December 13, 2016

Time for a Revolution at the SEC

J. W. Verret

Senior Affiliated Scholar

Bold changes to the accredited investor definition can serve as the beginning of a new revolution at the SEC which would reflect priorities of free-market conservatives and populist voters at the same time.

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During this political season, much emphasis has been placed on the diverging views of the populism movement shaping the presidential election and the free-market views of many Republicans in Congress.

And yet little emphasis has been placed on the unique areas, particularly in financial regulation, where those two movements directly overlap.

One area of clear overlap is with respect to an ongoing debate at the Securities and Exchange Commission (SEC) about the threshold wealth and income requirements that allow investors to participate in more lightly regulated investment opportunities like hedge funds, private equity funds and venture capital funds. These private avenues for raising capital have slowly grown alongside the public markets that are more heavily regulated by the SEC.

The current "accredited investor" standard, as it is called, allows only the top 10 percent of households to participate in these lucrative investment opportunities. Households must collectively earn over $300,000 with their spouse or have a net worth of over $1 million (excluding value of primary residence).

From the perspective of the populism movement, this wealth-based approach looks demonstrably unfair.

Why should the government create special investment opportunities for millionaires and billionaires?

Why shouldn't retirees who desperately need risk-adjusted returns be able to invest in unregistered offerings personally, alongside their pension funds, which likely already invest in these opportunities?

From the free-market perspective, unregistered offerings have vindicated free markets as an engine to finance growth. An SEC study confirmed in 2014 that over 300,000 investors participated in unregistered offerings, $133 billion of which went to non-financial businesses raising an average of $2 million to finance small business growth projects.

This critical link of unregistered offerings has managed to keep business equity financing alive during the regulatory assaults on financing economic growth that public markets endured at the hands of the Dodd-Frank and Sarbanes-Oxley Acts over the last 15 years.

Recent legislation seeking to amend the accredited investor definition passed the House by an overwhelming margin of a 347-8 vote in February of this year. The legislation requires the SEC to expand the accredited investor definition to include certain experts with professional licenses who may not meet the current threshold and other highly skilled professions recognized as having expertise by self-regulatory organizations like the Financial Industry Regulatory Authority (FINRA).

But the legislation stops short of mandating a more drastic expansion of the accredited investor definition. A prior effort to mandate that the SEC expand the definition to include investors who pass a basic financial literacy exam was excluded from the bill in order to maintain bipartisan support from democrats.

The SEC could undertake this project on its own, pursuant to its existing authority, without need for legislation. There are many options to responsibly expand the definition of accredited investors.

A financial literacy test could establish an investor's ability to take responsibility for their own investments. The definition could include investors who are advised by a registered financial professional, there to remind investors of the benefits of diversification and that prior returns do not necessarily indicate future performance. The test could expand to include investors with professional certifications and educational backgrounds in basic business, economics and finance.

The United Kingdom's analogous regime is perhaps the most free-market on the globe and could serve as a helpful guidepost. Individuals may simply "self-certify" their sophisticated investor status by noting they have previously invested in an unlisted company.

In the United States, this model could be adapted such that investors who develop experience with unregistered investments, such as crowdfunding portals, which are not subject to a wealth test, could then bring that experience to bear in the larger unregistered markets.

The number of households able to utilize this exemption has expanded somewhat since 1983, from 2 percent of households to 10 percent today. Critics see this as a problem to be solved through massive inflation adjustments to further restrict this investment option to only the uber-elites.

But the expansion of this investment avenue has made private offerings overtake the dwindling public securities markets, to the point that they are comparable in size today with over $1 trillion in annual fundraising each.

This alternative to the public markets has proven essential, as an SEC study in 2014 noted: "The importance of private capital markets as a source of financing in the economy is underscored by the fact that less than 0.03 percent of the estimated 28 million firms in the U.S. are currently [public] firms."

The accredited investor definition, and the related exemptions from public registration that created the private markets, were developed at the SEC in the early 1980s as part of the Reagan revolution. A new initiative at the SEC to open up new pathways to private capital formation can help finance economic growth in free and effective financial markets.

It can also serve as a bold statement that working-class Americans should no longer be shut out of lucrative investment opportunities by their government.

Bold changes to the accredited investor definition can serve as the beginning of a new revolution at the SEC which would reflect priorities of free-market conservatives and populist voters at the same time.