IS THE SEC’S ACCREDITED INVESTOR DEFINITION UN – CONSTITUTIONAL?
Many have railed against what can be argued is the irrationality of protecting non-accredited investors from themselves, i.e. the accredited investor definition. The definition was crafted by the SEC back in the early 1980’s as the centerpiece of what has been the most utilized method for companies to raise capital in an offering not registered with the SEC, Regulation D.
In simple terms, if a company wishes to raise capital without registering its offering with the SEC, it can utilize the Regulation D “safe harbor” created by the SEC to sell securities to both accredited and unaccredited investors alike. In practice, however, most issuers have excluded non-accredited investors from their Regulation D offerings. Why? Once an issuer includes even a single non-accredited investor in the offering, stringent (as in onerous) disclosure requirements kick in.
In 2011, courtesy of a 2,000 page bill known as the Dodd-Frank Act, Congress threw more gasoline on the fire of the oft perceived inequality of treating non-accredited investors differently. It altered the definition of accredited investor – raising the bar even higher. Previously, an individual with an income of $200,000 ($300,000 with spouse) or a net worth of more than $1 million would qualify. Then along came Dodd-Frank: now mandating that the SEC must exclude the equity in an individual’s principal residence in calculating net worth eligibility. Simple math tells us that this can only shrink the pool of accredited investors even further, adding to the legions of non-accredited investors.
Then Title II of the JOBS Act came along in 2012, allowing issuers to publicly solicit their “private placements” under Rule 506 of Regulation D, but with a catch: no non-accredited investors could participate – disclosure or no disclosure – and investors would need to prove up their accredited investor credentials before they could invest.
And finally, Dodd-Frank also requires the SEC to periodically review the “accredited investor” definition, a process currently in progress and subject to comment by the public.
The result has been an ongoing and increasingly raging controversy over both the definition of “accredited investor” itself, as well as the wisdom of even having such a concept. I, for the most part, have stayed outside the fray, given both the voluminous number of opinions, and advocates, on both sides of the issue and the somewhat “lose-lose” nature of the issue. In fact it’s been more than two years since I weighed in on this issue publicly – in Crowdfund Insider.
Why “lose-lose”? You see, from my perspective, as both an American and a securities lawyer, it makes great sense to expand the pool of accredited investors. This will both increase the available pool of capital to small and emerging businesses, and allow the average American, regardless of income or net worth, to carry a more diversified investment portfolio.
In my view, this leaves but two regulatory choices. One, expand the accredited investor definition. But each time you draw new lines, those who do not fall within the new line will undoubtedly feel aggrieved – many of them rightly so. Two, throw out the definition entirely. Some have argued for this. But now, one brave soul, a newly minted lawyer no less, has taken his case to Federal court, filing a lawsuit against the SEC and its Chair, Mary Jo White in June 2016.
The case is styled Morello v. White (2:cv-04440), launched in the Central District of California. The Plaintiff, Chase Morello, according to public records, is a second year associate at a reputable corporate law firm in Southern California. Mr. Morello has launched this on his own, as both the Plaintiff and his own lawyer. His firm’s name nowhere appears on the pleading. That’s probably a good thing, if nothing else given the unfortunate misspelling of the lead defendant’s name, SEC Chair White (misspelled Mary Joe White), not exactly a good start out of the gate. The lawsuit seeks to have the accredited investor definition declared unconstitutional, on a number of independent grounds, and seeks to have the lawsuit certified as a class action. The SEC’s response is due in early October – undoubtedly a lengthy motion seeking to dismiss the Complaint at the pleading stage.
My educated guess is that this lawsuit will go nowhere – fast. But this is now in the hands of a Federal judge in Los Angeles.
So get the popcorn out, but don’t invest in a big supply. In my view, better to work this issue through the SEC rulemaking process and – where appropriate – through the legislative process. Yes, it is slow going, to be sure, but after all, it took over 80 years of legislation and rulemaking to get us here.
More often than not, slow and steady wins the race.
P.S. – For those of you who sympathize with Mr. Morello, but wish to participate in a more subdued manner, you may want to sign the Petition he filed with the White House last week to declare the accredited investor definition unconstitutional.
Samuel S. Guzik
Guzik & Associates
1875 Century Park East, Suite 700
Los Angeles, CA 90067