the term “investment adviser representative.”
The version of the Fair Investment Opportunities for Professional Experts Act introduced by Senators Tillis and Cortez Masto is better drafted than the House-passed legislation, and would increase access to private offerings to a much greater degree. Like the House bill, it would codify the current income and net-worth thresholds. It would, however, index them for future inflation. It would treat as accredited “any natural person who is currently licensed or registered as a broker, dealer, registered representative, investment adviser, or investment adviser representative.” (Emphasis added.) The bill does not, therefore, have the same drafting error discussed above that is contained in the House bill. It would have the effect of allowing registered representatives and investment adviser representatives who provide investment advice to others to make investments in private offerings themselves. The bill also instructs the SEC to issue regulations treating as accredited any natural person that the SEC determines to have demonstrable education, job, or professional experience, sophistication or knowledge, to qualify such person as an accredited investor and sets forth criteria that the SEC should use in drafting the rule. Provided the SEC adopted bright-line tests in its rule, this provision could be highly useful.
Congress should democratize access to private offerings so that they are available to more investors. The Tillis–Cortez Masto version of the Fair Investment Opportunities for Professional Experts Act would take important steps in that direction. The House-passed version would only do so if the drafting error is corrected.
—David R. Burton is a Senior Fellow in Economic Policy in the Thomas A. Roe Institute for Economic Policy Studies, of the Institute for Economic Freedom, at The Heritage Foundation.