On

Regulating Investors:
The JOBS Act and the Accredited Investor Standard

Abstract

July 13, 2013

Mercer Bullard
Jessie D. Puckett, Jr., Lecturer and
Associate Professor of Law
University of Mississippi School of Law

One component of the multi-faceted structure of financial services regulation

is a set of rules that governs what investments investors are permitted to make. This
regulation of investors finds one of its more prominent expressions in the
accredited investor standard under Regulation D, which generally prevents natural
persons from investing in private securities offerings unless they satisfy the
standards income or net worth requirements. Although the accredited investor
standard is normally viewed as a form of regulation of issuers and intermediaries,
rather than of investors, current trends in securities markets and regulations may
militate for thinking about the standard as a mechanism for regulating investor
qualifications and conduct. These trends include what could be described as the
increasing democratization of financial markets, as illustrated by certain provisions
of the JOBS Act that will effectively de-regulate investors by granting them greater
access to unregistered offerings.
The JOBS Act is among a combination of factors that are likely to trigger
fundamental changes in the accredited investor standard and, more broadly, in the
way that the Securities and Exchange Commission manages investor eligibility
requirements. First, it widely recognized that the income and net worth tests fail to
reflect the investor characteristics financial sophistication and ability to bear loss
that the accredited investor standard is generally intended to measure. Second,
Section 413(b)(2)(A) of the Dodd-Frank Act requires the Commission to conduct a
review of the standard in its entirety in 2014. Third, the JOBS Acts elimination of
the general solicitation and advertising ban (GS&A) under Regulation D will

Electronic copy available at: http://ssrn.com/abstract=2468031

subject the accredited investor standard to greater scrutiny, in part because the
growing market for Regulation D offerings is likely to be matched by a proportional
increase fraudulent activity. Finally, the Commission is required to adopt rules
implementing the crowdfunding exemption under the JOBS Act, which will include
investor eligibility requirements that are pointedly more closely aligned than the
accredited investor with an investors actual financial sophistication and loss-
bearing ability.
The widely acknowledged inadequacy of the accredited investor standard led
a departing SEC Commissioner recently to describe it as a perennial albatross for
the Commission. Commentators have frequently observed that neither the income
nor the net worth standard bears any necessary relationship to an investors actual
financial sophistication or ability to withstand a complete loss on an investment. No
empirical evidence of such relationship exists, and even there were one, the
Commission long ago abandoned any pretense that the $200,000 income and $1
million net worth minimums bear any rational relationship to such investor
characteristics. The dollar amounts for the minimums were set in 1982; if they had
been adjusted for inflation, both would have more than doubled. If income and net
worth are proxies for sophistication, then todays accredited investor falls far below
the sophistication standard set more than three decades ago, while the increasing
complexity of financial products has raised the level of sophistication necessary to
understand them.
The amount of the income and net worth minimums is not even their
primary shortcoming; more importantly, they are structurally deficient. Regulation
D imposes no limit on the amount actually invested or the percentage of the
investors net worth that the investment may represent. Thus, a diversified investor
with a net worth of $999,000 cannot invest 5 percent of her portfolio in a private
offering, but an undiversified investor can place his entire net worth of $1 million in
a single stock. A total loss on the investment would destroy the latter investors
investment portfolio, while the nonaccredited investor with a lower net worth
would be relatively unscathed. As this example shows, an investors net worth alone
will never bear a sufficient relation to his ability to withstand a loss to act as an

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Electronic copy available at: http://ssrn.com/abstract=2468031

effective safe harbor. For a net worth test to provide a useful proxy for loss-bearing
ability, it must incorporate the percentage of the investors net worth the potential
loss that the amount invested represents.
Although income provides stronger evidence of an investors loss-bearing
ability, that factor alone is, again, structurally inadequate to serve as a reasonable
proxy. In theory, a higher income correlates with a higher loss-bearing capacity
because the investor can use her future income to recover investment losses.
However, this relationship is more a function of time and income trajectory than
dollar amount. To illustrate, a 70-year-old investor with an annual income of
$200,000 is likely to be far less able to recover from a large loss than a 30-year-old
with an annual income of $50,000. The 70-year-old has little prospect of earning any
future income, much less any increase in income. The 30-year-old can recover her
losses from both future income and the expectation that that income will grow.
Income alone says very little about an investors ability to bear investment losses.
For income to be a useful proxy for loss-bearing ability, it must incorporate the
present value of an investors future income stream. These are but two examples of
how the backward-looking income and net worth standards ignore basic principles
of finance.
One way to reform the accredited investor standard would be to require a
more expansive collection and evaluation of investor characteristics, as is already
required in other contexts. For example, the suitability rule requires that brokers
securities recommendations reflect the kind of complete picture of an investors
financial situation that the accredited investor standard eschews. The nonexclusive
list of factors that brokers have long been required to consider includes the
investors other investments, financial situation and needs, tax status, and
investment objectives. In February 2013, FINRA added age, investment experience,
time horizon, liquidity needs and risk tolerance, thereby rounding out a list that
implies the kind of fully contextual consideration of an investors characteristics
that is notably absent in the accredited investor standard. The same amendments
also added investment strategies and holds to the types of recommendations

covered by the rule, which further embrace a kind of wholistic, non-transaction-

specific investor evaluation.
Another, broader approach would be to require that investments in
unregistered offerings satisfy generally accepted investment theory, as is also
already required in other regulatory contexts. For example, basic diversification
principles are reflected in ERISAs limit on defined benefit plan investments in
company stock to 10 percent of total assets. Under ERISA, fiduciaries can rely on a
safe harbor from liability for imprudently selecting investment options in a defined
contribution plan if the participants have exercised control over the direction of
their investments. A participants has exercised control if, among other things, he
has an opportunity to choose, from a broad range of investment alternatives, the
manner in which some or all of the assets in his account are invested. A broad
range of investment alternatives has been provided if the participant has an
opportunity to: (1) materially affect the potential return and degree of risk of the
account, (2) diversify so as to minimize the risk of large losses; and (3) choose from
at least three diversified investment options. These components of the safe harbor
crudely reflect basic elements of modern portfolio theory. Similarly. FINRA has
provided a safe harbor from the suitability rule for recommendations produced by
asset allocation models that are based on generally accepted investment theory.
These requirements reflect generally accepted principles of diversification and
modern portfolio theory, neither of which is reflected in the accredited investor
standard.
The foregoing considerations have been present for years, so it would be fair
to ask what has pushed problems with the accredited investor standard to the edge
of a paradigm shift. There are a number factors that suggest that this issue is
reaching a tipping point, including, as noted above, the continued growth of private
markets and the added stimulus of the elimination of the GS&A ban, and the Dodd-
Frank Acts requirement that the Commission review the accredited investor in
2014 (it requested comments in a just-issued release). Another impetus is that the
JOBS Acts crowdfunding provisions require not only that the Commission adopt a
new set of investor regulation rules, but also that these rules fix, albeit crudely,

some of the accredited investor standards most significant shortcomings. The

investor eligibility requirements in the crowdfunding provisions of the JOBS Act
may jumpstart the reconsideration of the accredited investor standard.
Like the accredited investor standard, the crowdfunding investor standard
relies partly on investors income and net worth to determine their eligibility to
invest. The crowdfunding standard differs, however, in that an investment is limited,
for investors whose income or net worth is less than $100,000, to the greater of
$2,000 or 5 percent of their income of net worth. Other investors may invest the
lesser of $100,000 or 10 percent of their income or net worth. Thus, the
crowdfunding standard takes a very different approach from that of the accredited
investor standard both by limiting the amount of the investment and by applying
this limit as a percentage of the investors income or net worth.
The crowdfunding investor standard also indirectly restricts how much an
investor may devote to a particular category of securities, thereby creating a kind of
diversification requirement. The above-stated investment limits apply to an
investors total crowdfunding investments within a 12-month period. Under the Act,
crowdfunding intermediaries must positively affirm[] that the investor could bear
the loss of the entire investment, which implies that, consistent with the suitability
rule discussed above, the crowdfunding intermediary must consider the investment
in the context of the investors entire portfolio. This affirmation requirement,
coupled with the requirement to aggregate all crowdfunding investments for
purpose of the investment limit, indirectly require that an investor limit the amount
of their portfolio to a particularly class of security. This is not to say that
crowdfunded investments represent an appropriate class for purposes of limiting,
for example, the percentage of an investors portfolio that is exposed to high-risk
equities. However, the structure of this aspect of the crowdfunding standard
requirement mirrors how one might begin to apply a portfolio diversification test to
investors in unregistered offerings.
Another relevant aspect of the crowdfunding investor standard is its
apparent requirement that investors pass a financial sophistication test. The Act
requires that crowdfunding intermediaries ensure that each investor -- . . .

answers questions demonstrating an understanding of the level of risk generally

applicable to investments in startups, emerging businesses, and small issuers; . . .
the risk of illiquidity . . . [and] such other matters as the Commission determines
appropriate, by rule. Unlike accredited investors, whose income and net worth are
assumed proxies for financial sophistication, crowdfunding investors must actually
prove, in theory, their financial sophistication bona fides. Ironically, one might argue
that a genuine diversification requirement should obviate the sophistication test on
the ground that the latter looks to an appreciation of the systematic risk that
diversification neutralizes.
Thus, the JOBS Act may have planted the seeds of what form a new accredited
investor standard might take. This aspect of the Act could also be viewed as part of a
broader democratization of finance that will place greater pressure on the
outmoded, simplistic model that the accredited investor reflects. Americans
individual responsibility for managing financial risk has increased dramatically, as
most vividly illustrated by the shift from defined benefit to defined contribution
retirement plans. As Americans financial security increasingly depends on their
making prudent investment decisions, the pressure will increase to rationalize the
regulation of investors with investment theory and behavioral finance. This can be
accomplished without restricting access to high-risk investments; a principal benefit
of modern investment theory is that it enables investments in high-risk securities
without necessarily increasing the risk of an investors overall portfolio. The JOBS
Act would provide a welcome change if it spurred the reformulation of the
accredited investor standard to reflect the lessons of modern financial theory.