Democratizing Startups Requires Financial Freedom
On August 26, 2020, the SEC made modest and insufficient changes to the accredited investor definition for natural persons - the first since personal residence was excluded in 1982. The new definition includes professionals holding FINRA Series 7, 65, and 82 licenses and limited professions. These are expensive, time consuming, and unduly burdensome financial literacy / sophistication tests reminiscent of voter literacy tests that kept Americans from exercising the right to vote.
The majority of Commissioners agree that more needs to be done to increase financial freedom. However, little is said about the harm done by the current rule. The SEC’s part in perpetuating discriminatory finance practices contribute to the loss of an estimated 9 million jobs and $300 billion in collective national income.
Here is what the Commissioners and the SEC's Small Business Capital Formation Advisory Committee have to say.
SEC Small Business Capital Formation Advisory Committee
On August 4, 2020, the Small Business Capital Formation Advisory Committee met specifically to focus on How Capital Markets Are Serving Underrepresented Founders. On August 26th, the Committee published a general recommendation acknowledging a need for leadership to close the startup funding gap.
Former SEC Chairman, Jay Clayton:
Statement on Modernization of the Accredited Investor Definition
"The test for individuals to qualify as accredited investors has largely remained unchanged for over 35 years. This test relies exclusively on a person’s income and net worth. If you make enough money or have sufficient assets, you are eligible to participate, and if you do not, you generally are not eligible. The Commission’s use of income or wealth as the exclusive proxy for an individual’s financial sophistication and ability to assess and bear risk has long been unsatisfactory. Individual investors who do not meet the wealth tests, but who clearly are financially sophisticated enough to understand the risks of participating in unregistered offerings, are denied the opportunity to invest in our private markets. For example, using only a binary test for wealth disadvantages otherwise financially sophisticated Americans living in lower income/cost-of-living areas."
SEC Commissioner, Hester Peirce:
Statement on Amending the “Accredited Investor” Definition
"These newly minted accredited investors are not your typical mom and pop retail investors, a fact that should assuage the concerns of those that fear any expansion of the definition. It does not assuage my concerns. Why shouldn’t mom and pop retail investors be allowed to invest in private offerings? Why should I, as a regulator, decide what other Americans do with their money? The alleged justification is investor protection: people can’t lose their money on investments if they aren’t allowed to invest...[They] will, however, lose. [They] will lose the opportunity to see [their] money grow more than it could sitting in a bank account. [They] will lose the opportunity to be part of enterprises that [they believe] will transform society. And [they] will lose [their] right to make decisions for [themselves]."
SEC Commissioner, Elad L. Roisman:
Commissioner Roisman Statement on Amending the “Accredited Investor” Definition
"For decades, only the wealthiest among us have qualified as accredited investors. This group has been afforded the broadest access to investment opportunities, not only those in our public markets (those that anyone can invest in), but also in our private markets (where the wealthy and institutional investors such as pension funds and venture capital funds have continued to invest given the beneficial returns). Private market opportunities can range from investing in your brother’s or sister’s new restaurant to buying stakes in private equity, hedge funds, or potential unicorn companies when they are in their infancy. Such investments—like all investments—involve risk. But, our rules have only allowed people of means to weigh these risks against the potential benefits of investing. In other words, only the wealthiest are allowed this level of control over their own money in the securities markets... I have long advocated that such a system is fundamentally unfair, unequal, and unjustified. As I have previously stated, wealth is a crude measure of a person’s ability to make financial decisions."
SEC Commissioners, Allison Herren Lee and Caroline Crenshaw:
Joint Statement on the Failure to Modernize the Accredited Investor Definition
" While the release fails to address known risks to investors, it also evidences another problem: there is a great deal we simply do not know about how the private market functions. We don’t know how many investors participate in these offerings. We can’t distinguish individual investors who participate in such offerings from institutions. We don’t know how much they invest or how they fare. We can’t say with confidence how many private offerings even take place. We don’t know how many investors will be newly eligible for private offerings under these amendments. Thus we are operating under significant data constraints—largely of our own making—and today’s rulemaking regrettably does not include any efforts to enhance visibility into this market."
The Accredited Investor Rule Harms Investors
The SEC’s mission is to “protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.” Yet the current definition of “accredited investor” defies all three of these mandates. The opinion of SEC Commissioners seeking to further reduce the number of accredited investors states "The accredited investor definition is the single most important investor protection in the private market." This is a misnomer. The definition is not a protection, but a restriction - one that applies only to the private markets and harms the U.S. and global economies, turning the public market into a glorified ponzi scheme that leaves retail investors holding the bag.
Data from Cambridge Associates and Capital Dynamics show that “private equity investments offer greater protection against financial downturns than public equity indices.” Restricting access to less volatile, high risk, high return investment options based on 3rd party accreditation is unfair. Moreover, it impedes the development of efficient private markets, which ultimately feed the public market, even as new, innovative, secondary markets emerge.
Remember 2008's Stock Market Crash?
The greatest risks to Main Street, "retail" investors, public interest, and the economy, exists in the public markets. In fact, the SEC was formed in response to the 1929 Stock Market Crash to protect retail investors from institutional bad actors and insider trading - an area of oversight at a three-decade low. Over $16 trillion in net worth and $2 trillion in retirement was lost in the 2008 crash.
Documentary films like The China Hustle, and Chasing Madoff underscore how senior citizens and others have been demonstrably harmed, with entire nest eggs / 401Ks at risk. Furthermore, the public market requires far more sophistication with its complex investment strategies (calls, puts, spreads, etc.) and consumer apps allowing retail investors to invest beyond their means through the use of margin.
The most important investor protection, free investor education on how investments in the private markets work, is more abundant than ever. The SEC can do better to leverage these resources to increase investor education on private investing. Instead, it focuses on risks without disclosing any data sufficient to demonstrate risks beyond those of the public market. Furthermore, it gives undue weight to lobbyists, like NASAA, who profit from Advisor licensing and oversight, and fall short of substantiating their opposition to democratized accreditation.
Balanced education will increase investor sophistication and decrease the likelihood of private market fraud. Furthermore, it will increase confidence in the markets, facilitate more efficient capital formation, and wealth creation, all of which will lead to increased participation in the public markets through advised funds.
The spirit of investor protection is disclosure. Disclosure expectations for newly formed companies should not be expected to mirror publicly traded companies with significantly more robust operations. Just as public market investors consult with trusted advisors to make investments, private market investors should have the same freedoms, and not have to become licensed professionals themselves or meet income and net-worth requirements to make "wholesale" investments.
The SEC already allows non-accredited investors to invest in Regulation Crowdfunding offerings of private companies. Why shouldn't those who don't meet the accreditation thresholds be able to diversify their risk by investing in funds offered under Regulation D 506(C), which limits offerings to 99 natural persons? The patchwork off offering rules don't add up to anything other than a picture of securities redlining.