In March the SEC finished receiving comments on an alteration mandated by the Dodd-Frank Act that changes the calculation which determines whether an individual can be considered an “accredited investor.” The alteration, which already went into effect upon passage of the Dodd-Frank Act, excludes the net equity an investor may have in his/her home from the calculation of his/her net worth. This change is significant because there are a large number of relatively small financial institutions that are only allowed to engage accredited investors as clients, given those institutions do not comply with the plethora of filing/reporting requirements generally required for public offerings.
The rationale for the distinction is fairly straightforward: legislators want to protect individual investors from being taken advantage of by financial institutions that are not completely transparent with their operations. At the same time, legislators are aware that smaller financial institutions may not be able to bear the cost of complying with the numerous regulatory requirements that have been implemented over the years. As such, Congress provided an exception to the reporting/filing requirements: financial institutions could forego the regulatory requirements so long as they only engaged a relatively small number of clients that were believed to be relatively sophisticated (and therefore in less need of protection by the government).
These sophisticated investors were given the designation of “accredited investors” and the status was dependent in large part on their demonstrable net wealth (initially set at $1,000,000). The Dodd-Frank Act chose to tighten this exception by eliminating the inclusion of the net equity an investor has in his/her “primary residence” in the calculation of his/her net worth. Consequently, this change will inevitably limit many investors from being able to invest in numerous private companies and financial institutions.
The criticism that wealth is not indicative of sophistication in investing is obvious, as is the criticism that the requirement limits smaller, less affluent investors from realizing the best available investment opportunities. One potentially significant criticism, which has resonated which numerous professionals in Silicon Valley in particular, is that the change greatly reduces the ability of emerging companies to access the “friends and family” network for initial capital formation. Many assert that this source of funding is essential for a substantial portion of young entrepreneurs, and the proposed alteration will seriously (and yet inconspicuously) limit economic growth. The counterargument can be made that there is no shortage of capital flowing to emerging companies, particularly those in Silicon Valley (at least for the time being).
One interesting factor that is worth watching is the effect that stock market volatility and low government bond interest rates will have on large net worth investors interest in investing in the companies and financial institutions that only accept accredited investors. Presumably, as investors flee from the risk of the stock market and are unwilling to accept the low returns on government bonds, private equity could assume a much larger role in the financial industry, and therefore the economy.