The SEC Just Expanded Who Can Buy Risky Securities. Should I Make More High-Risk Investments?

Until recently, only accredited investors could invest in private equity funds, which include start-ups that haven’t yet gone public with an Initial Private Offering (IPO). When a company “goes public,” they must first submit a lot of information about its finances to regulators. This information gives a much clearer picture of the company’s business and offers brokers a more complete picture of the health and prospects of the company.

On August 26, 2020, the SEC announced that it is broadening the definition of “accredited investor” to include investors who have passed certain entry-level financial adviser exams. According to the earlier definition, an “accredited investor” was an investor who had a high income or high net worth. That could amount to either $1 million in net worth, not including a primary residence, or a salary of at least $200,000 per year for two years, and reasonable expectations for that salary to continue.

The SEC originally wanted to limit who could invest in private capital because of the high level of financial sophistication necessary to assess a private equity. By limiting the definition of accredited investor, the SEC sought to protect investors from risky financial decisions. Instead, the SEC now will allow anyone who has passed the Series 7, Series 65, and Series 82 tests, all of which are required to obtain an entry-level stockbroker’s license, to be included as an accredited investor. SEC Chairman Jay Clayton said in a statement, “There is no doubt persons who have successfully obtained these certifications…are sufficiently financially sophisticated to participate in the private markets.”

But private investments offer the tantalizing opportunity for higher rewards. In 2018, the return on private equity funds had an average annual return of 14.2%, compared with 7.3% for publicly traded stocks. What’s more, some analysts feel that the option to participate in the private market should be more democratic. After all, why should simply having a lot of money equal investment savvy?

Chris Cummings from the Wall Street Journal had a different take, quipping, “The reforms are good news for junior analysts at private-equity firms who want to blow their first paycheck on a buyout fund.” According to another article from The Wall Street Journal, while the SEC doesn’t provide an estimate of how many pre-IPO investors this will add to the capital market, it stands to reason that lawyers, MBAs, and financial analysts will now want to take those exams so that they can qualify as accredited investors.

Understandably, the idea of getting in on the ground floor of “The Next Big Thing” brings with it quite a bit of excitement. But for anyone familiar with the securities industry, this expansion seems likely to expand the pool of disappointed investors. For proof that brokers with the proper accreditations often fail to understand the private securities they recommend, we need only to review the many investor complaints in BrokerCheck.

BrokerCheck, which includes a public record of client complaints levied against brokers, has a wealth of complaints related to high-risk investments and private securities. In fact, “Unsuitable investment recommendation” is one of the most common investor complaints disclosed in broker records. In these complaints, investors allege that their financial adviser recommended a security that turned out to be too risky for their financial situation. This violates FINRA Rule 2111, which requires brokers to understand their client’s financial needs and risk tolerance.

Brokers with disappointed clients are typically more than qualified, according to the SEC’s broadened definition. They’ve passed the tests, they have a high level of financial sophistication, and they still make bad picks. Brokers in these situations could be motivated by an undisclosed financial interest in the company they’ve recommended to their clients, or the promise of a big payday with a steep management fee, but they can also simply be wrong about a company’s prospects. It’s an easy mistake to make — after all, approximately 75% of venture-backed startups fail.

What is the SEC’s motivation to change the definition of an accredited investor?

The SEC believes that the definition needed an update to reflect the changes made to the investment landscape by the internet. As the SEC’s “Concept for Public Comment” states, “Given the rise of social media…as well as online trading platforms for unregistered securities, information about exempt securities offerings is far more readily available to potential investors and to the general public and at a lower cost than at the time many of the exemptions were promulgated.” The Concept also mentions the 2012 Jumpstart Our Business Startups (JOBS) Act as an influential piece of legislation, as it loosened regulations to encourage more investors to provide capital for new businesses.

Chairman Clayton says that this reform will allow small business without wealthy family connections to participate in the private market, something that he suggests will even out the playing field. Under the new definition, the SEC opened up the private market to small businesses, including LLC’s with $5 million in assets, and Rural Business Investment Companies (RBICs). Clayton states: “It has been noted that these wealth-based limits on opportunity can have a disproportionate impact on minority- and women-owned businesses and other underrepresented founders.”

It’s worth noting that private capital has its own lobbyists in Washington, and their influence has grown in the past few years. The private capital market took a hit in the wake of COVID-19, and this expanded definition might help the private capital market get a much-needed influx of cash.

There’s no doubt that some small businesses will benefit from the expanded definition of accredit investor. But this expanded definition also opens up smaller and less sophisticated investors to a higher level of risk, and it’s a statistical likelihood that financial heartbreak is around the corner for at least a few newly minted accredited investors.