Finally. The Securities and Exchange Commission on Monday put out for comment its proposal for changing the net worth standard for accredited investors, which determines who can invest in a private placement under Rule 501 of the Securities Act of 1933.
Typically the standard is applied to investing in hedge funds, venture capital, private equity and other private partnerships.
Under its proposal, it kept the net worth threshold at $1 million. However, investors can no longer count the value of their primary residence. This was required in the Dodd-Frank bill.
This is a good first step for the SEC. After all, since the current hurdle was first set in 1982, housing values in the country have tripled or quadrupled in many areas. As a result, two middle-class people with average earnings could have easily achieved the accredited investor threshold.
This is not a good thing. You dont want these people risking their money on hedge funds, especially the smaller ones with the flimsy or non-existent track records for which these investors mostly qualify. In fact, in 2008 even so-called superstar hedge fund managers lost 40 percent to 50 percent of their money.
However, I think the SEC should have gone even further and raised the minimum, excluding the primary residence. In fact, it should have taken its own advice.
Several years ago the SEC tried to alter the definition of accredited investor by also requiring them to own at least $2.5 million in investments. It then called for adjusting this figure for inflation every five years.
The SECs Office of Economic Analysis at the time estimated that about 1.3 percent of U.S. households would have qualified for accredited status based on owning $2.5 million in investments. When the current thresholds were set in 1982 when Regulation D was adopted, about 1.87 percent of U.S. households qualified for accredited investor status. By 2003, however, that percentage increased to 8.47 percent of households.
In proposing its additional requirement, the SEC asserted it met its goal of providing an objective and clear standard to use in ascertaining whether a purchaser of a private investment vehicles securities is likely to have sufficient knowledge and experience in financial and business matters to enable that purchaser to evaluate the merits and risks of a prospective investment, or to hire someone who can.
There is hope for a change. The SEC also is proposing, under the authorization of Dodd-Frank, to undertake a review of the definition of the term accredited investor every four years, beginning four years after enactment of the Dodd-Frank Act.
Hopefully this provision also winds up in the final rule. And in four years it lifts the threshold to that $2.5 million level.
I would also like to see it not base its accredited investor definition solely on net worth. Just because someone has $1 million or $2 million, does not mean they understand or can handle the risks inherent in a private placement or private partnership.
They also should be required to demonstrate some level of understanding of the strategy they are investing in and the risk they are taking.