On Wednesday, August 26, 2020, the U.S. Securities and Exchange Commission (SEC), by a vote of three to two, adopted amendments to the definition of “Accredited Investor.” That definition, as noted in an August 26, 2020, statement by SEC Chairman Jay Clayton had “largely remained unchanged for over 35 years.” This action by the SEC was significant enough to earn a Page A 1 article “SEC Eases Access to Private Markets” in the Wall Street Journal of Thursday, August 27, 2020 (col. 6).

The amended definition substantially expands the number of categories of individuals and entities that, again, in Chairman Clayton’s words, “…have demonstrated financial sophistication such that they should not be excluded from the very large, multifaceted and important private capital markets.” The two Commissioners who voted not to approve the definition amendments did so primarily because one key provision in the definition was NOT amended, namely the so-called wealth thresholds. These were not previously and have not been indexed to inflation, which the dissenting Commissioners, Allison Herren Lee and Caroline Crenshaw, note have resulted in an increase of 550% in qualifying households since the thresholds’ adoption in 1983. The dissenters also call out the risk of fraud and of abuse of seniors in the less than transparent private market transactions. On the other side Commissioner Roisman points out that only wealthy individuals had qualified as accredited investors, and noting that “wealth is a crude measure of a person’s ability to make financial decisions,” resulted in “a system [which is] fundamentally unfair, unequal, and unjustified.” While Commissioner Pierce asks: “Why shouldn’t mom and pop retail investors be allowed to invest in private offerings? Why should I, as a regulator, decide what other Americans do with their money?” One may rightfully wonder what it is that drives such disparate views and, further, ask if the very regulatory design does not merely reflect, but also exacerbate the fundamental tensions in the original statutory scheme?

Section 5 and Section 4(2) of the Securities Act of 1933

The market collapse in 1929 and the speculative abuses leading up to it led to the enactment of the suite of Federal securities laws, beginning with the Securities Act of 1933 (the “33 Act”). Section 5 of the 33 Act required the registration with the SEC of ALL securities before they could be sold, SUBJECT to certain limited exceptions, the most significant for our purposes is that found in Section 4(2), which provides that registration is NOT required for “transactions by an issuer not involving a public offering.” Neither the 33 Act nor any other Federal securities law defines, or even frames in outline, what is “a public offering.” For the first 20 years of practice under the 33 Act, the requirements for this private placement exemption received little attention. A 1935 SEC release No. 285 (11 Fed .Reg. 10952) directed that consideration be given to:

1. The number of offerees and their relationship to each other and the issuer;

2. The number of units offered;

3. The size of the offering; and

4. The manner of the offering.

See, for example, SEC v. Sunbeam Gold Mines Co., 95 F. 2nd 699 (9th Cir. 1938)(offer to 530 stockholders was a public offering). Release 285 included the statement “under ordinary circumstances an offering to not more than approximately twenty-five persons is not an offering to a substantial number and probably does not involve a public offering.” As one commentator has noted, ”As a practical matter, both the Staff of the SEC and the practicing bar tended to focus on the question of the number of offerees.” Stanley Schwartz, Jr., “Rule 146: The Private Offering Exemption – Historical Perspective and Analysis,” 35 Ohio State L. J. 738 (1974).

Then in 1953, the United States Supreme Court decided SEC v. Ralston Purina Co., 346 U.S. 119. Ralston Purina had some 7,000 employees. Beginning in 1911, it had encouraged stock ownership by those employees, selling nearly $2 million of its common stock just between 1947 and 1951, relying on the private placement exemption. Those employees were all around the country, had low to high salaries, and numbered between 400 and 1,100 purchasers.. the company claimed that these were all “key” employees. The Court found that Ralston Purina was NOT entitled to rely on the private placement exemption. This led to an understanding that a private placement could ONLY be made to someone with special “access” to the issuer, such as directors and/or officers. In its way, this is consistent with language in the House Report on the 33 Act, which states that the Act:

…carefully exempts from its application certain types of securities and securities transactions where there is not practical need for its application or where the public benefits are too remote.

After Ralston Purina the concept of “access” became both a term of art and the target of regulatory focus, leading to the rejection of much of the thin extant prior case law jurisprudence. So, especially in SEC v. Continental Tobacco, Inc., 463 F. 137 (5th Cir. 1972), where the appellate court reversed a trial court decision finding the issuer met the requirements for the exemption, stating:

The record does not establish that each offeree had a relationship with…[the issuer] giving ACCESS to the kind of information that registration would have disclosed.

In addition, the 5th Circuit also held that the issuer “failed to sustain its burden of proving that there existed no practical need for the …[registration of the offering]” or that “the public benefits …[of registration] were too remote.” Hence, an issuer had to insure that offerees had access to registration-like information AND be able to prove it if challenged in court. This decision reportedly substantially inhibited the ability to raise capital in private placements. In both Ralston Purina and Continental Tobacco, the SEC demonstrated, through its vigorous opposition to the claims by the respective issuers to be able to use Section 4(2) exemption, the Commission’s fundamental distrust of private placements. That “two minded” perspective can still be seen in the several 26 August statements of the Commissioners cited above. It has been noted:

For over forty years the determination of when … [the] vaguely-worded [Section 4(2)] exemption was available was left to ad hoc administrative and judicial interpretations which, in turn, created even greater uncertainty. Robert A. Kessler, “Private Placement Rules 146 and 240 – Safe Harbor?” 44 Fordham L. Rev. 37 (1975).

Market Developments (1953 – 1978) and Efforts to Bring Clarity

The SEC observed in 1962 (in Non-Public Offering Exemption, Release No. 33-4552 [Nov. 6, 1962], 27 FR 11316) that Section 4(2) was traditionally viewed as a way to provide “an exemption from registration for bank loans, private placements of securities with institutions, and the promotion of a business venture by a few closely related persons.” But the “increased use of the exemption for speculative offerings to unrelated and uninformed persons” caused the SEC to issue Release No. 33-4552. After the end of World War II, venture capital investment firms began to operate, starting with American Research and Development Corporation and J.H. Whitney & Company, both founded outside of Boston in 1946. In 1958, at the time of a significant economic contraction, Congress passed the Small Business Investment Act which authorized the U.S. Small Business Administration to create Small Business Investment Companies to help finance and manage small entrepreneurial businesses. Related changes in the Internal Revenue Code helped the rise of private equity funds. In addition, more Americans began investing in the capital markets, a development aided by considerable growth in the mutual fund industry. By 1960, Fidelity Investments, Inc., also of Boston, was marketing its funds to the public at large and not just to wealthy individuals. By the 1960s the development of the transistor, the evolution of computers and photocopiers, and the material advances in the levels of capital market success and participation (the days of the “Nifty Fifty” stocks and of Gerry Tsai and momentum investing) led many more Americans to enter into, or even seek out, “speculative offerings,” especially any offers involving a company a name ending in “tronics.” Yet, the Commission’s 1962 guidance remained a focus on often subjective factors, namely “all surrounding circumstances, including … the relationship between the offerees and the issuer, the nature, scope, size, type and manner of the offering.” By the 1970s, venture financing had come to Silicon Valley with the founding of both Kleiner Perkins and Sequoia Capital in 1972, and the creation in 1973 of the National Venture Capital Association. Then, in 1974, Congress enacted the Employee Retirement Income Security Act (“ERISA”), which among many other provisions forbade company pension plans from investing in “risky” securities, a prohibition not relaxed until the U.S. Department of Labor adopted a “prudent man” investment rule in 1978. The relaxation of this ERISA restriction helped lead institutional investors including pension plans to seek out private equity opportunities.

Pressed by professionals for a more structured regulatory environment, as the SEC had long since refused to provide comfort as to any particular offering, in 1974 the SEC adopted Rule 146 “Transactions By an Issuer Not To Involve Any Public Offering” Release No. 33-5487 (Apr. 23, 1974) 39 FR 15261. Rule 146 provided a “safe harbor” (i.e. registration was not needed and no enforcement action would be brought for violating Section 5 of the 33 Act), in the Commission’s words, “in an effort to provide greater certainty in the application of Section 4(2) exemption.” In the Adopting Release the SEC identified two goals for Rule 146: one, it would “deter reliance on Section 4(2) … for offerings to persons who were unable to fend for themselves in… obtaining and evaluating information about the issuer”; and two, it would “reduce uncertainty and provide more objective standards … when raising capital.” The key provisions of Rule 146 (a Rule that the SEC rescinded only eight years later) were: no more than 35 purchasers; no general advertising; offerees must be furnished OR have ACCESS (that word again) to information about the offering comparable to what would be in a registration statement; only a person who could afford the economic risk of loss from a failed investment AND who was a person the issuer “reasonably believed” had the knowledge and experience to evaluate the risks and merits of the investment OR was the person who had an “offeree representative” capable of providing that knowledge and experience. Once again the Commission approached Section 4(2) with two minds – one, seeking to foster capital formation; the other clearly concerned about possible misuse of the exemption to take money from the unsuspecting. Another commenter hypothesized:

Initially, one might well ask why it took so long for the SEC to come up with these “objective criteria” so that issuers could readily determine when they could safely rely on the exemption. A safe guess is that the SEC probably feared that mechanical tests would leave a loophole through clever securities lawyers could distribute securities to the public without registration and thus impede the investor protection …which registration is designed to insure. In any event, there was great confusion as a result… Kessler, op. cit. 44 Fordham L. Rev. at 41.

The Origin and Function of “Accredited Investor”

As the SEC itself has conceded: “Despite the adoption of Rules 146 [and a parallel Rule 240], the uncertainty surrounding private placements and small business offerings continued.” SEC “Report on the Review of the Definition of ‘Accredited Investor’,” December 18, 2015 ( the “Review Report”), at page 13, ( the Review Report was mandated under Section 413 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 [the “Dodd-Frank” Act]). So in 1978, the Commission conducted a full-scale review (including 21 days of public hearings in six cities across the country) of its regulations in this area, the “Examination of the Effects of Rules and Regulations on the Ability of Small Businesses to Raise Capital and the Impact on Small Businesses of Disclosure Requirements Under the Securities Acts,” Release No. 33-5914 (Mar. 6 1978) 43 FR 10876. This review led to several administrative actions intended to assist the capital raising process, including adopting Rule 242 in January 1980, which allowed limited offerings of up to $2 million under certain conditions and amending both Regulation A to increase the offering limit from $500,000 to $1.5 million and Rule 146 to relax the information required for offerings up to $1.5 million. Rule 242 also introduced the concept of “accredited investor” into the Federal securities laws. Then, later in 1980, Congress enacted the Small Business Investment Incentive Act, which exempted offerings of up to $5 million made to accredited investors from registration under Section 5. Prompted by this Congressional enactment the SEC in December 1980 gave notice that it was considering a wholesale redesign of regulations governing the availability of Section 4(2) exemption. This redesign resulted in the promulgation by the Commission in 1982 of Regulation D and the rescission of Rules 146, 240, and 242. Regulation D consolidated essentially all of the SEC’s approaches to exempting non-public offerings from the registration requirements of Section 5. “Accredited Investor” under Regulation D included the following:

1. An individual making at least $200,000/year (or jointly w/spouse $300,000) for the most recent two years which is expected to continue

2. An individual (or jointly w/spouse) whose net worth not counting the primary residence exceeds $1 million; certain entities w/at least $5 million in investments

3. Banks, savings, and loan associations

4. Registered broker-dealers

5. Insurance companies

6. Registered investment companies

Regulation D operates to give a “safe harbor” from registration to securities offerings, subject to certain constraints on offering size and method, so long as the offerings are made to “accredited investors.” Once again, the SEC did not define either a ”public offering” or its converse, a “non-public” or private offering, rather it identified a “safe harbor” from civil and/or criminal liability for securities offered to specified investor types. Those types have, as Chairman Clayton noted in his August 26, 2020, statement, “…largely remained unchanged for over 35 years.” But, just a fortnight ago, the definition and the types of investors to whom or which securities may be sold without registration changed, materially. But has the Commission’s “two-minded” mindset changed as well, or do the very limitations inherent in the SEC’s contradictory understanding of its purposes continue to inhibit efficient capital formation in the name of investor protection?

Regulatory Design and the Revised Definition

In addressing the purposes for the “accredited investor” definition the SEC stated in the “Review Report” on page 5-6:

The accredited investor definition attempts to identify those persons whose financial sophistication and ability to sustain the risk of loss of investment or ability to fend for themselves render the protections of the Securities Act’s registration process unnecessary. An overly narrow definition that limited the number of accredited investors could risk restricting businesses’ access to a crucial source of capital and be inconsistent with the Commission’s capital formation mandate. An overly broad definition, on the other hand, could potentially be inconsistent with the Commission’s investor protection mandate and run counter to one of the basic tenets of the Securities Act by failing to provide investors with adequate disclosures before they make an investment decision.

Legal systems employ and rely upon a branch of symbolic logic known as deontic logic. This is commonly called the “If -, Then -” design. So for example: IF there is a traffic light at an intersection and it is red, THEN an automobile driver must stop. We know, however, that the automobile does not stop itself, stopping the automobile requires a human agency to operate the automobile to cause it to stop. If the driver does not function as the logic intends, then the automobile will continue through the intersection and a collision or other unforeseen occurrence may happen. So, with Regulation D, if a potential securities purchaser is an “accredited investor,” then Section 5 does not require registration. But deontic logic is not necessarily self-activating OR complete. It is not necessary to invoke the philosopher Ludwig Wittgenstein (who rejected the possibility of a mathematical basis for logic on the grounds that even mathematics is a product of human agency and, hence, imperfect) to recognize the potentials for unexpected and, indeed, inaccurate results. Consider the paradoxes pointed out in the works of, among others Bertrand Russell and Kurt Goedel. Something classified as “x” may sometimes be both “x” and “not x” so that a statement about that thing (as a result of being classified as “x”) is both true and untrue. So if one contemplates a particular potential investor, who has inherited wealth (in excess of $1 million, net of any liabilities and not counting his primary residence) and who does not have a regular occupation but has become a leading collector of classic automobiles. May a start-up biotechnology company proposing to develop artificially manipulated genetic material which will function as an organic computer offer and sell its securities to him without registration because he is an “accredited investor?” Phrased in the Commission’s own words, is he one of those “persons whose financial sophistication and ability to sustain the risk of loss of investment or ability to fend for …[himself renders] the protections of the Securities Act’s registration process UNNECESSARY” (emphasis added). On the other hand, an experienced microbiologist earning under $200,000 a year with limited wealth other than a primary residence may be fully capable of evaluating at least the technology aspects of the investment proposal of the biotechnology company, but he is NOT an “accredited investor. Of course, almost all classifications involve some level of arbitrariness and the “accredited investor” is not different. But, neither has the SEC engaged in some “stage 3 clinical trial” involving both econometrics and cognitive analytics to assess how closely the definition’s classifications comport with the actual abilities of real persons and, hence, how well those classification choices match the Commission’s espoused selection criteria. That is not to say that there have not been extensive cognitive studies carried out by university and private researchers, especially looking at the decline in cognitive capacity with aging. Accordingly, seniors are seen as more likely to be susceptible to inappropriate or even fraudulent investment proposals, a point made strongly in the August 26 joint statement of Commissioners Lee and Crenshaw cited above. Neither the prior definition of “accredited investor” nor the August 26 revised definition contains any particular provision referencing age or cognitive ability.

The SEC’s August 26 amendments to the definition of “accredited investor” added both new categories of natural persons and new categories of entities. The new natural person categories include:

• Holders of certain professional certifications, designations or credentials issued by an accredited educational institution as recognized by the SEC; the SEC notes that it believes this is a reliable indication of investor sophistication and initially designated by Order holders of Series 7, 65, and 82 securities licenses issued by the Financial Industry Regulatory Authority, Inc.,. The SEC invites proposals of additional “accredited investor” certificate holders;

• Knowledgeable employees of funds, matching a parallel provision under the Investment Company Act of 1940; this allows senior level employees as well as trustees and advisory board members of a private (i.e., hedge or equity) fund; the SEC notes that it believes these persons are likely to be financially sophisticated and able to fend for themselves; and

• Spousal equivalents – a cohabitant equivalent to a spouse -may be counted for the joint income and jointly held asset thresholds.

The new entity categories include:

1. LLCs that meet the same requirements (assets held for investment) as corporations

2. Any SEC or State registered investment adviser

3. Any adviser to a private fund that is exempt from SEC registration under the Investment Advisers Act of 1940

4. A rural business investment company (“RBIC”)

5. Any entity, including an Indian tribe, “owning” investments in excess of $5 million and not formed specifically to make the investment; this category includes divisions and/or instrumentalities of tribes, federal, state, and local government bodies and/or funds, and entities organized under the laws of foreign jurisdictions, and “investment” is a concept derived from the Investment Company Act and may include real estate, commodities, futures, financial contracts, and even cash and cash equivalents

6. Family offices with at least $5 million in assets under management and the family clients as well

The amended definition also includes some additional clarifications in relying on the joint net worth of spouses or equivalents the revised definition makes clear that it is not necessary that the Regulation D investment is made jointly and when an entity is owned by other entities, the entity is an “accredited investor” if all of the natural persons owning interests in the proposed investing entity or entities holding interests in that investing entity are themselves “accredited investors.” Further, the Amendment also amends other SEC regulations to bring greater uniformity to various exemptive provisions. Appropriate parts of Rule 163B, Release No. 33-10699, 17 CFR Part 230 (adopted in September 2019) that allows “test-the-waters” communications to “accredited investors,” is amended to reference the newly added categories of “accredited investors”. Similarly, Rule 144A, 17 CFR Part 230, allowing private resales of securities to “qualified institutional buyers (“QIB”),” is amended to add the new categories of entities that are “accredited investors”, so long as the entities meet the QIB $100 million thresholds. And, again, Rule 215, 17 CFR Part 230, is amended to add the new categories of “accredited investors” for purposes of the exemption for offers up to $5 million.

The SEC’s August 26 action was, much like the Review Report cited above, a result of the mandate in Section 413 of Dodd-Frank to review the definition of “accredited investor” and to propose such amendments and modifications “taking into account the economy,” which widely understood to be a call to adjust at least the net worth and income thresholds to reflect the impact of inflation between 1983 when those thresholds went into effect and 2020. Commenters proposed both raising the thresholds and indexing them for inflation going forward. The Commission did neither, over the strong objection of Commissioners Lee and Crenshaw (noted above), who voted against the Amendment. The SEC also declined to include another basis for “accredited” status, namely customers of a broker-dealer or of a registered investment adviser, where the broker-dealer or investment adviser would function rather like an “offeree representative” under Rule 146. The Commission did not accept that broker-dealer or investment adviser would, could, or should be the source of the natural person’s sophistication and ability to fend for him- or herself. This seems quite reasonable, especially given the overwhelming focus on the potential conflicts of interest of such industry professionals in the only recently effective (June 30, 2020) Regulation BI, Release No. 34-86031, 17 CFR Part 240.

The Wall Street Journal in the front page August 27 article cited above notes that the three Commissioners in the majority held at least 13 meetings or telephone calls with lobbyists for angel investors, private-equity firms, and hedge funds after the Amendment was proposed in December 2019. The Journal also reports that strong supporting submissions were filed with the SEC by Bridgewater Associates LP, Blackstone Group Inc., and Carlyle Group LP. The Journal notes that according to the SEC’s own estimates $2.7 trillion was raised in private market transactions in 2019, in sharp contrast to the $1.2 trillion raised in public markets last year. Those supporting the SEC action stated that the private markets have grown too large to ignore AND that wealth is not just a crude measure, but in fact, a meaningless way to assess a person’s ability to weigh the risks of an investment. The executive director of Healthy Markets, an investor group focused on the structure of the capital markets is quoted as observing with respect to the SEC’s invitation to propose additional certifications as the basis for “accredited investor” status, “Now that they’ve opened this door, there’s going to be a lot of trucks trying to drive through,” as the Journal notes that chartered financial analysts, lawyers and M.B.A. holders may well seek such a result.

What, Then, Has the SEC Produced?

At “the end of the day,” what has the Commission accomplished? Has it really “honored” its self-announced “investor protection mandate?” Or has it simply moved the proverbial deck chairs around while the liner is already far from shore? More than one commenter has noted the complexity and occasional irrationality of the Commission’s efforts to regulate in this area, almost all driven by the contradictory “two-mindedness” of the 33 Act and the commission’s understanding of its mandateS (emphasis added). The clear financial evidence is that Section 4(2) is more important to the American capital markets today than is Section 5. As technology continues to evolve that is almost certain to continue apace. In such circumstances, the exemption (somewhat like the “trucks” envisioned by the executive director of Healthy Markets) may eventually “swallow” Section 5 in almost its entirety. Hence, it is hardly possible to see Regulation D, including the August 26 Amendment, as more than a less-than well designed temporary putative exercise of regulatory authority. One is left sympathizing with both the pointedness and forthrightness of Commissioner Pierce’s observations (and critique of the regulatory paternalism inherent in the “investor protection mandate”) “Why should I, as a regulator, decide what other Americans do with their money?” In June 2019, the SEC published its “Concept Release on Harmonization of Securities Offering Exemptions,” Release 33-10648, 17 CFR Part 210, and sought comments on ways “to simplify, harmonize, and improve the exempt offering framework to promote capital formation and expand investment opportunities” (but, in the next phrase adding, “while maintaining appropriate investor protection”). The Adopting Release for the August 26 Amendment, Release Nos. 33-10824 and 34-89669, 17 CFR Parts 230 and 240, states that the Amendment: “will provide a foundation for the [SEC’s] ongoing efforts to assess whether the exempt offering framework … is consistent, accessible and effective for both issuers and investors.” Let the process continue, with what one may hope is more faith in the intelligence of Americans and less confidence in the wisdom of regulators.

The August 26 Amendment becomes effective 60 days after publication in the Federal Register.