Tech Crowd

SEC, stop insisting rich means smart

By Joanna Schwartz, CEO of EarlyShares

The Securities and Exchange Commission is currently reevaluating the definition of what constitutes an "accredited investor," the benchmark against which the SEC determines if an individual investor is eligible to invest in private ventures.

The SEC review process doesn't go nearly far enough. By solely revisiting (and possibly readjusting) the existing accreditation criteria, the SEC is missing a hugely important point: Using wealth as the sole measure of investment acumen means the SEC is essentially saying that rich people are smarter than the less wealthy.

What makes an investor "sophisticated" enough to have access to private investments? The SEC starts by assuming it has to be some measure of income or net worth.

It's an arbitrary assumption that's outdated at best and elitist at worst.

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According to the U.S. government's chief regulatory body, the most appropriate proxy for an individual's investment acumen is the size of his or her bank account. An "accredited investor" is a natural U.S. person with an annual income exceeding $200,000 or a net worth of $1 million.

In a July 10 meeting, it was proposed that the SEC raise the thresholds to $500,000 and $700,000 (with spouse) for income and $2.5 million in net worth.

Due to our changing job market, even the most highly educated, financially savvy individuals among us may not earn a six-figure income. Plenty of JDs and Ph.Ds struggle to cover their student loan payments, and a recent salary estimate for a professor in a Top 30 economics department at a PhD-granting university was $115,000—a figure $85,000 from qualifying that (immensely financially savvy) individual from investing even a few thousand dollars into a private company.

Additionally, U.S. income inequality has reached peak levels within the past several years, making it harder than ever for the non-rich to get richer. Financial advisors recommend that 5 percent to 20 percent of an investor's portfolio be comprised of alternative assets that are not correlated to the stock market. But alternative investing in private companies, a tool that can help smart people make money, is prohibited to individuals based solely on their financial standing.

I’m fully committed to protecting investors and following all rules and regulations set by the SEC. Like many other members of the investing community, though, I believe investors deserve better ones.
Joanna Schwartz
EarlyShares CEO

The prohibition is in place under the pretext of investor protection, which is certainly an immensely important goal. But imposing a wealth-based measure on who is allowed to invest is overprotective, to say the least, since it eliminates personal responsibility from the equation.

No matter your income, the government doesn't "protect" you from opening a high-interest credit card, purchasing a $30,000 designer handbag or gambling away your life savings. But it does bar you from investing $5,000 into a venture-backed accelerator-graduated start-up, even if you've done extensive research on the company, industry and terms; even if you're extremely knowledgeable about private investing; and even if you make $199,000 per year.

Those private ventures can be start-ups, real estate projects, private equity funds, established small businesses, or growth-stage companies. Since assessing and evaluating these types of investment opportunities takes a certain amount of experience and savvy, the accreditation standard was implemented to protect "unsophisticated" investors from being taken advantage of.

The accreditation standard has been in effect since 1982 as part of Reg D, the SEC regulation that establishes the exemptions under which private companies can sell securities to investors without undertaking a registered offering. The criteria for accreditation have been updated only twice in the past 32 years: once to add joint income or joint net worth thresholds for married couples (in 1988) and once to formally exclude the value of one's primary residence from the net worth total (in 2011, as part of the Dodd-Frank Act). Dodd-Frank also stipulated that the SEC must review the accredited investor definition every four years, which is why the commission is doing that now.

The SEC's exclusionary principle

What happened to the 'spirit of the JOBS Act' in the SEC review process?

In light of recent regulatory changes, one would think that the SEC might use this timely review opportunity to lower the accreditation thresholds. After all, we're only 28 months out from the passage of the JOBS Act, which was designed to expand access to capital for entrepreneurs by lessening restrictions on investors' access to the private market.

The JOBS Act included a much publicized, somewhat controversial provision that would allow the general public (aka "non-accredited" investors) to invest for equity. Though that provision, Title III "equity crowdfunding," has yet to be implemented—having hit some major regulatory hurdles since 2012—its initial passage was heralded as a signal that the SEC recognized the changing landscape of private equity and was ready to welcome many more individual investors into the private investing community.

Instead, they may exclude millions more investors by increasing the accreditation standards.

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A study by the U.S. Government Accountability Office found that if the commission were to simply increase the net-worth limit to adjust for inflation—changing it from a $1 million threshold to $2.3 million—the number of qualifying households would decrease from approximately 8.5 million to around 3.7 million. Whereas $1.3 trillion was invested into private equity in 2010, just $546 billion is estimated to be invested under higher thresholds.

By making the pool of potential investors significantly smaller and limiting access to capital for early-stage companies, the SEC would be taking a regulatory action in complete opposition to the JOBS Act. The SEC's consideration to up the accreditation criteria is made even more shocking by the fact that states—including Georgia, Kansas, Michigan, Alabama and Maine—have taken steps to lessen wealth-based restrictions on investing. (All of those states moved to implement their own "intrastate crowdfunding" rules to enable non-accredited individuals in their states to invest rather than wait for the SEC to move forward on Title III.)

A better solution

Investors need and deserve protections that are not based on how much money they make. Private investing requires a level of acumen that should be assessed prior to allowing an individual to participate. Many areas of finance that require similar acumen also require participants to maintain a license or certification, such as Series 7 for broker-dealers, Series 66 for registered securities advisors, examinations for certified financial planners and certified public accountants.

A standardized testing process could be implemented to allow individuals to become accredited investors (lending actual credence to the term "accredited"). If deemed appropriate, those with advanced degrees or professional financial designations/licenses could bypass testing. A system that actually evaluates investment acumen, rather than assumes it based on an arbitrary measure like wealth, is the only logical solution.

By lifting the general solicitation ban, the JOBS Act created new avenues for investors to access opportunities, avenues that can help investors make money and entrepreneurs create jobs. But the new rules are stifled by the outdated accreditation standards that accompany them.

I'm fully committed to protecting investors and following all rules and regulations set by the SEC. Like many other members of the investing community, though, I believe investors deserve better ones.

By Joanna Schwartz, CEO of EarlyShares, a private investment platform for accredited investors.