Arbitrary Paternalism and the SEC Accredited-Investor Standard

By Leah Duncan

Associate Editor, Vol. 24

In developing the current accredited investor requirements to balance competing considerations of investor protection and capital formation, the Securities and Exchange Commission has used proxies that give rise to discrimination against communities of color.[1] While this problem is on its face economic in nature, I will approach it through the lens of race and ethnicity to illuminate the ways in which the accredited investor requirement excludes communities of color from avenues to wealth.

Pursuant to the Securities Act of 1933, the SEC requires that a company or private fund either register the sale or offering of their securities or be exempted based on a safe harbor regulation. Section 4(a)(2) of the Act provides an exemption for private sales which are further governed by Regulation D requirements that dictate purchasers must be “accredited investors.”

So, what does it mean to be an accredited investor? The SEC defines an accredited investor as anyone who “has a net worth over $1 million alone or together with a spouse” or someone who “has earned income that exceeded $200,000 or $300,000 together with a spouse in each of the prior two years, and reasonably expects the same for the current year.”[2] In order for a person to invest in a private security offering, they must comply with at least one of these requirements. The goals of these requirements include protection of investors and the facilitation of capital formation.[3] The SEC has had to grapple with how to balance these two aims. Over-protection of investors could make it more burdensome for some investors to participate in the capital markets. While too much focus on facilitating capital formation may leave investors prey to heightened risk of financial harm. With these concerns in mind, the SEC has decided that income and net-worth “serve as proxies for financial experience, sophistication, and adequate bargaining power.”[4]

Does this requirement really strike the right balance between investor protection and capital formation? Many investors and scholars of capital markets do not think so. On one hand, the accredited investor requirement seems extremely arbitrary. The standard only considers wealth in determining if a person may invest which makes it “possible for unsophisticated, inexperienced investors” to invest in typically high-risk securities.[5] This brings to light an interesting conundrum where the SEC intends to protect investors but uses a metric that does not quite meet this aim.

On the other hand, some crowd-funders suggest that the accredited investor requirements do not do enough to limit the amount of people who can invest. Since the accredited investor requirements have not been adjusted in over three decades, inflation has “eroded their original significance”[6] and has essentially opened the floodgates to everyone to be an investor.[7] Again, we meet another conundrum–the SEC seeks to protect investors but uses an outdated metric that does nothing to limit the amount of people who could potentially be harmed by risky or fraudulent securities.

While the SEC believes that the accredited investor requirement strikes the right balance between investor protection and streamlining capital formation, no analysis has been directed toward the impact this can have on communities of color who seek to access this avenue of wealth formation. Those who attack the accredited standard because of its arbitrariness and those who attack it based on its lack of teeth conveniently leave out the fact that these requirements draw a racial and socioeconomic line, which ultimately exacerbates racial and economic inequalities. The SEC paternalistically attempts to distinguish between who can fend for themselves and who cannot.[8] The real impact of this may be felt in the communities of color who are unable to access these markets.

Systemic racism has prevented communities of color—particularly black families—from building wealth. According to the Economic Policy Institute, “more than one in four black households have zero or negative net worth, compared to less than one in ten white families without wealth.”[9] The SEC’s accredited investor requirement plays into the institutional barriers that continue to prevent people of color from accumulating wealth by using wealth as a proxy for sophistication. While it is certainly important to protect investors, requirements should not do so at the expense of communities of color who may want to pool their funds to get a community-based startup off of the ground, for example. Certainly, startup securities can be risky investments that may require greater institutional knowledge, but wealth as a proxy for knowledge excludes people for the wrong reasons.

If the SEC is concerned about investor protection and facilitation of capital formation, they should not only revise the accredited investor requirement to more accurately assess investor knowledge, but go further and provide resources for investors to become better educated. Some scholars have suggested that imposing a requirement of having a registered investment adviser would not only solve the problem of approximating the investor’s understanding of financial risk, but would also be a feasible solution to implement.[10] Though this would be a great step in the right direction, there would still be a financial barrier since investor’s would have to pay out of pocket for the services of the adviser.[11] Without greater availability of resources, there would still be a sizable institutional barrier to this avenue of wealth formation. Suffice it to say, the SEC should think more creatively about the ways in which their requirements and regulations impact people of color and should specifically include capital formation in communities of color in their review and creation of these rules and regulations.

[1] See generally, U.S. Securities and Exchange Commission, Investor Bulletin: Accredited Investors (2013). https://www.investor.gov/additional-resources/news-alerts/alerts-bulletins/investor-bulletin-accredited-investors.

[2] I am excluding discussion of the sophisticated investor requirement because while it is more relaxed, the focus of this article is on the accredited investor requirement; U.S. Gov’t Accountability Office, GAO-13-640, Alternative Criteria for Qualifying as an Accredited Investor Should be Considered (2013), https://www.gao.gov/products/GAO-13-640. Pg. 2

[3] U.S. Gov’t Accountability Office, GAO-13-640, Alternative Criteria for Qualifying as an Accredited Investor Should be Considered (2013), https://www.gao.gov/products/GAO-13-640. Pg. 2

[4] Id.

[5] Larissa Lee, The Ban Has Lifted: Now Is the Time to Change the Accredited-Investor Standard, 2014 Utah L. Rev. 369, 369 (2014), https://dc.law.utah.edu/cgi/viewcontent.cgi?article=1136&context=ulr.

[6] Devin Thorpe, SEC Mulls Changes to Accredited Investor Standards, 18 Crowdfunders React, Forbes, July 15, 2014, https://www.forbes.com/sites/devinthorpe/2014/07/15/sec-mulls-changes-to-accredited-investor-standards-18-crowdfunders-react/#66f6c7f412f2.

[7] Id.

[8] Michael S. Piwowar, Chairman, U.S. Sec. and Exch. Comm’n, Remarks at the SEC Speaks Conference 2017: Remembering the Forgotten Investor (Feb. 14, 2017), https://www.sec.gov/news/speech/piwowar-remembering-the-forgotten-investor.html.

[9] Janelle Jones, The racial wealth gap: How African-Americans have been shortchanged out of the materials to build wealth, Econ. Policy Inst.: Working Econ. Blog (Feb. 13, 2017, 12:01 PM), https://www.epi.org/blog/the-racial-wealth-gap-how-african-americans-have-been-shortchanged-out-of-the-materials-to-build-wealth/.

[10] U.S. Gov’t Accountability Office, supra note 2, at 24.

[11] U.S. Gov’t Accountability Office, supra note 2, at 25.