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This teleforum will consider the U.S. Securities and Exchange Commission’s accredited investor standard. This standard is used as a screen to determine the group of investors eligible to invest in offerings that are exempt from most SEC rules on public offerings and which are the primary fundraising tools of hedge funds and private equity funds. The SEC currently uses a wealth and income-based standard, which raises questions about whether limiting investment opportunities to only high-income individuals is sound government policy. Some critics of this standard have urged the SEC to expand the standard to include individuals with financial experience, but who do not otherwise meet the wealth threshold. Other critics have suggested more aggressive reforms. Supporters of the accredited investor standard, however, have advanced proposals to further restrict the group of eligible investors by increasing the income and net worth requirements. The SEC has promised to revisit the accredited investor standard soon, and this teleforum will consider and debate potential reforms to the rule.
- Urska Velikonja, Professor of Law, Georgetown University Law Center
- J.W. Verret, Associate Professor of Law, Antonin Scalia Law School, George Mason University
Visit our website – RegProject.org – to learn more, view all of our content, and connect with us on social media.
[Music and Narration]
Operator: This is Free Lunch, the podcast of The Federalist Society's Regulatory Transparency Project. All expressions of opinion on this podcast are those of the speakers.
Devon Westhill: Good afternoon and welcome to episode 37 of the Federalist Society Free Lunch Podcast for the Regulatory Transparency Project. As I always suggest, if you’re interested in where government regulation might be improved, visit the RTP website at regproject.org, R-E-GProject.org, and subscribe to our biweekly newsletter. You might also consider following the RTP on Facebook, Twitter, and LinkedIn. And we actually have an Instagram now, so there’s some pictures there. My name is Devon Westhill. I’m the Director of the RTP, and I host the Free Lunch Podcast.
In this episode, we discuss and debate reform of the Securities and Exchange Commission’s Accredited Investor Standard. Very briefly, the standard functions to limit the group of investors eligible to invest in certain offerings, in part due to their level of wealth or income. The standard has raised questions about whether it is appropriate to limit investment opportunities only to the rich and high earners. I can’t answer that question, but our two Free Lunch Podcast guests today can. Let me introduce them. I’ll start with J.W. Verret.
J.W. is an Associate Professor of Law at the Antonin Scalia Law School at George Mason University, where he has been on the faculty since 2008. However, in 2013, he took a leave of absence for two years to serve as the Chief Economist and Senior Counsel for the U.S. House Committee on Financial Services. After earning both his J.D. and MA from Harvard, and prior to joining the Scalia Law faculty, J.W. clerked in the Delaware Court of Chancery and practiced law Skadden, Arps in D.C.
J.W.’s academic work has been featured in numerous outlets, such as the Yale Journal on Regulation and the Stanford Law Review, and he’s been invited to give expert commentary in every major news publication and cable network. In addition to about 1,000 other things that I could say about J.W., I will end by saying that he volunteers his time as a scholar to several nonprofit endeavors, including the Mercatus Center’s Working Group on Financial Markets and, of course, as Chairman of the RTP’s Financial Services and Corporate Governance Working Group here at The Federalist Society.
Our other guest on this episode is Urska Velikonja. I think I got that right. Urska is a Professor of Law at Georgetown University Law Center. Before joining the Georgetown faculty in 2017, Urska taught at Emory University and the University of Maryland and visited at U.C. Berkeley, University of Chicago, and Duke Law School. She graduated first in her class at University of -- Urska?
Urska Velikonja: Ljubljana.
Devon Westhill: Ljubljana School of Law, thank you very much, and earned her LL.M. and J.D. magna cum laude from Harvard Law School. Prior to entering academia, Urska clerked for Judge Stephen F. Williams of the U.S. Court of Appeals for the D.C. Circuit and practiced law in her native Slovenia.
Urska has written extensively on securities regulation and securities enforcement. Her work has won praise and has been published in top tier journals such as the Cornell Law Review and the Yale Law Journal. Urska’s work on SEC enforcement is regularly discussed by regulators and has been featured in stories for major U.S. and international publications, like the Wall Street Journal.
As I have alluded to, I have significantly truncated the biographies of our speakers in the interest of time. If you’d like to learn more about J.W. or Urska, please visit regproject.org where we have listed their full life stories. Okay. In just a minute, I’m going to turn the floor over to J.W., who will be the first to speak. Before I do, I remind everyone that The Federalist Society takes no position on particular legal or public policy initiatives, and, therefore, all expressions of opinion on Free Lunch Podcasts are those of our featured speakers. Also, as usual, both Urska and J.W. will take questions from our audience, so please be prepared with any questions that you have prior to the start of the Q&A period at the tail end of the call.
J.W. and Urska, thank you very much for joining us today as our Free Lunch Podcast guests. J.W., as I mentioned, you have the mic. The floor is yours. Thank you.
J.W. Verret: Thanks so much, Devon. So today’s discussion is focusing on the Accredited Investor Standard. This is a standard the SEC uses to differentiate between investors and provide some investors with preferential access to investment vehicles that are more lightly regulated and primarily used by hedge funds, private equity funds, and venture capital funds, and also some issuers, startup issuers that sometimes go public in a very big way. So this standard and the private market offerings that were created -- that are allowed to be invested in through those who meet the Accredited Investor Standard go back to Reagan era law designed to promote capital formation.
The two basic types of offerings allowed under the Accredited Investor Standard are Regulation D, where over a trillion dollars in offerings are currently outstanding. So the Regulation D market, private market, is a similar market cap to that of publicly traded companies. This is primarily used as the primary financing vehicle for private equity funds, hedge funds, and venture capital funds. And then the Regulation A market, which is partly restricted to accredited investors. Non-accredited investors can invest up to a certain limit for what’s called the Tier 2 of Regulation A. They’re allowed to invest up to the limit of 10 percent of their income, if they’re unaccredited, or unlimited, if they are accredited investors.
The basic definition, how we differentiate in the securities lost between these investors, who’s sophisticated enough to take care of themselves and invest in the private market and who’s not and needs the helpful hand of government, is basically this: if you have a million dollars in personal wealth, excluding the value of your home, or do you make $200,000 alone, or $300,000 a year with a spouse, that’s the basic definition of accredited investors. Regulation D has some disclosure requirements for offerings that also offer to non-accredited investors. Regulation A has a pretty extensive -- many registration requirements that is similar to the SEC’s basic requirements for public issuers but is more modified and limited.
These private markets are very helpful to issuers. Think of it this way: that one study in 2018 by the Wall Street Journal noted that private startups valued at over one billion or more -- so this is private startups valued at a billion dollars, unicorns, went from 32 in 2014 to 103 in 2018. 103 issuers worth a billion dollars decided they preferred the private markets to the public markets. You’ve got to ask yourself why is that? Some raised over a billion, like Airbnb, Uber, Spotify, in private offerings before going public or contemplating going public. So why is that? Why do they stay private for so long? Well, many of the cite in surveys, in discussions with the SEC’s Small Business Advisory Committee that I work on, and in my work with them they cite a few things.
They cite the cost of compliance with Sarbanes-Oxley, SOX 404(b)’s internal controls certification requirements. They cite the costs of securities class actions. They cite the cost of proxy advisors, shareholder proposals, and a wealth of corporate governance requirements that they feel like they aren’t ready for as private issuers. And they feel that financing through the private markets is better for them. So the SEC did a thoughtful study of the Accredited Investor Standard that it was required to do by the Dodd-Frank Act. It came up with a number of ideas that we’ll have a chance to discuss today. Part of my comments are about how I think we should expand the Accredited Investor Standard, in part because I have a serious issue with the notion, generally, that wealth is a good proxy for sophistication.
I would cite anyone’s favorite -- I won’t mention someone specifically, but anyone’s favorite idea of a Hollywood actor as a great example, there are thousands of them, for why wealth is such a horrible proxy for financial and intellectual sophistication. But that aside, I think one of the things, this helps investors. It helps issuers. It helps promoters of capital. It helps financing, but it also helps investors, in that it helps to provide for diversification advantages. Now, there are a lot of returns to be made during some timeframes in these types of investments. Sometimes, they don’t do much better than the S&P 500. I think if you look back at the private equity IRR over 1990 to 2006, it did great for a decade or two, until the financial crisis. And then since the financial crisis, it’s pretty much done as well as the rest of us in our 401(k)s.
But even then, even when returns are low for PE D.C. hedge fund sectors, they still provide diversification advantages because the variance is significant. Not that we should use median returns as a means to judge where we should regulate and where we shouldn’t because I don’t think we should. But I think it just provides evidence of some of the advantages that you’re going to give mainstream investors as you allow them more opportunity to invest in Reg D, Reg A type offerings as you expand the accredited investor definition.
For issuers, what does it allow? I think it provides a great advantage to just get around the ‘33 Act’s main registration requirement. As a securities law professor, I love teaching the ’34 Act, the basic anti-fraud rules and regular reporting rules. But the ’33 Act, the process of an IPO, is horrifically complicated. It’s a morass of gun jumping rules, and waiting periods, and micromanagement of the communications between someone doing an IPO and the potential investor in an IPO.
And I can understand why an issuer would want to get around it however they could. There are issues to think about in fundamental fairness here for the non-securities law technical listener. Think about just fundamental fairness, whether you’re a populist, or progressives, or a libertarian. You should agree -- I think the best way to redistribute wealth is to promote access to wealth. The best way to promote liberty, the best way to promote redistribution of wealth, is both, I think, to promote access to wealth. Do we really want the government to be in the business of deciding who gets access to these special investment opportunities based on their personal wealth?
So that’s my generalized argument, but I think we could get specific, too, because -- and we could talk about potential areas where we might agree because the SEC has put accredited investor reform on its agenda. It’s gone onto the Reg-Flex Agenda at OMB, so the SEC is going to do something. The SEC prior study was, I think, a thoughtful look at all sorts of different possibilities for how to compromise on this issue. I would do something more significant, more revolutionary in taking a pen to the Accredited Investor Standard. But let’s talk about potential compromise here.
And I think we could sort of be a window in today’s discussion, if there’s interest, into what sort of compromises would be reasonable, would be possible, and maybe be a window into the ultimate compromise we’ll see from the Democrat and Republican commissioners in the SEC. Because the SEC study lobbed out a bunch of ideas, mostly inspired by the way that other countries approached this issue. Similar type accredited investor limitations, provisions, around the world are very different and, frankly, much more lax, much more liberal, much more free, I would say, than the SEC’s approach in the United States. For example, just the number used in the United Kingdom, in Australia, even in the EU, is much lower than the average in the United States.
So the United States does 200 grand a year on your own, 300 with a spouse. It’s roughly $150,000 in comparable western developed nations: the EU, Canada, Australia, UK, $150,000. So right away, just to stay with the rest of the modern world, I think lowering the Accredited Investor Standard makes sense.
But there are other ways to think about financial sophistication, other than wealth, like professional certifications, education, prior experience with unregulated offerings. The U.K. takes an approach where if you go into some of the unregistered offerings that you have opportunities to invest in and you have some experience and you learn that things don’t always work out in those investments, then a certification that you have that investment experience allows you to invest in other types of offerings that are similar to those that the Accredited Investor Standard serves as a gateway for in the United States.
So I expect the SEC is going to explore those, and that might be something we can dig into a little further on today’s call. My time is running out, so the last thing I’ll mention in introduction is that, in addition to a discussion about the wealth threshold used for the Accredited Investor Standard and whether or not, on the one hand, consumer advocates are lifting the standard so that fewer people are able to access Reg D and Reg A offerings, whether we should lower that wealth standard, and whether we should think about non-wealth avenues for success. And another one I’ll mention is a simple financial literacy test to give people an opportunity to invest in non-registered offerings.
Another thing to think about is a part of the accredited investor definition that deals with non-persons, that deals with business entities, because that was written a long time ago. For example, it doesn’t reference LLCs. It allows business entities with $5 million in wealth to invest as long as they are trusts, and it lists out a couple of different things. But it doesn’t include things that we would think about today and that would have been included if it had been written today, like government entities, LLCs, 529 plans, or, frankly, for that matter, Indian tribes, which are, I think, an interested party in this debate. So institutional access, increasing institutional access to Reg D and Reg A offerings is also something that’s on the table and that was explored in the SEC study. I’ll stop there. I’m sure my friend Urska will have many informative things that I will learn from, but glad to be here and looking forward to continuing the discussion.
Urska Velikonja: First, thanks to Devon and to the Federalist Society [for] having me here on this program. And thanks to you, J.W., for a great introduction to our conversation. I think there’s plenty of things we agree on. There’s also plenty of things we disagree on, so hopefully we’ll have an inspired conversation. So let me start with my remarks. I’m going to give a little bit of background to how we got to the Accredited Investor Standard before I start discussing the pros and cons and how we might modify the Accredited Investor Standard.
In the United States, we like to think we’re number one and the best at pretty much everything. Now, I’m not a politician or running for office, so I can cite the fact that this is often not true. But we really are the first and the best when it comes to securities regulation. In my view, at least, our capital markets are lively because of, not despite, our securities laws. And if you’re not convinced, just compare capital markets, generally, with how the crypto-markets are doing right now, crypto-markets being markets not covered by securities regulations, at least according to the crypto industry.
Now, the securities laws at the time they were adopted in 1933 and 1934—and I actually like teaching the Securities Act of 1933—they were a real innovation at the time they were adopted, and they continue to be an innovation. Developed and developing countries around the world pretty much just copy what we did back in the ‘30s.
And what the laws do, they take what is a fairly simple, straightforward approach. They require registration for all offerings, shift the burden to proving compliance to issuers. That’s the basic idea. Now, I agree with J.W. that perhaps some of the details are mind numbing and unpleasant, but the basic idea is straightforward. If securities offerings are risky, shift the burden of proving compliance to issuers, and then capital markets will grow, which they, in fact, did and have done since the 1930s. Now, one exception from registration is the private placement exception, which today allows issuers to sell securities to credit investors without registering with the SEC. The statute doesn’t define what’s private placement and deferred at the time to this newly established agency, expert federal agency, to work out the details.
Now, that wasn’t the only missing definition in the act, but it was one that the SEC was actually compelled to clarify very early on. So in 1935, right, two years after the adoption of the Securities Act, the SEC came up with a four factor test, deciding these are the types of offerings that can be offered to -- that don’t have to be registered. And they say, well, if the offering is small, if it’s made in large denominations to few investors who knew each other and the issuer and who negotiated terms of the offering with the issuer, then the offering was private and did not have to be registered. Otherwise, it was public and had to be registered. Now, note that these initial views of the SEC are largely about the offering and the relationship between issuer and investor, not about investor qualification. So it was somewhat easier to administer, perhaps, but looks nothing like the modern Accredited Investor Standard.
Then in 1953, the Supreme Court steps in with a different answer, right, so interprets the Securities Act in a decision called Ralston Purina and explains what are private placements and who can invest in private placements. The Court said private placements are offerings made to investors who do not need the protections of securities laws. The size of the offering, then, doesn’t matter. What matters is investor qualification. And the Court then went further to explain investors who don’t need the protection of securities laws are those who are sophisticated and informed so that they understand what information they need about the offering to make an educated decision.
In other words, unlike Mom and Pop, sophisticated investors know what they don’t know and know to ask. Great idea, impossible to administer. So in 1982, as J.W. mentioned, the SEC, under substantial pressure, came up with this Accredited Investor Standard and shifted from looking at sophistication qualification to a wealth standard for individuals. The function of the Accredited Investor Standard is then to draw the line between individuals who need protection of securities laws and those who don’t. And it’s a binary switch, not a toggle. Easy to enforce, but it really does raise questions about fairness that J.W. so ably raised in his comments. And the cutoff floor at the time, as J.W. mentioned, $200,000 in annual income for an individual, $300,000 for a married couple, which in today’s dollars, this hasn’t been indexed for inflation, is about $500,000 for individuals, $800,000 for married couples.
It also created a wealth standard, or if you have a million dollars in net worth, you can be an accredited investor, which is about $2.7 million in today’s dollars, if you were indexed for inflation. Now, these cutoffs mean that about three percent of individuals qualify based on income. This is today’s figures. And based on net worth, about ten percent of households, plus/minus, would qualify as accredited investors. Everyone else does not. Right? So that means 90 percent of Americans do not get to invest in private placements that do generate substantial returns.
Now, what the rule did, the market in private placements grew tremendously. As J.W. mentioned, private placements, such as rules of Regulation D in which the accredited standard is included, raised in 2017 $1.8 trillion. That’s more than all public offerings combined in 2017. One and a half trillion was raised in public offerings. And these types of investments include, as J.W. also mentioned, early stage companies, but mostly include investments in private funds, such as hedge funds, private equity, to a lesser extent venture funds. And they are often associated with fabulous returns. Though, the returns do tend to be much better for founders and for fund managers than they do for the investors. I digress.
The returns really are great. They tend to be higher than the public market as a general matter and don’t require leverage. Now, these returns create the perception that, for example, if one could invest in a young Facebook or baby Tesla, then you could put up a few thousand dollars, wait ten years, and retire at age 40. If that’s true, it really does see profoundly unfair that such investments are opened only to people who are already wealthy. Now, the problem with this framing that I have is that it focuses only on the supply side and not enough on the demand side. Only about ten percent of those who qualify for the Accredited Investor Standard, ten percent of rich people, actually use it.
Now, some of it is because some rich people, perhaps many rich people, are not interested in high risk investments, but much of it is because of issuer demand for capital. Now, we know as a general matter the Ubers and the artificial intelligence and F0intech companies of the world don’t want Mom and Pop’s money, unless it’s their own parents, right? Founders are looking for money and experience. Early stage companies, they want money plus experience, hence, money from venture funds, not from Mom and Pop because they have neither. Private equity hedge funds don’t look for experience, but they want money. And they want lots of money. Many limit minimum investments in funds to, say, $5 million, which is much more than even most accredited investors have.
They don’t want to bother with small time accredited investors. Now, that’s the real issue, and then there’s really not much the law can do about it. But it doesn’t mean that the law shouldn’t be updated, which J.W. and I agree. And I would suggest, perhaps, it should be both tightened and expanded. I’m very much in favor of expanding the Accredited Investor Standard to financial sophisticated investors. That would track with what the Supreme Court told us in 1953 in Ralston Purina much more closely than the accredited standard currently on the books. Also, just as J.W. mentioned, we are one of very few jurisdictions, developed jurisdictions, that limit private placements to wealthy individuals.
In Canada, an individual who’s a registered advisor or dealer can invest in private placements. In Australia, investors who hold financial services licenses can invest in private placements. In the EU, they have a sort of combination of criteria that have to be satisfied but similarly allow people with trading and financial experience to invest in private placements, which we don’t. Those markets haven’t crapped out. Sorry for the bad language. Those markets are doing okay, not as well as ours, but they’re doing just fine. So that would be a strong argument in favor of expanding the standard to actually financially sophisticated investors, even those who might not be super rich. At the same time, maybe we ought to think about tightening the investor standard at the same time.
I mentioned that, by law, one doesn’t have to be that rich, in quotes, to buy private placements and that about ten percent of U.S. households do actually have more than a million in net worth. Now, some of it is because it includes houses, but many older households have substantial 401(k) holdings that push them above the million dollar net worth standard.
Now, I just mentioned that quality issuers don’t want Mom and Pop’s money, even somewhat affluent Mom and Pop. But fraudsters, they prey on Mom and Pop. So because of the way the rule is written right now and the way it operates, in fact, in practice, small-time accredited investors don’t get to buy into quality offerings but are free to lose their retirement to those who prey on upper-middle class Mom and Pop.
So under the current standard, there’s at least a smaller -- the group on the lower end of that income and wealth threshold, there’s very limited upside to this low threshold and only downside. If I’m right, then I would suggest the SEC go ahead and revise the rule by first adding financially savvy licensed investors but perhaps working around, working with, the financial threshold, perhaps include 401(k) assets from the calculation of net worth, for example.
One last point here, to say that non-accredited investors cannot invest in private placement is not entirely true. They just can’t do so directly. Non-accredited investors could conceivably invest in mutual funds which are allowed to invest up to 15 percent of fund assets in illiquid investments, which would include things such as investments in early stage companies.
But currently as it’s structured, it’s not the cap that has stopped large mutual fund managers from investing in private companies. It’s been their own internal rules. Fidelity, for example, limits fund investments in illiquid assets to 10 percent, not 15 as the law allows. But most of Fidelity’s funds that do hold such assets only invest about one to three percent in non-listed business. That is probably largely because, even though the variance in returns for private entities tend to be considerably higher than for public companies, these returns do tend to correlate with returns in public companies, which means when the markets are great, the private companies are doing great, even better. When the markets turn south, the private companies do even worse than the public companies. So variance is greater, but it is correlated with private market returns, which means that it doesn’t really do much for investors, unless, of course, you’re lucky and you exit when the price is high. Okay. I will finish my remarks here, and I’m very eager to discuss this further.
Devon Westhill: Thank you very much, Urska, and thank you, J.W. I think there might be a little bit of back and forth we need to have here. J.W. is probably eager to respond to a couple of things that Urska said, and that may make Urska eager to respond to J.W. But after --
J.W. Verret: -- there always is with Urska.
Devon Westhill: After a little bit of back and forth, we will go to Q&A. So let me turn to you, J.W.
J.W. Verret: Yeah. Well, with my friend Urska there always is because it’s hard for me to keep up. But she spurred a few thoughts and I’ll sort of respond to that. So first, to the existing exposure that retail investors, non-accredited investors can have to offerings that they’re fully prohibited from directly, you’re right. The mutual funds have not been quite as involved in -- not quite as interested in that to the limited extent that funds of funds, funds of hedge funds are one way to do this. This is, by the way, how Anthony Scaramucci, the “Mooch” Scaramucci, made his money, with funds of hedge funds. The fees are incredible. It’s at two and twenty, on top of a two and twenty, a four and forty. Which even if they are doing abnormal returns, you lose them with the fees.
So I would push back on what I think is Urska’s assumption that there’s more opportunity for fraud in the unregistered offering space than there is in the registered offering space. I haven’t seen the extensive evidence that there’s more consistent fraud in the lighter touch Reg D, Reg A offerings than there is in registered offerings. In fact, what I’ve seen is -- look at Rice and Weber 2014, an examination of SOX 404(b), which was one of the primary tools designed to root out fraud. It shows that the overwhelming majority of the time, something like 60, 70 percent of the time, that publicly traded registered firms restate their financials there was no finding of material weakness of internal controls from the outside auditor. Like if 80 percent of the time you have a heart attack, your last physical was spot on perfect, maybe there’s trouble there with the doctor.
That’s one of the things that private firms are trying to avoid, at least to the extent private firms are involved in unregistered offerings. We’ve got to think about the fact that similar market caps for private offerings and public offerings, similar amounts raised, even more raised more recently, in Reg D, Reg A offerings than in registered offerings. There’s something wrong with the ’33 registration system when so much of the capital formation in this country is trying to find desperately -- most of the capital formation of this country is trying to find a work around that system. I’m suggesting a look at private offerings through a sober look at potential returns and potential diversification. I’m not suggesting that the story to sell this is the unicorn story. I’m suggesting that it provides great diversification relative to the market through the ‘90s and before the crisis.
Urska is absolutely right. During the low interest rate environment, it’s pretty much tracked the S&P. My suspicion is it’ll go back to providing some great diversification advantages with potentially abnormally higher returns, relative to the S&P, when we get back to a normal interest rate environment. But, again, I would limit myself to justifications for private offerings just because of the relative returns there or demand for capital from the capital formation side. I would give the opportunity even if it’s unused.
I think where Urska and I probably agree is sort of the way to think about this, when the SEC begins a compromise and a limited review of the Accredited Investor Standard, is think about somebody who has a Ph.D. in finance, is a chartered financial analyst at Blackstone in the private equity group, who’s not wealthy yet, maybe. Maybe for some reason they just started -- maybe not a Ph.D. But anyway, somebody who’s just below the threshold, right, that they can’t invest in the offerings -- in the Reg D offerings that Blackstone’s doing, but they’re clearly far better situated to take care of themselves under the Ralston Purina standard, that case, than, say, Paris Hilton or basically anyone from any reality show ever.
The one other thing I’ll throw out there, a last thought before Urska has another round and we do questions and all that, is one thing I would suggest as a way to think about compromise is think about as changes to the Accredited Investor Standard are on the table for Regulation D offerings that do not currently include non-accredited investors, there’s a light touch disclosure regime under 502(b)(2).
And I think this is a great, flexible, interactive disclosure regime. It’s what we could have today with current technology. It contemplates Reg D issuers doing back and forth questioning with investors. It’s something that the internet allows that that communication technology when the 1933 Act was adopted did not allow for. And 502(b) has sort of a limited thing where you have to raise up to two million. You only are at the balance sheet, and for higher offerings, sometimes, you have audits on some of the financials, but not all of the financials. And maybe if you could show it’s onerous, you limit the audits only to the balance sheets to reduce the cost of the audit, and you get around some of the other requirements that come with a full ’33 Act offering.
But that’s to suggest only that, as we’re tinkering with the Accredited Investor Standard, we can also tinker -- if Urska -- if we’re starting the negotiations, I’ll put on the table scaled disclosure could be part of the compromise as well.
Urska Velikonja: I’ll take it and I’ll raise you one, right? So I think you’re absolutely right, J.W., that we are in agreement on having someone who is actually sophisticated able to show that they’re, in fact, sophisticated. Now, I think we would disagree on how exactly they would do it, right? I mentioned Canada and Australia that look at our UA licensed professional. Do you have a license? If so, then you are authorized to invest in a private placement. So the equivalent might be do you have a license to be a broker dealer, Series 7, Series 63 license from FINRA, one of those licenses. I think J.W. was suggesting a financial literacy test, and then, of course, one can quibble about the details of what exactly that test would do and how we would test literacy.
But we are in agreement that someone who has a Ph.D. in finance and isn’t yet affluent probably should be allowed to invest in private placements. I would be surprised, if the rule is amended, if that particular outline isn’t added. But certainly, that’s the area for compromise.
Another thing that J.W. suggested is to think about scaled disclosure for small time investors. As the things stand now, Reg D does in fact allow issuers to make private placements to non-accredited investors. Now, it caps the number to 35, non-accredited investors per offering, but for the vast majority of offerings, that would be just fine. The median offering is sold to a single digit number of investors.
We’re talking about up to ten investors per for the median offering. The average offering is somewhat higher because there apparently is some very large offerings. But the median issuers sell to very few investors, so in theory, that bar that you can have no more than 35 non-accredited investors shouldn’t really be a problem. But it turns out that the issuers aren’t selling to non-accredited investors, and it might be precisely because of the disclosure requirements. This is not something issuers really want, as it stands now. I’m looking at the SEC’s report released -- it’s now released a report every year that, on average, about seven percent of all private placements under Regulation D included at least one non-accredited investor. That’s a very low number. Only seven percent included at least one. 93 percent included no non-accredited investors to whom they were sold.
But that doesn’t mean we shouldn’t think about what we might be able to do. For example, let me use Canada again as an example. In 2016, Canada created a general exemption for individuals to invest in private placement, and they said, sort of across the board, an individual, anyone, can invest up to $10,000 per year in companies without registration, so long as an investor receives an offering memorandum that has certain standard disclosures and checks the box that they’re not getting the benefits of registration and so forth. So up to $10,000 per year in any type of investment.
They lowered it. It used to be $150,000. They lowered that in 2016 to $10,000. So one thing we may want to do is look to Canada to see, okay, how has that rule played out in Canada and what has it done and perhaps model it.
J.W. Verret: I love Canada. I think we can learn a lot from Canada. One thing, we’ve talked a lot about Regulation D. Another thing to think about in this context is that for Tier 2 offerings for Regulation A that limits the ability of non-accredited investors to invest. And there’s a lot of pent up demand. Unlike Regulation D, there’s a lot of pent up demand on the issue aside. So lifting that cap on Reg A was the key to making Reg A something real, and I think further lifting the cap, further tinkering with the limits on non-accredited investor participation in Tier 2 of Reg A, you would see, at least, a lot of pent up demand.
Urska Velikonja: Yes and no. At the same time, if you look at Reg A, how much capital that’s raised, we’re still talking about really small numbers. Certainly real for issuers who use Reg A, but we’re talking about a few hundred million dollars under Reg A compared to trillions under Reg D. I really can’t stop myself from just coming back to the whole demand side in the issuers market, both on the private equity side and hedge fund side, as well as some issuers. Issuers don’t seem to want money from Mom and Pop investors, individually. Right? You can see why that would be, right?
Let’s say you’re starting a business. You’re an early stage company. You sort of have a good idea, but you don’t actually know who you might want to sell it to, where you’re going to get the funds. The last thing you want is some dude who has a little bit of extra cash invest in your company and then micromanage your idea. Something that professional investors experience. Sophisticated investors might understand maybe you don’t micromanage an issuer, but someone who’s put their entire retirement in an early stage company might feel like “you owe me because you gave me this money, and the risks involved are significantly great.”
So perhaps, in order to make this market work, we do in fact need an intermediary, such as a fund, even though, as you say, the fees are really high such that they make investments in private companies through funds less appealing than direct investments might be.
J.W. Verret: Well, I think, in order to open up the demand side and the supply side of investments here, this is another debate and another call. But we can start talking about the other side of this which is the resale restrictions on Regulation D, which limit the ability for a secondary market in that. But Devon, do you want to see if there’s any questions from the audience?
Devon Westhill: Sounds good.
J.W. Verret: I bribed my students to call in, so maybe one of them is here.
Devon Westhill: [Laughter] That sounds good. We’ll do an accounting and look at the phone numbers to make sure that you did get some to call in. You can give some extra credit or something. But anyway, that’s been a really good discussion, so we will turn to Q&A now. In a moment, everyone on the call is going to hear a prompt indicating the floor mode’s been turned on. After that, to request the floor, particularly if you’re a student of J.W.’s, I think it’s a good idea, enter star and then pound on your telephone keypad. And we’ll get to you in turn. I’m going to go ahead and open the floor now. Okay.
The floor mode is on now. When we get to your request, you’ll hear a prompt. Please thereafter state your name and affiliation, and then you can ask your question. We’ll answer questions in the order in which they’re received. Again, to ask a question, please enter star and then pound on your telephone keypad. I see at least one question now, so we’ll go ahead and get started with the questions.
John Berlau: This is John Berlau with the Competitive Enterprise Institute. Thank you so much for holding this call.
J.W. Verret: Hey, John. Good to hear from you.
Urska Velikonja: Hi.
John Berlau: Okay. My question is for Urska, but J.W. is welcome to comment. If fact, I’d be interested in hearing his comments. Urska, you gave an interesting presentation. Both of you did, but I’m curious as to how you can say we’re leading the world in our capital markets when we actually, according to the National Bureau of Economic Research, have the fewest publicly listed companies on our stock exchange in 40 years, fewer even than the bear market of 1975. What’s more, the size of IPOs have gone up so much, after Starbucks. But before Starbucks, most company’s IPOs were less than 50 million. Starbucks and Cisco raised less than 50 million.
They were the size that early stage companies were now, and yet, they were looking for retail investors. And sometimes, if you watch Shark Tank, VCs do micromanage companies all the time. So they may want retail investors precisely for that reason. I’m just wondering if both of you could comment on both the increase in size, the decrease in number of companies on the stock exchange, while in other countries, the numbers have increased, in Europe and Asia.
Urska Velikonja: J.W., if it’s okay, I’ll start, and then, by all means, please respond. So that’s a great question. It’s a fun one that I like to talk about, and it sort of relates to what J.W. started with about why companies are not going -- the big issue, right? Why are companies not going public? Is it because of liability and regulatory costs, and maybe our regulations are terrible? Or is it because -- let’s just use Elon Musk as an example because public markets come with public investors, some of whom short your stock. And then you’re not happy with them, right? Elon Musk has not complained much about the regulatory cost, even though he doesn’t like enforcement actions. He has complained about how the markets, investors present in those markets, have made his life difficult.
Now, how do we evaluate the quality of capital markets? You suggest one metric, which is the number of listed companies and the number of IPOs, which are perfectly decent metrics. I was looking at the size and the depth of capital markets, and our capital markets continue to be the largest, the deepest of any place in the world. You’re right that we have lost some ground. It used to be that U.S. capital markets were about half of total global capital markets. Half, okay? And we only have, what? Ten percent? We have like five percent of global population. So they used to be half. The last number I saw, and I don’t know how reliable they are, we’re down to about a quarter of total global capital markets. That is a considerable decline. It’s not inconsistent with my statement that we’re still number one.
But should we be worried about few public companies and why have IPOs grown over time? That’s a complicated question. As Chair Clayton, the current SEC Chair Clayton, suggested during his nomination hearing, perhaps regulation is the reason why we have few public companies. But if you look around the world, they have pretty strong regulations as well. They’re not being slackers when it comes to regulating public companies. So of the reasons that come to mind, one is that the public companies have disappeared not so much through fewer listings but through acquisitions. Public companies get acquired by other public companies, which reduces that number.
So there’s a study coming from finance economists at Ohio State suggesting that at least as much as perhaps 40 percent of the decline in public companies is due to acquisitions. The size of the IPO has grown, but is that because of regulation? Is that because people don’t want to become the next Elon Musk, who’s hounded by sharks? Or is it because there’s so much free floating private capital? Those are confounding factors that determine the size of public capital markets, rather than it’s just because of regulation. So I’ll end here, but I’ll let J.W. respond.
J.W. Verret: Yeah. Actually, I agree with Urska on the fact that -- I actually don’t like the metric of where are we on IPOs relative to where were we on IPOs ten years ago. That’s such a messy thing because it’s for a few reasons, and it’s the wrong reason to support deregulation. I have lots of other reasons to support deregulation. I think it’s partly a question of economies of scale and scope that led to more consolidations, more mergers. I think it’s partly a question of the impact of regulation. It’s also a question of the fact that it’s great that a lot more money is being raised through private fundraising. And so rather than going public, you delay.
So it’s partly a symptom of a well-functioning private market, which is a good sign. So it’s a variety of causes, but certainly part of it is -- a component of it, I don’t know the size, but a component of it is regulatory costs. I think you can test these individual regulatory constructs and their effectiveness and see whether or not we might want to think about either changing them or opening up the gateway for private capital. And when I look at the empirics behind things like 404(b), behind things like the Securities Class Action Reform and the deterrence effect and moving money from shareholders to other shareholders and issues about the empirics behind particular corporate governance fad of the day in shareholder proposals, I can see a reason why you might want to avoid IPOs.
I certainly would, but I didn’t open with the discussion about IPOs are dead. I opened with the discussion about particular startups that delay going public and why. For me, that’s mostly a story about the benefits of private markets and fundraising. So I know Chairman Clayton. I love Chairman Clayton, and he focused in on the decrease in IPOs. But that’s not my preferred metric for this fight.
Urska Velikonja: Agreed.
Devon Westhill: Thanks for the question, John, and great discussion, Urska and J.W. We’ve got another question, so why don’t we go to our next caller now.
Jeremy Kidd: Morning. This is Jeremey Kidd at Mercer Law School. Thanks for an interesting discussion. Kind of on the same lines, there was a point raised earlier -- an argument raised earlier that our markets are thriving because of our securities regulation. I wonder if that’s maybe too strong of an argument. I don’t know what the evidence would be for that proposition or how you’d tease that out with how complicated our financial markets are. It seems to me a better way of phrasing that would be that there are good and there are bad securities regulation. There have to be.
So it seems like the best we could say was that, on net, our markets function better with our regulations, but then we have to decide whether our default ought to be our regulations are good unless they can be proven to not be good or whether we have a default that our regulations are bad unless they are proven to be good. It seems like, in a capitalistic society, shouldn’t we have the second default, that people ought to be free to engage in voluntary transactions, unless we can show that a regulation is essential?
J.W. Verret: Thank you, Professor Kidd. That’s deep, man. You know, I think that’d be a great topic for the next teleforum.
Urska Velikonja: Yes.
J.W. Verret: Some of that is implicated in questions about -- I’ll take your question as sort of focusing us to the economic analysis requirements behind SEC rulemaking. And an SEC’s rulemaking on amendments to the Accredited Investor Standard will have to meet that cost benefit analysis requirement. And that might be a component of what DERA needs to look to. But I just want to go more micro here and just suggest some reasonable compromises to the credit investor definition can help encourage more private market investment. There’s a deal space where the commissioners can make a deal on this in a way that enhances access to capital, and I’m all for it.
Urska Velikonja: Right. So let me add to this. So I like making controversial statements because they’re good conversation starters, and I’d be happy to discuss this at some future time. But to this specific question, one of the things that I look for securities reg -- so you want good quality regulation. You also want regulation to be predictable, as a general matter for issuers, so that they can make investments in reliance on existing rules. Over the last decade, let me say decade, we did a lot of revisions in securities laws, many so quickly that we couldn’t even study how the earlier revisions have worked because we changed the law so quickly after that.
The Accredited Investor Standard is not one of those. Yes, Dodd-Frank tinkered a little bit with how you calculate net worth, but the same rules have been on the books for a very long time. And I agree with J.W. It’s about time that they were revised. And I further agree with J.W. that I do think there is a Venn diagram -- there is overlap on the Commission in how exactly those rules ought to be regulated. There’s certainly agreement -- I expect there would be agreement on expanding the list to actually financially sophisticated investors, and I imagine there might be some agreement for allowing regular investors to make smaller investments in private placements without registration.
J.W. Verret: Urska, what did you think about -- an issue brought up in the Accredited Investor study by the SEC is that another path to becoming an accredited investor is that you have $5 million in assets and you’re an entity. They list trusts and other things, but they don’t have the full range of business entities we have now from corporate law innovation. What about adding LLCs, state and local governments, Indian tribes, 529 plans? Alaska’s Permanent Fund, you know where Alaska puts all its oil money, wants to invest, and they feel like they can’t under the current definition. Or they’re not sure under current -- there are no action letters interpreting the Accredited Investor Standard. What about lumping those in, as long as they have $5 million? They’ve got their own investment committee. They’ve got sophisticated people there. What about --?
Urska Velikonja: So allowing small-time investors to invest in companies such as that, essentially creating a fund through an LLC, is that what the idea would be?
J.W. Verret: Yeah. It’s not necessarily retail access.
Urska Velikonja: So as long as there’s an investment committee?
J.W. Verret: Yeah. It’s not even necessarily the retail access; it’s just the entity themselves.
Urska Velikonja: Right now, you have a sort of rule, like you can have -- a partnership can invest, but not if it’s created to evade the standard separately. As a general matter, so long as there’s someone watching over the investments, I think that’s something that’s certainly worth studying and perhaps expanding. I don’t have a knee jerk reaction to a proposal like that.
J.W. Verret: Any other questions on the line, Devon, or should we keep going?
Devon Westhill: No, we do have an additional question, and I do think it will probably need to be our last one. And then maybe we’ll finish up with some additional remarks from the two of you. So let’s go to that last question right now.
Sean McDonald: Hello. My name is Sean McDonald, and I’m one of Professor Verret’s students.
Devon Westhill: All right.
J.W. Verret: Bonus points. Welcome. Welcome.
Sean McDonald: Thank you. So Professor Verret, I understand that one of your proposals for amending the process to becoming an accredited investor is a financial literacy test, and both you and Professor Velikonja seemed opened to the professional license holders without the threshold level of wealth becoming accredited investors, like in Canada. My question is, if either of those proposals are adopted, is the suggestion that we eliminate the wealth requirements entirely or increase them or decrease them as we determine that other metrics of sophistication, which is all the wealth requirements are a stand-in for, are critical?
J.W. Verret: I would suggest eliminating the wealth standard or leaving it in place or -- I don’t know what to do with the wealth standard. I would basically leave it in place but open up additional pathways. It’s entrenched. It’s been there a long time. I wouldn’t get rid of it now, given that so many have relied on it. For the financial literacy test, my fear is that the SEC would make it look basically just like the Series 7 test, if it had its own way. And that would concern me because that wouldn’t do much. That would basically be the same thing as professional licensure.
I would have a hundred basic questions that you might expect on a basic college level finance class that anybody could -- you don’t have to go to college. You just take an online moot course and learn within a few weeks, understanding basic things like the net present value, how to do a net present value calculation, the difference between preferred and common stock, the fact that how diversification helps and the diversification frontier, basic things like that would be how I would design it if the SEC wanted me to do that.
Urska Velikonja: Yeah. And I would suggest that so many people would fail that test, probably more than would fail the License 7 test. It’s surprising, when you look at actual people’s financial literacy, you figure out pretty much everyone’s illiterate. Right? We agree that we want some sort of financial literacy test. And the wealth standard, well, it’s really easy to administer, which probably explains why so many countries around the world have some type of a wealth standard. As J.W. suggested, people have settled expectations now on that wealth standard. They have invested. They, perhaps, hope to continue to invest.
I don’t see that wealth standard disappearing, even if it has all the flaws that J.W. mentioned and then some others. Some of my favorite enforcement actions to teach and I’ll mention in class is a Ponzi scheme run by a party planner from Long Island, not Billy McFarland, another one, that offered investments in -- he claimed he secured Hamilton tickets from producers, and he was going to be able to resell them but needs investments to actually pay for those tickets. We know Hamilton tickets sell at huge premiums.
It was all fraud. He didn’t have any contract, right? It was all fake. Yet investors in his Ponzi scheme were made to accredited investors. Michael Dell invested, that Dell, Paul Tudor Jones, a hedge fund manager, was sitting on the board of trustees of UVA, and an unnamed managing partner or some sort of managing director at J.P. Morgan or Morgan Stanley, one of those. So wealth and sophistication isn’t always a good defense from fraud.
J.W. Verret: Oh, wait. I invested in that guy.
Urska Velikonja: You did? Oh, get out.
J.W. Verret: I’m just kidding.
Urska Velikonja: In any event, we’re using these things as proxies and we hope they work well.
Devon Westhill: Thanks for that question, and thanks again, J.W. and Urska. What I’d like to do now, since we’re very close to the 12:00 hour when we need to wrap things up, is just ask the two of you to give any closing remarks that you think would be helpful here at the end of our podcast for our listeners and folks who will be listening to this down the road some other time. So maybe I’ll turn to J.W. Do you have any closing remarks?
J.W. Verret: Well, I think the key to the SEC getting this right, as the division of corporate finance moves to a rethink of the Accredited Investor Standard, the one thing that would make this thing pop, that would really make it sing, the SEC needs to host a round table on this issue. They need to invite me and Urska to come and continue the discussion, the debate, and inform the SEC about what they need to do.
Urska Velikonja: Here, here. I could not agree more. Thank you so much for debating this with me, and I hope we can carry on the conversation in the future.
Devon Westhill: Thanks again to both of you and thanks to our audience, especially our listeners who had questions. I thought they were very good. So on behalf of The Federalist Society’s Regulatory Transparency Project, thanks again, and hopefully you’ll be here to meet us for our next Free Lunch Podcast when we air. So long, everyone. Goodbye.
Operator: On behalf of The Federalist Society's Regulatory Transparency Project, thanks for tuning in to Free Lunch. As always, you can subscribe on iTunes and Google Play to get new episodes of Free Lunch when they're published. Also visit our website at regproject.org. That's R-E-GProject.org. There, we regularly upload content in addition to our podcasts such as short videos and papers. And you can join the discussion by sharing your story of how regulation has personally affected you. Until next time, remember, there's no such thing as a free lunch.
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