There have been lots of interesting stories over the past few days about what the intentions of the SEC are with respect to the 500 shareholder limit and the solicitation rules around public offerings. Buried (somewhat) in these discussions, another critical issue has been raised regarding the concern that, if companies were to delay their IPO and stay private (because they no longer will be forced to do so because they violated the shareholder limit), only wealthy investors and institutions would be able to buy the shares in these rapidly-growing, world-changing businesses because only these types investors are knowledgeable enough to understand these risks. As unfair as this sounds, it really is the right idea, but, unfortunately, it is the wrong implementation.
This reason that everyone can’t invest in these types of shares is that there is a little term called an “accredited investor”. Set up in the Securities Act of 1933 and modified in Dodd-Frank, this rule states that, for an individual to be considered an accredited investor, he/she must have a net worth of at least one million US dollars not including the value of one’s residence or have made at least $200,000 each year for the last two years ($300,000 with his or her spouse if married) and have the expectation to make the same amount this year. Why this rule is important is that you need to be an accredited investor to invest in private companies and private partnerships among other types of securities. So, if you are not “wealthy”, you can’t buy Facebook. This rule has often been called the “big boy” rule because it says, essentially, that when you and I enter into a deal with one another to buy and sell these types of securities, you and I are both big boys and know that these types of investments are pretty risky so if one of us loses all of our money, we know that is one of the possible outcomes.
Garrett Sloane wrote an interesting piece in the NY Post yesterday about this issue and I was quoted as saying that there are $1,000,000 morons and $100,000 geniuses, in other words, your net worth might not be an indicator of your sophistication as an investor. My point was that, while we should not limit less wealthy people from buying Facebook, etc, we should certainly limit people who cannot fathom the inherent risk of these investments in trading these securities. While it might be unfair to call these people “morons” (at least in some cases), they are not sophisticated enough to understand the risks and the financial exposure they incur in these investments. Wealth is not an indicator of knowledge, knowledge is!
There has been a lot of activity to relax this standard to allow more people access to these types of investments. I agree that the accredited investor rule is outdated and needs to change, but not in the way most people think it ought to change. We live in a world where everyone wants less regulation. However, as a society, we have proven, over and over, that with less or no regulation, we will drive ourselves off a cliff (ask the banks about this one). It never fails because greed and stupidity will take over in any heated market and then, when disaster strikes, it is always someone else’s fault. Somewhere in our culture we have developed an ethos that my success is mine (just look at how wonderful I am) but my failure is yours (how could you have done this to me – I had no idea that would happen!). What the financial system does not need is less regulation, it needs different regulation. Without rules, we will not have trust. Without trust, our markets will not function and, without our markets, our country will lose its most critical global competitive advantage.
A key element of trust is protecting people from themselves. That’s why we should start with the accredited investor rule. Barry Silbert, the CEO of SecondMarket (I am an investor and board member), has a brilliant idea for how to change this system and I talked about it in a break-out meeting at the Treasury conference held by Tim Geithner a few weeks ago. Barry’s proposal is simple: create a standardized test to determine whether or not you are knowledgeable/intelligent enough to trade a certain type of security, i.e. do you understand not only the opportunity, but also the risks involved in investing in that particular instrument? Net worth or salary is not the right indicator. That would be akin to saying that since you bought a BMW, you don’t need to take a test for your driver’s license! We all need to take a driver’s test before we drive a car. And, if we want to drive an 18 wheeler, we have to take a different one. So why wouldn’t we do the same thing for securities?
This way, when a dentist from Long Island, or a little old lady from Topeka or a lawyer from Pasadena decides to buy Groupon shares at $100 billion (hey, it could happen) and then finds that the company is only really worth $20 bilion, we won’t have a bunch of law suits saying these poor little investors had no idea what was happening. They certainly did know what the risks were and here are the questions they answered and the materials they studied that absolutely prove that they knew what the risks were and how these investments go sometimes. On the other hand, the guy or gal putting himself/herself through night school who has researched the opportunity and has insight, ideas and, more importantly, knowledge, should be able to invest – we have a test here that shows they understand the rules better than most investment professionals.
Having investors accredited through demonstrated knowledge rather than circumstantial evidence of sophistication like their net worth or earnings capacity is a first step forward to something this nation needs more of: personal accountability -yes, success is mine, but so is failure. I understand the risks, I proved I understand the risks and I will accept the consequences of my actions. I am truly a “big boy” or a “big girl” now!