For more than three decades, the Securities and Exchange Commission has measured the ability to bear the risk of investing in private placements by financial assets, not acumen. That may be about to change.
In 1982, the SEC adopted Regulation D to help small businesses raise capital by offering the sale of unregistered securities to accredited investors deemed able to fend for themselves in the private-placement market. Accredited investors include those with net worth in excess of $1 million or income greater than $200,000 in each of the past two years ($300,000 for couples).
"DEEP DIVE'
Dodd-Frank requires the SEC to review the definition every four years. The last review was in 2011, and Chairwoman Mary Jo White has said the SEC's staff is taking “a very deep dive” into the issue.
The financial stakes are significant. In 2013, Reg D issuers raised more than $1 trillion, versus $1.3 trillion raised in public offerings.
Two of the SEC's volunteer advisory panels have weighed in with recommendations for changes.
The most expansive set of comments come from the Investor Advisory Committee (IAC), which focused on investor protections.
In contrast, the Advisory Committee on Small and Emerging Companies' recommendations centered on capital raising. It advocated a “do no harm” approach, guided by the philosophy that “any modifications to the definition should have the effect of expanding ... the pool of accredited investors.”
Both committees endorse expanding the definition to include people who pass a sophistication test, regardless of their net worth or income. The IAC offered the possibility of basing sophistication on achieving a nationally recognized designation, such as Chartered Financial Analyst, or passing a standard examination, such as the Series 7 securities test.
Though choosing a designation from among the dozens in the industry would be tricky, there is precedent for such a quasi-official seal of approval. For example, state regulators for years have waived the Series 65 exam for investment adviser representatives who hold one of five nationally recognized designations.
It is worth noting that a financial sophistication requirement does show up under Reg D for certain securities sales that allow nonaccredited investors.
Specifically, Rule 506 allows for a limited number of nonaccredited investors who know enough to make an informed decision on their own or who are advised by a “purchaser representative” with the necessary level of sophistication.
If the definition is expanded through a sophistication test, these nonaccredited investors would apparently become accredited, and the limitation on their numbers would be removed.
PURCHASER REPS
Purchaser reps include investment advisers, brokers, lawyers, and others with appropriate knowledge and experience. The IAC has recommended changes to the requirements for purchaser reps that would sharply curtail conflicts of interest and require fiduciary accountability for these professionals.
Should the SEC decide to add a sophistication test to expand the accredited investor definition and strengthen the requirements for professional purchaser representatives, it is easy to envision a much larger role for advisers in the private offering marketplace. The doors could eventually open much wider to those willing and able to perform the necessary due diligence on nonregistered securities.
Experienced advisers know the importance of small-cap stocks in client portfolios, which is probably the best proxy for the risks of private placements. Small caps can reduce overall market risk for long-term investors through diversification. Research also suggests somewhat higher rates of return than those for mid- and large-cap stocks.
Early-stage companies amplify business-specific risks, however, and private placements generally lack liquidity and third-party research coverage.
Due diligence will demand an intense look into a company's financials and industry position. Because management typically will not have a proven record, interviews may be warranted.
New opportunities to work with accredited investors in private placement may seem like manna from heaven. But fiduciary advisers will have to appreciate the heightened responsibilities that come with the territory.
Blaine F. Aikin is president and chief executive of fi360 Inc.
