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The Current Accredited Investor Rules Are Discriminatory... And About to Get Worse
Prescient Advisors

Jeff Joseph

May 10, 2010


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Recently, (Let It Be) we noted that Senator Chris Dodd’s financial reform bill that is on the way to the House floor contains new provisions that would reduce the number of individual eligible to invest in private ventures. The original draft of the bill would increase the $1 million net worth threshold that defines an “accredited investor”, which in turn determines an individual’s eligibility to invest in exempted private securities offerings under Regulation D of the 1933 Securities Act.

These Reg D offerings enable startup businesses access to “angel” capital — the critical means of finance for early-stage ventures that could not otherwise bear the prohibitive costs and regulatory burdens of SEC registration.

The angel investor and entrepreneurial community responded vociferously against the proposed legislation citing the chilling impact that an estimated 77% reduction in the ranks of accredited investors (per Bloomberg BusinessWeek’s estimate) would have on angel investment, financing startups, new job creation and reviving the reliable stalwart of economic growth—the small business sector.

Now we hear that the Angel Capital Association announced that Dodd and his Senate Banking Committee have drafted amendments to the initial proposal whereby the threshold for “accredited investor” would stay the same, although the standard for net worth of $1 million would be revised to exclude the investor’s primary residence.

The ACA has proclaimed that although “we would have preferred no adjustment to the standard for angel investors, we believe this is a good compromise” adding that the amendments “improve the bill so that it balances the importance of small business capital formation while protecting angels and other types of private investors from securities law violators.”

What bunk. The ACA should be opposing such compromising compromises. The opportunity to make a private investment in a private venture should be every investor’s right. The ability to invest in a new business should not be an exclusive privilege bestowed by politicians upon persons of a certain economic class.

Moreover, there are ample investor protections already in place. The SEC’s powerful Rule 10b-5 is all about protecting investors, and it applies to private investors just as it applies to the general public. Every state has securities laws on the books that protect private investors from fraud. Indeed, the registration requirements of the 1933 Act also serve that protection purpose.

As explained by SEC alumnus Patrick Daugherty of Foley & Lardner, “Regulation D is an exemption from those registration requirements. It’s part of our law precisely because there exists a class of investors who can ‘fend for themselves,’ in the words of the Supreme Court’s venerable Ralston Purina holding. Congress, the SEC and the Supreme Court have believed for fifty years that offerings limited to investors who are ‘rich and smart’ about finance need not be registered.” 

Although there is no doubt that the majority of frauds have occurred in highly regulated or visible investment schemes (remember Refco, Enron, Worldcom), there is ample history of unscrupulous brokers, dealers, issuers and promoters abusing Reg D and defrauding investors. The SECs recent indictment of Provident Royalties, LLC for a massive $485 million ponzi scheme is a good example of how the SEC’s limited resources could be effectively allocated away from surfing porn on the web.

But I have never heard a cogent argument that supports the notion that any individual should be restricted from the opportunity to invest in a startup or new business venture that has appropriately disclosed the risk of failure and loss of all capital that is inherent to venture investment.

Private venture investment in startup and early-stage businesses should be entirely exempt from the Reg D accredited investor provisions.

Angel investors know the risks are high and that a significant portion, if not the majority of their venture investments will fail. There is absolutely no evidence that angels investing in startups played any role whatsoever in the recent financial crisis that has prompted Dodd’s proposed reform bill. So, who does this compromise “protect”?

The notion that net worth is an effective indication of an individual investor’s sophistication or ability to bear the risk of loss is laughable. The bright-line standard used to ascertain an investor’s sophistication is ironically unsophisticated and utterly under-inclusive.

I align with Richard Rahn, chairman of the Institute for Global Economic Growth that “the rule makes little sense and strongly discriminates against knowledgeable people who are not yet wealthy but are quite capable of making good investment decisions.” Rahn refers to this as “financial fascism”.

In this connection, there is no reason to suppose that investors who are millionaires only after including home equity are unable to fend for themselves while those who are millionaires exclusive of home equity are self-reliant. Consider Sid and Nancy. Sid has $500,000 in financial assets and a $1 million home with no mortgage. Nancy has $1.4 million in financial assets and a $1 million home with a $900,000 mortgage. Both Sid and Nancy have a net worth of $1.5 million. Sid has constructed a more-conservative balance sheet for himself. But Senator Dodd says that Sid needs federal protection while Nancy doesn’t.

This makes no sense, especially since Sid can “become accredited” simply by borrowing $500,000 against his house and investing the proceeds in securities. Does Senator Dodd really want to encourage greater mortgage borrowing as a means of facilitating private capital formation?

Does anyone really believe that an IT professional making $75K is less able to evaluate a web startup than a professional athlete? Is a recent B-school grad less able to assess the merits of a new retail business venture than a trust fund baby? Is a cook any less able to evaluate a new restaurant venture than a lottery winner with an eight grade education? Wealth is simply not an effective proxy of sophistication.

But what I find most offensive is that this “compromise” only compromises personal financial freedoms and investor’s rights and liberties…a viewpoint shared by my old friend John Mauldin, acclaimed creator and curator of commentary at investorinsights.com, a blog focused on private money management.

“Why should 99% of Americans be precluded from the same (investment) choices available to the rich? If you were to tell investors that they would be discriminated against because of their gender or race or sexual preferences, there would be an outcry….It is a matter of Choice…Equal Access…Equal Opportunity…it is time to change a system where Americans are relegated to second-class status based solely on their income and wealth.”

Nice, John. I also see that one of Canada’ top angel investors also shares our opinion that any investor should be able to make angel investments (assuming the proper disclosure of risks).
 

Regulators and politicians whom plead that such provisions protect the poor and unsophisticated from unscrupulous promoters are hollow hypocrites. Presently 42 state governments run lottery programs—a regressive tax that preys on lower-income households to the tune of more than $17 billion in 2007, the most recent annual estimate. Recently, researchers have identified a correlation between economic difficulties and the popularity of lotteries….so we are likely seeing greater lottery ticket sales today.

Single state lotteries usually have odds of about 18 million to 1, while multiple state lotteries have odds as high as 120 million to one. The state lottery and government officials know that it is a sucker’s bet that is disproportionately supported by low-income households and marketing programs make sure to advertise in lower income areas and increase television advertising when welfare and social security checks are distributed. The poor and unsophisticated are left to their own defenses when government acts as the issuer and the promoter.

Government should be encouraging private investment in new businesses which historically account for the majority of the innovation and job creation in the American economy. The Kauffman Foundation, tells us that “between 1980 and 2005, virtually all net new jobs created in the U.S. were created by firms that were 5 years old or less…That is about 40 million jobs. That means the established firms created no new net jobs during that period.”

Startups continue to be a robust and critical engine of job creation as according to Bloomberg, despite the sluggish economy some 259,480 angels invested $17.6 billion in 57,225 entrepreneurial ventures in 2009.

As the average startup employs approximately eight people, increasing the bracket for accredited investors in any manner will only make it more difficult than it already is for startup businesses to raise money and create new jobs.

To the contrary, nothing would be gained by reducing the pool of accredited investors—no additional protections to investors and no benefits to the national financial system or the economy. Private venture investment in startup and early-stage businesses should be entirely exempt from the Reg D accredited investor provisions.
 

Jeff Joseph is an angel investor, venture catalyst, financier and libertarian-leaning CEO of Prescient Advisors and Managing Partner of Prescient Capital Partners. He blogs at www.venturepopulist.com.

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