The SEC Expanded the Definition of Accredited Investor, But Did It Change Anything?

Over the past 30 years, we’ve seen a remarkable shift from public to private markets, and that has major implications for ordinary investors. Today, companies are waiting longer to go public, if at all, opting instead to raise private capital. In fact, between 1996 and 2017, the number of publicly traded companies decreased by 46%.

This wouldn’t be a big deal if more people could invest in startups and other pre-IPO companies. Unfortunately, these opportunities have long been reserved for accredited investors — a designation given only to those with considerable net worth or income.

So when the SEC amended the rules to seemingly include the ability to “test in” to accredited status in late 2020, it appeared knowledgeable investors would no longer be barred from accessing private investments.

As is often the case with legislation, though, the devil is in the details, as a close friend of mine recently discovered.

Before we dive into her story, it’s helpful to have some context on the definition of accredited investor.

What Is an Accredited Investor?

The term “accredited investor” was introduced in 1982. Prior to 2020, the definition had hardly changed. Being an accredited investor meant you could invest into private securities, including startups, and pre-IPO shares. To qualify as one, there were two paths: income or wealth tests.

The income test required you to earn $200,000 or more in each of the previous two years — $300,000 if including your spouse. The wealth test required that you have more than $1 million in net worth, excluding the value of your home residence.

Why were these the tests to determine whether you were allowed to invest into private securities? It was supposed that your financial status was a proxy for financial acumen, or at a minimum, financial stability should the investment not pan out.

Over the last 30 years, however, this accredited investor threshold has become an issue of investment access. Companies no longer race to their IPOs, opting instead for private funding for longer periods of time. This translates into greater returns accruing to private investors, those lucky few that are able to “get in” before a company goes public. By the time of an IPO, there can be relatively slim pickings left for the rest of us.

How The Accredited Investor Definition Changed

For years, the SEC recognized that the accredited investor definition needed an update. Finally, in August of last year, the SEC expanded the definition beyond income and net worth. In doing so, the agency acknowledged that:

1. Access to information on private securities had greatly increased, enabling better diligence of private opportunities.
2. Just because you are rich doesn’t mean you know what you’re doing when it comes to investing.

But you know who does know what they’re doing? People who can demonstrate their investing acumen by passing rigorous standardized tests. The SEC’s expanded accreditation criteria seemed to acknowledge this reality by including individuals with knowledge, experience, and certifications related to investing. If you held one of the listed financial professional licenses (Series 7, 65, or 82), you would now qualify as an accredited investor.

The Devil Is in the Details

So let’s get down to the specifics. The expanded definition was part of the amended Rule 501(a). The relevant text from the amendment creates:

“…a new category to the definition that permits natural persons to qualify as accredited investors based on certain professional certifications, designations or credentials or other credentials issued by an accredited educational institution, which the Commission may designate from time to time by order. In conjunction with the adoption of the amendments, the Commission designated by order holders in good standing of the Series 7, Series 65, and Series 82 licenses as qualifying natural persons…”

Since this rule change was published, much has been written about the ability to “test into” accreditation status. Unlike the Series 7 and 82 licensing exams, which require a sponsoring organization, such as a broker dealer, to even register, anyone can take the Series 65.

As a result, investing groups have sprung up to help non-accredited investors pass the Series 65 test. This exam is rigorous, on average taking 50–100 hours of preparation.

However, in actuality, there is no way for a non-accredited investor to “test into” accreditation. It’s a sad fact that few know, not even state securities regulatory bodies.

Passing the Exam Is Not Enough

A friend of mine, who previously worked in private equity, learned of the updated definition and immediately set out to study for the Series 65 exam. Given her background, she was confident in her ability to diligence deals and evaluate risk. Although previously accredited, she’d recently taken two years to start a company, which impacted her income. Then she used a lot of her savings to buy a home with her spouse, which impacted her net worth.

She studied hard and passed the exam. Upon reaching out to the Tennessee Securities Division to confirm next steps, though, she learned of a devil in the details of the Rule 501(a) amendment.

Initially, the state securities body had no idea about the new accredited investor definition, and so they reached out to the SEC directly to clarify. In communicating back to my friend that she didn’t qualify as an accredited investor, they commented that the rules were unfortunately unclear.

While the amendment (as written) supports my friend’s interpretation, in actuality, passing the Series 65 test was not enough. For her to be considered a holder “in good standing” of a Series 65 license, she would also need to work as a registered investment adviser at an investment advisory firm.

This additional, undisclosed, requirement drastically limits the impact of the amended rule. And to what end? The demonstration of investing knowledge is clear by having passed the test. This arbitrary and self-imposed limitation serves no apparent purpose and drastically limits who may benefit from the expanded accredited investor definition.

Another Bite At the Apple

Shifting the criteria for investor accreditation from net worth and income to measures of merit was an overdue step in the right direction. But it fell far short, and it’s unclear if this was due to intent or oversight.

Hope is on the horizon, however. The SEC is once again evaluating the accredited investor definition. They have the opportunity to address the gap in investment access that is so clearly evident.

Should regulation fail, there is the potential for a legislative fix. A recently introduced bill, The Equal Opportunity for All Investors Act of 2021, would create an exam specifically to measure an individual’s investing acumen. Those who pass would then qualify as accredited investors.

With private market investments becoming an increasingly important part of a diversified portfolio, changing this outdated barrier is important to the outcomes of many educated investors. Since proof of investor acumen, as evidenced by passing stringent tests, would be a prerequisite to accreditation, it’s unclear who the existing rules are really protecting.

The views and opinions expressed herein are those of the author’s and do not necessarily represent the policy, position, or opinions of Alto Solutions, Inc., or any other entity with which the author may be affiliated.