Who should be accredited these days?

It’s about time the Securities and Exchange Commission got serious about updating its definition of an accredited investor. The current definition — a person who either has an income of at least $200,000 ($300,000 for couples) or a net worth of at least $1 million, not including a primary residence — is woefully outdated and does little to keep “unsophisticated” investors from investing in vehicles that are entirely unsuitable for them. Financial thresholds fail to provide adequate protection for investors whose net worth is based on a retirement nest egg or on illiquid holdings.

It’s time the SEC revamped the definition in a way that both broadens the potential pool of investors and strengthens verification that they qualify.

A lot of money is at stake. Two years ago, the SEC estimated the private placement market at about $1.6 trillion. No doubt that figure is even higher today.

SCRAP INCOME, WEALTH

So far, we like where the SEC Investor Advisory Committee is going on this matter. Two weeks ago, all but one member of that committee voted to recommend that the SEC scrap the income and net-worth floors and instead consider a definition of sophisticated investor that takes into account an individual’s education; professional credentials, such as the chartered financial analyst designation or a Series 7 license; and investment experience.

Another approach put forth by the committee would be to develop a financial-sophistication test.

If the SEC elects to maintain income and net-worth standards, the agency should limit participation in private placements to a certain percentage of an investor’s income or assets, the Investment Advisory Committee said.

Finally — and we think this is key — the committee recommended that responsibility for verifying accredited investor status shift from securities issuers to third parties, who could include brokers, investment advisers, accountants and attorneys.

Another idea worthy of further consideration is one put forth last year by the Government Accountability Office calling for the SEC to consider requiring that investors work with a financial adviser as a prerequisite for investing in private placements. For that to work, however, the SEC would have to ensure that advisers recommending investments in private placements are professionally certified and have a clear understanding of the risks associated with those investments.

To be sure, some will oppose all of these suggestions on the grounds that they will hamper capital formation by restricting the number of Americans who qualify as accredited investors, currently about 8.5 million.

But that is unlikely to be the case — especially if a new standard is expanded to encompass an individual’s financial literacy and whether they use a financial adviser or if it limits investments to a percentage of income and/or assets. That’s because the pool of potential investors would likely be expanded to include less wealthy — but more financially sophisticated — investors.

No matter what, it’s crucial the SEC take the time and care to update the definition in a way that does not impede capital formation and, at the same time, affords more protection to investors.

ON THEIR OWN

Because they are private offerings, these speculative and often illiquid securities do not have to be registered with the SEC, meaning investors are on their own when it comes to due diligence. Too many investors have been hurt, and billions of dollars lost, due to fraudulent private placements.

Developing a new standard to determine whether an individual can — and, more importantly, should — invest in private placements will go a long way toward keeping those who can least afford serious losses safe from financial ruin.