By: Thomas E. Holber
In recent months, the Securities and Exchange Commission (the “SEC”) has made two key investor protection reforms as a consequence of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). In general, securities regulations employ the concept of an exempt “sophisticated investor,” capable of bearing certain investment risks and requiring relatively less protection from those securities acts. While the concept of “sophistication” can be used as a term of art, rules promulgated under the Securities Act of 1933 (the “33 Act”) and the Investment Advisers Act of 1940 (the “Advisers Act”) and collectively (the “Acts”) codify a similar concept in financial terms, including net worth. The Dodd-Frank Act redefined net worth calculations under the Acts and essentially mandated regular review of each Act’s key definitions.
Both the 33 Act and Advisers Act define a class of “sophisticated” individuals that, based on relative financial knowledge and understanding, require less protection from the risks that the Acts are designed to protect against. Thus, the 33 Act exempts, subject to limitations, certain Regulation D offerings (Rules 501-508), unregistered under the Securities Act, to “accredited investors” (Rule 501). Rule 501 defines an “accredited investor” as an individual with $1m in net worth, including spousal assets, or, based on the past two years income and a reasonable expectation of similar earnings in the present year, $200k in individual income or $300k in joint spousal income. Similarly, the Advisers Act exempts the investment advisers of certain “qualified clients” (Rule 205-3) from the general bar on those advisers receiving performance-based compensation (§205(a)(1)). Rule 205-3(d) defines a “qualified client” as an individual with $750k assets under assets under management with that adviser or having $1.5m in net worth, including spousal assets.
Dodd-Frank makes two key changes to the definitions of exempt investors. First, the value of a person’s primary residence is excluded from net worth calculations under both the 33 Act and the Advisers Act. The SEC Final Rule release for the Advisers Act explained the rationale: “the value of a person’s residence generally has little relevance to the individual’s financial experience and ability to bear the risks [the Act is designed to protect against].” Thus, under the Securities Act, being an “accredited investor” now requires $1m in net worth, while excluding the value of a primary residence (compared to the previous standard of $1m, including that residence). Similarly, under the Advisers Act, net worth calculations now exclude the value of an individual’s primary residence, with other changes to the calculation discussed below.
Second, Dodd-Frank requires the SEC to regularly review the definitions of “accredited investor” and “qualified client” in order to insure that investors exempted from certain provisions of those Acts are capable of bearing the financial risks that the Acts are designed to protect from. While the Securities Act is otherwise unaffected, beginning in 2014, and every four years thereafter, the SEC must review the definition of an “accredited investor,” deemed capable of bearing the financial risks associated with investing in securities not registered under the Securities Act. As for the Advisers Act, Dodd-Frank amended §205(e) to require the SEC to inflation-adjust the definition of “qualified client.” Subject to that requirement, the SEC this week promulgated rules adjusting the definition relative to a 1998 baseline of the Personal Consumption Expenditures Chain-Type Price Index, a Department of Commerce publication “measuring inflation in the personal sector of the U.S. economy.” Pursuant to this revision, a “qualified client,” deemed capable of bearing the financial risks associate with paying investment advisers performance-based compensation, is an individual investing $1m in assets under management with that adviser (increased from $750k) or possessing $2m in net worth. Both requirements include joint spousal assets. The SEC also promulgated an amendment to Rule 205-3 requiring that, every five years, the SEC issue an order adjusting the “qualified client” definition for inflation.
While the security regulation developments discussed above are hardly novel, they express the underlying rationale of the Acts, in protecting financial market participants from the risks that each is designed to protect against. Moreover, mandating SEC review of the relevant definitions and otherwise applying inflation-adjustments offers a clear, easy way to modernize the Acts and ensure their continued efficacy.