Evaluating the Accredited Investor Exemption
The level of economic paternalism exerted by securities regulators will often be commensurate with the level of disclosure demanded of issuers. In 1965, the Ontario government commissioned a report in response to some recurring problems regulators faced such as the extent and consistency of disclosure to shareholders and insider trading.1 The Kimber Report identified two guiding principles which would become the foundation of modern Canadian securities regulation, namely the protection of the investor and the optimal allocation of financial resources. The report cited disclosure as the link between the two:
“[D]isclosure of financial information which depicts adequately the operations and financial position of companies is vital to the investing public; such disclosure also provides the capital markets with the information necessary to make a more satisfactory allocation of resources.”2 The premise became that providing information to investors would increase investor confidence by giving them the facts necessary to evaluate the potential for profits and ultimately choosing to invest in higher quality securities and rejecting lower quality ones.
Regulators also recognized that the goal of investor protection can impose excessive costs in terms of compliance and continuous disclosure, thus creating pressure from both investors and issuers for exemptions from the more stringent requirements of securities regulation. These exemptions impose risks on the investor and the issuer that are created by diminished disclosure requirements and are justified based on the assumed capacity of the investor to manage and sustain such risk. In Canada and the U.S., one such exemption is the “accredited investor” exemption. This exemption has come under scrutiny recently due to a reconsideration of whether such investors can actually bear the risk of diminished disclosure.
The accredited investor exemption is premised on the assumption that an accredited investor has a certain level of sophistication, the ability to withstand financial loss, the financial resources to obtain expert advice and/or the incentive to carefully evaluate the investment given its size.3 The monetary thresholds for persons who qualify as accredited investors were originally set by the U.S. Securities and Exchange Commission (“SEC”) in 1982. The thresholds were subsequently adopted by the Canadian Securities Administrators (“CSA”) in the early 2000s. The thresholds have not been changed or adjusted for inflation since. The current threshold for an individual’s income is $200,000; in 2011 dollars, the threshold would be over $443,000 based on 1982 dollars (the year of SEC adoption) or $245,000 based on 2001 dollars (the year the Ontario Securities Commission first adopted the exemption).4 Some say these thresholds are too low and allow unsophisticated, retail investors to participate in the exempt market, yet an increase in the thresholds may exclude investors who do not need the protections provided by a prospectus offering.
The SEC recently adopted an amendment to the accredited investor net worth standard which excludes the value of an individual’s primary residence. This was done pursuant to Section 413 of the Dodd-Frank Act which stipulates that the SEC “shall adjust any net worth standard for an accredited investor, as set forth in the rules of the [SEC] under the Securities Act of 1933, so that the individual net worth of any natural person, or joint net worth with the spouse of that person, at the time of purchase, is more than $1 million (as such amount is adjusted periodically by rule of the [SEC]), excluding the value of the primary residence of such natural person….”
This will reduce the number of investors who have previously been eligible to subscribe for shares of companies relying on this exemption from the Securities Act of 1933 for private and other limited offerings. This concern over the ambit of this exemption has also been reflected in Canada as Canadian regulators launched a review in November of 2011 of the domestic accredited investor exemption.
The CSA has cited the concern that the wisdom underlying the accredited investor exemption might be flawed. The CSA points out that
“[s]ome stakeholders have suggested that income and asset thresholds are not adequate proxies for sophistication” and that “[i]ndividuals may have significant wealth, but may lack investment or other experience.”5 For their part, regulators have concerns that some investors buying securities under the accredited investor exemption may simply not be accredited investors.6 Under Canadian rules, the accredited investor standard for individual investors includes both a $1 million financial asset test and a $5 million net asset test, the latter including an investor’s personal residence (minus liabilities). Depending on the comments and the results of the consultation period which ends on February 29, 2012, the CSA has indicated that it could (1) maintain the current form of the exemptions, (1) maintain the exemptions with adjusted thresholds, (3) limit the use to certain investors (such as institutional investors), (4) use alternative qualification criteria or (5) impose other investment limitations.
The most thought-provoking aspect of the CSA review is the slate of questions it raises in relation to the possible actions above. Each question suggests hypothetical scenarios for redesigning the exemption. For example, in considering whether to amend the thresholds of the exemption, the CSA asks whether the complexity of the security being offered should be taken into consideration. It also asks whether the threshold should be periodically indexed to inflation. When considering alternative qualifications for individual investors, the CSA suggests such factors as investment experience, investment portfolio size, work experience and education as possible criteria. These questions raise hypothetical standards for the accredited investor exemption which challenge the notion that net worth alone is the most reliable indicator of sophistication.
The only capacity unequivocally indicated by net worth’s is an investor’s capacity to absorb loss. It is not a conclusive indicator of investment experience or education. However, eliminating the threshold entirely and moving to an alternative criteria system for the accredited investor exemption would be equally fraught with policy hurdles, most notably the optimal allocation of financial resources. Were the accredited investor exemption limited only to those with specific experience or education in investment, millions of dollars would be shut of the capital markets. Such is the tension of securities regulation. The evaluation of the accredited investor thresholds in Canada and the amendment thereof in the U.S. represents a measured approach by regulators which attempts to walk that difficult line.
The content of this article is intended to provide general information for the reader and is not intended as advice or an opinion to be relied upon in relation to any particular circumstance. For specific applications of the law to a particular set of circumstances, the reader should seek professional advice.
Sam Carsley practices in the areas of corporate and securities law with McLean & Kerr LLP, a law firm based in Toronto.
“Report of the Attorney General’s Committee on Securities Legislation in Ontario,” (Toronto: Queen’s Printer, March 1965).
Ibid. at para. 1.07.
CSA Staff Consultation Note 45-401 – Review of Minimum Amount and Accredited Investor Exemptions – Public Consultation, November 11, 2011 at 2.
Ibid. at 5.