I was reading an interesting article the other day that had to do with the OWS movement giving some data on the background of the “top 1%” and the “top 0.5%”. Can’t say I agree with everything in this article, but it was still worth a read. What really stood out to me though was the realization that the SEC’s accredited investor rules (Rule 501 of Reg D) basically mean that you have to be almost into the 99th percentile (maybe the 98.5th percentile) in order to be considered competent by the SEC to make investments for yourself in privately traded companies. This means that you could be wealthier than 95 or 98% of Americans, and the government still doesn’t think you’re capable of wearing big-boy underpants (or big-girl panties) and making your own investment decisions on privately traded firms. The even more surprising thing to me is that it looks like the $1M net worth (excluding the value of your primary residence) number has been around for a long time. I can’t tell from sure without doing more digging than I want to do for a short blog post, but if this is really as old as the 1933 law it is part of (which it looks like it is from a few glances), at that point, accredited investors were probably the top 99.75th percentile.
Now, even though I’m pretty libertarian, I can at least empathize with the goal of not letting poor widows get screwed by unscrupulous privately-traded companies…but we put the people in the 90th and 95th and 98th percentile in this same category? Sure, privately traded companies, and especially startups can be pretty risky–even in strong and growing industries. But really these days, investing only in publicly traded companies is no guarantee that you won’t get screwed. There are all sorts of ways investors are allowed to do financially suicidal things with publicly traded companies, but aren’t allowed to take any risks with privately traded ones, even if they’ve managed to build net worths of several hundred thousand dollars not counting equity in their primary residences.
I just wonder what the investment environment would be like if the accredited investment rules had a cutoff bar of $500k vs. $1M. Not that it’ll ever happen, just surprised to realize how high of a bar current accredited investment rules really are for investment.
That is all.
Jonathan Goff
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The ostensible purpose of Regulation D is to control brokers, not investors. Anybody can buy a private placement, not necessarily through a brokerage house. Only accredited investors can buy one through a broker.
I worked as a broker for eleven years.
Jardinero1,
While the ostensible purpose of Reg D may have been for dealing with brokers, it still greatly increases the risk for a startup to take money from people who don’t count as accredited investors. Most companies I know won’t even touch non-accredited investors with a 20ft pole due to the higher risk of getting sued or getting sent to jail if the startup isn’t successful.
All that aside, I still don’t get why we’re so concerned about protecting the 95th-98.75th percentiles from investment risks…
~Jon
You are at no higher risk of being sued whether you engage in a private placement to small investors or big investors. It doesn’t matter. Your risk as a business owner has little to do with whether the business fails or who the investors are at the time of failure.
You can check this with an attorney. An investor, whether it be via private placement or a public offering, only has recourse if management has willfully engaged in fraud or willfully failed in its fiduciary duty. There is no criminal liability unless management has willfully engaged in fraud or willfully failed in its fiduciary duty. If a business fails merely because it was poorly managed or expenses exceeded revenue, then there is nothing any investor can do about it, except make a claim at liquidation.
The ideas of suitability and accredited investor are only applicable in cases involving brokerage houses and, in that case, the liability to the investor falls upon the broker and the brokerage house if an investment was later found to be not suitable for the investor.
VC’s will talk about accredited investors and suitability but such talk is smoke and mirrors whose purpose is to impress the listener.
“I still don’t get why we’re so concerned about protecting the 95th-98.75th percentiles from investment risks…”
With regard to that point, the purpose of Reg D is not to protect the bottom 98 percent but to capture the top two percent. This solely benefits the investment banking houses and brokerage houses who cater to them.
When I was a broker I would occasionally get a query from a client who wished to sell all or part of his own business. He would ask something like, “Do you know anyone who would invest in my auto repair business, it’s going great and I want to expand.â€
I would politely reply, “Sorry, if I recommend any of my customers to you, that would be construed as a private placement. I can’t recommend your business/private placement to any of my customers who are not accredited investors. None of them are.â€
He asks, “What can I do then? I only need a couple hundred thousand.â€
Me, “I can refer you to the investment banking side, they can determine if your business is a good fit for any of our accredited investors and a private placement or they could underwrite a public offering for youâ€.
Him, “It’s only a couple hundred thousand, I am too small for them to mess withâ€.
Me, “I know, but the back office only wants me advising my customers to invest in things which generate commissions for the back office. If I refer you to any of my customers, the back office won’t make any money off the funds my customers invest with you.â€
This regulation also inhibits financial innovation. I saw this with betting markets. These are securities that pay out fixed amounts, if an event occurs (or doesn’t occur). For example, Intrade.com (an Irish-based business) is currently the largest real money market of this sort.
In the US, there are two choices for a real money betting market, either create a market recognized by the SEC (no one has tried this route) or only allow accredited investors to trade on the market (in which case, you don’t need to do anything for the SEC). End result is that the big investment firms and banks trade derivatives (which include betting market securities as a subset) and anybody else who is so inclined does betting in a foreign country (taking on legal risk since Congress has passed laws against the practice and a variety of other risks since their money is now in a business in another country).
The original obstacle was supposed to be much more onerous than it currently is. Inflation has allowed more people in to this group. Every so often you see parties advocate a return to a higher threshold for accredited investor.
As for the above discussion, I gather there really is a difficulty with bringing in nonaccredited investors.
I apologize in advance for the long-winded rant that follows. I started out just making an observation, and it kinda snow-balled from there. Apparently, I care about this issue a lot more than I would like to admit, and I’ve been holding this in for too long.
The linked article states that the 0.1% did nothing technically illegal to amass their fortunes, but it’s obvious that their actions had tremendous consequences on the wider economy and on the lives and livelihoods of millions of people. A doctor can be sued if he inadvertently injures a patient, even if he technically did nothing wrong. If engineers were to build a product or structure that maximized their own profit without any regard for the consequences to the public, they would be sued into destitution and never be allowed to practice their profession again. Why have we not been able to prosecute anyone for gross negligence, or have these people sued on behalf of the millions of people whose livelihoods were destroyed when the sub-prime house-of-cards came crashing down?
I think it’s time that these protest movements start focusing their anger and frustration where it will actually do some good. The 0.1% on Wall Street and beyond have only ever been accountable to themselves, their clients, and their share holders. I strongly doubt that they got where they are today by having a particularly strong sense of social justice and equality. The 0.1% do not have to answer to the broader public, and they probably have several other quite comfortable places to escape to if it gets too noisy outside of their office window. So, hanging around the financial district, hoping to make them feel guilty (or whatever it is the OWS movement is trying to accomplish), is unlikely to have much of an impact.
I believe it’s time for the protesters to begin to demand accountability from the individuals who were put into their positions of power specifically to serve the public good. The politicians need to be reminded that they should be serving the greater interests of the people of this nation and not just the narrow interests of the few uber-wealthy. The 0.1% have gamed the system and made a killing doing so. It’s time we demanded that the game be made fair again.
Unfortunately, the current protest movements seem to believe that the political system cannot be trusted. After all, it was the politicians who enacted the legislation that put the current system in place and enabled the 0.1% to profit from their irresponsible actions. Recent political actions taken by representatives of the Tea Party have only further exacerbated the situation. I understand that our political system has been co-opted by those with money and power, but it was never meant to be that way.
It’s time we focused on fixing the parts of the system that are broken, starting with the parts that allow corporations and individuals to maximize their profits without regard for the consequences of their actions. We don’t allow this kind of behavior in any other part of our society. I don’t think it should be allowed here either.
Jon is apparently not the only person to notice this issue:
The Economist on H.R.2930 Entrepreneur Access to Capital Act. Will allow individuals to invest up to $10k in non-SEC listed start-ups.
There is pushback from industry, and it’s a Whitehouse initiative so don’t expect Rep support. Those who agree with Jon (and live in the right country, heh) should shout appropriately at both their Congressweiner and Senatard.
I read the text of the proposed rule change. The Economist did not report correctly. I reiterate that, any investor can invest directly in a not-SEC listed start up, just not through a broker, until this proposed rule change goes through. The proposed rule change allows non-accredited investors to invest up to 10k, through a broker, subject to certain provisos.
I doubt seriously it will make any difference to small startups for the reasons stated in comment 5 above. The big brokerage houses don’t make any money handling offerings on little start ups so there are not gonna mess with it. It’s a nice sop and a step in the right direction though.