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The Northwestern Securities Regulation Institute kicked off yesterday with the Alan B. Levenson Keynote Address, and for the second year in a row an SEC Commissioner addressed the topic of Regulation D reform. Commissioner Mark Uyeda delivered a speech addressing potential changes to Rule 506 of Regulation D and other offering exemptions, one year after Commissioner Crenshaw outlined controversial proposals for Rule 506 of Regulation D at the 2023 Securities Regulation Institute. In his speech, Commissioner Uyeda addressed the complexity of exempt offering alternatives that issuers face today, noting:

Our regulatory regime should have an offering exemption tailored to each of the common capital raising scenarios. The requirements to raise capital for a start-up company in the “friends and family” round should be different from the requirements to raise capital for a billion-dollar company shortly before its IPO. The conditions for an operating company seeking money for working capital should be different from the conditions for a pooled investment vehicle seeking subscriptions for the fund.

Addressing the definition of “accredited investor” in Regulation D, Commissioner Uyeda noted how any efforts to raise the net worth and annual income thresholds in the definition as it applies to individuals could have profound implications for racially and ethnically diverse investors and younger investors:

The first group is racially and ethnically diverse investors. Black and Hispanic investors qualify as accredited investors at a lower rate than White and Asian American investors. Increasing the net worth and annual income requirements would have a disproportionate impact on these groups and heighten the disparity. This may be particularly consequential because diverse investors are more likely to fund diverse founders. Entrepreneurs of color may not have adequate access to traditional financial systems, including bank loans, and they may not benefit from an existing network of accredited investors. Accordingly, any reduction in the pool of diverse accredited investors may also adversely affect the ability of persons of color to finance their start-ups.

The second group is younger investors. These investors may not have had the time or opportunities to build more than $1 million in net worth or exceed $200,000 in annual income. However, they may have less need for liquidity, longer investment horizons, and greater risk tolerance compared to a person nearing retirement. The profile of younger investors may make them better suited for investments in private companies, but more stringent net worth and annual income thresholds do not reflect those considerations. By making it more difficult for younger people to qualify as accredited investors, our rules may deny them opportunities to invest in private companies at an earlier age and build wealth through that investment as they age and the company grows.

As an alternative to revisiting net worth and annual income thresholds, Commissioner Uyeda suggested that the Commission should consider new approaches for defining the pool of eligible investors that can invest in private companies. He suggested a “sliding scale” approach, described as follows:

With a sliding scale approach, a person would be able to invest up to a certain percentage, based on a personal financial metric, in private companies during a rolling time period. The percentage would increase as the amount of the financial metric increases. The financial metric could be the dollar value of a person’s investments in securities. For example, if a person’s securities investments were less than $100,000, then the person could invest up to 5% of such amount in private companies during a rolling 12-month period. If securities investments were between $100,000 and $500,000, then the person could invest up to 10%. The percentage would increase until it reaches 100% when the person’s securities investments exceed a certain level.

This approach, as opposed to simply indexing the net worth and annual income tests to inflation, is rooted in the notion that investor protection cannot be achieved through paternalistic policies. Investments in private, growth-stage companies that are higher-risk, higher-reward may be beneficial as part of a person’s diversified portfolio. Our regulatory regime should allow an investor to include these investments in their portfolio to some degree if the investor believes that the risk is appropriate. Prohibiting individuals who fall below net worth and annual income thresholds from making such investments, under the guise of investor protection, may ultimately harm those individuals by depriving them a source of wealth accumulation and reducing their risk diversification. Such prohibition also harms entrepreneurs and start-up companies by denying them potential sources of capital.

On the topic of the growth and size of private markets that has been the subject of recent debate, Commission Uyeda noted the important point that the vast majority of capital raised under Rule 506 of Regulation D is raised by private funds as opposed to operating companies.

With potential amendments to Regulation D on the Commission’s agenda for 2024, we will likely see more debate on this topic in the months ahead.

– Dave Lynn