Accredited Investors: A Need for Increased Protection in Private Offerings

By Zimmerman, Christopher R. | Northwestern University Law Review, January 1, 2019 | Go to article overview

Accredited Investors: A Need for Increased Protection in Private Offerings


Zimmerman, Christopher R., Northwestern University Law Review


Introduction

Venture capitalist Aileen Lee coined the term "unicorn" six years ago to describe a privately held startup valued at over $1 billion.1 Once a rarity, there are now over 196 unicorn startups in the United States, with at least fifty-three reaching that status in 2018 alone.2 Unlike a publicly traded company, which must comply with the registration requirements of the Securities Act of 1933 (the Securities Act), these startups and other privately held businesses rely upon exemptions from the Securities Act to raise capital by selling securities through private offerings.3 With less than 0.02% of businesses in the United States publicly traded on an exchange, the amount raised through private offerings is huge-more than $3 trillion in 2017 compared to $1.5 trillion that was raised through registered offerings.4

Many companies choose to remain private because of the significant cost and regulatory burden of registering with the Securities and Exchange Commission (SEC).5 While a lower regulatory burden benefits a company, it can create potential problems for investors. Issuers in a private offering are not subject to comprehensive disclosure requirements, so each investor must be aware of, ask for, and obtain all of the information necessary to make an informed investment decision.6 Without the correct information, investors may be unable to tell whether they are investing in a legitimate business or the next Theranos.7 Additionally, most securities sold through private offerings are restricted, requiring that they be held for a specified period, and do not have a well-established market, making their resale potentially difficult.8 Because of these increased risks, the SEC has developed elaborate exemptive frameworks that govern private offerings and limit who may invest in them.9

The most frequently used exemption is found within Regulation D.10 Regulation D allows a private company to raise an unlimited amount of money from an unlimited number of "accredited investors."11 The definition of an accredited investor includes institutions such as banks and investment companies, as well as any natural person who has a net worth of over $1,000,000 or who has earned at least $200,000 per year for the past two years.12 Intended to balance capital formation against investor protection,13 the accredited investor definition uses wealth as a proxy to identify individuals whose financial knowledge, sophistication, and ability to withstand the risk of loss allow them to "fend for themselves" without needing the protections afforded by the Securities Act's registration process.14

When the accredited investor definition was adopted in 1982, the SEC made a policy choice to look only at an investor's wealth to provide issuers with a clear, objective standard15 that could be easily administered to determine who was qualified to participate in a private placement.16 That choice has done well for capital formation, with today's private markets booming;17 however, over the last thirty-seven years, the protections offered to retail investors18 by the accredited investor definition have not been maintained. The monetary thresholds that provide the sole means of determining who is able to "fend for themselves" have never been revised, despite the effects of almost four decades of inflation.19 Without adjustment, the income and net worth requirements are effectively less than half of their original amounts, allowing "an ever-expanding group of individuals to qualify as accredited investors."20 Accompanying this expansion are increased risks for today's accredited investors due to the approval of general solicitation in private offerings,21 significant preemption of state securities laws, and an increase in the number of complex investment opportunities such as hedge funds.22

This Note argues that the SEC, in order to fulfill its statutory duty to protect investors, must revise the definition of an "accredited investor" to meet the demands of the modern investing landscape. …

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