At an open meeting this morning, the SEC proposed changes to the definition of "accredited investor," as well as new rules relating to disclosure of payments by resource extraction issuers. As discussed below, Commissioners Robert Jackson and Allison Lee dissented on both of these proposals. Notably, the responses of all the Commissioners to these proposals highlighted their sharply divergent views on the role of government and the fundamental purposes of the securities laws. Both proposals will be open for comment for 60 days.
Definition of Accredited Investor
One of the questions raised in the SEC's concept release on harmonization of private securities offering exemptions (see this PubCo post) was whether "the limitations on who can invest in certain exempt offerings, or the amount they can invest, provide an appropriate level of investor protection (i.e., whether the current levels of investor protection are insufficient, appropriate, or excessive) or pose an undue obstacle to capital formation or investor access to investment opportunities, including a discussion of the persons and companies that fall within the 'accredited investor' definition." Should the rules focus on the sophistication of the investor, the amount of the investment or other criteria rather than just the income or wealth of the investor? There has also been significant discussion about whether the definition of "accredited investor" should remain binary—that is, if you are accredited you can participate in the transaction to any extent and if you are not accredited, you can't participate at all. Would it be more appropriate to scale the level of investment permitted relative to the wealth of individual? And SEC Chair Jay Clayton has even suggested to the SEC's Small Business Capital Formation Committee the possibility of looking at a co-investment model, where non-accredited investors invest pari passus with sophisticated investors. (See this PubCo post.)
Recommendations from SEC advisory committees and from the public on the concept release were taken into account in formulating this proposal. (See, e.g., this PubCo post.) Some view early stage investments as, on the one hand, highly risky and/or, on the other hand, where much of investment growth now takes place (compared with growth post-IPO). Accordingly, the goal is to expand opportunities for investors in the private markets, while maintaining appropriate investor protections. According to the press release, the proposed amendments to the accredited investor definition are only "an initial step in a broader effort to consider ways to harmonize and improve the exempt offering framework." The proposal would include as accredited investors new categories of individuals based on professional knowledge, experience or certifications, to be determined by the SEC by order (without notice and comment), as well as new categories of institutional investors. No changes were proposed to the income and wealth thresholds, which were established in 1982 (and 1988 for joint income) and have not been updated since. Corresponding changes are proposed to the other related rules, including to the definition of QIBs in Rule 144A. In the press release, Clayton remarked that the "current test for individual accredited investor status takes a binary approach to who does and does not qualify based only a person's income or net worth....Modernization of this approach is long overdue. The proposal would add additional means for individuals to qualify to participate in our private capital markets based on established, clear measures of financial sophistication. I also am pleased that the proposal specifically recognizes that certain organizations, such as tribal governments, should not be restricted from participating in our private capital markets."
More specifically, the proposal would:
- "add new categories to the definition that would permit natural persons to qualify as accredited investors based on certain professional certifications and designations, such as a Series 7, 65 or 82 license, or other credentials issued by an accredited educational institution;
- with respect to investments in a private fund, add a new category based on the person's status as a 'knowledgeable employee' of the fund;
- add limited liability companies that meet certain conditions, registered investment advisers and rural business investment companies (RBICs) to the current list of entities that may qualify as accredited investors;
- add a new category for any entity, including Indian tribes, owning 'investments,' as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered;
- add 'family offices' with at least $5 million in assets under management and their 'family clients,' as each term is defined under the Investment Advisers Act; and
- add the term 'spousal equivalent' to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors."
[Below is based in part on my notes, so standard caveats apply.]
In his opening comments, Clayton described the proposal as part of an effort to "increase opportunity for more of our Main Street investors to participate in the private capital markets." Under the current rules, the tests for accredited investor status are financial only, and exclude persons who have the financial sophistication but do not meet the financial thresholds from participating in the private markets; the proposal would maintain the current financial tests unchanged and add new non-financial categories for individuals that "have the demonstrated financial sophistication," as well as additional tests for institutional accredited investors. Interestingly, he again raised the possibility of
"examining whether appropriately structured funds can facilitate greater Main Street investor access to private investments, particularly as a component of an investment portfolio that is analogous to the portfolio of a well-managed pension fund. I believe it is important to focus on solutions that provide access to investment opportunities on substantially the same terms as those that would be available to institutional investors with protections—including alignment of interest between individuals and institutions, and transparency—that are akin to the protections in our public market. This alignment of interest is extremely important to me and I ask that commenters please recognize that I and many of my colleagues are skeptical of approaches that do not have either (1) demonstrated financial sophistication of the individual investor or (2) clear, ongoing alignment of interest with the sponsor."
Both Jackson and Lee decried the potential negative impact of the proposal on investor protection. Jackson's position is made apparent by the title of his public statement: Statement on Reducing Investor Protections around Private Markets. While Jackson agreed that the rules were "ripe for review," he objected to the absence of "careful, data-driven analysis of how to best balance the risks investors face in these markets with the potential rewards of participation. Instead, the release repeats by rote the intuition that exposing investors to these markets comes without corresponding costs." In essence, he believes that the new release does not "take seriously" the issues related to investor protection in the private markets: there is "virtually no analysis of the costs of expanding eligibility to participate in exempt offerings." He points, for example, to the request for comment on whether an investor "that is advised by a registered investment adviser or broker-dealer [should] be considered an accredited investor." The "intuition" here is that "investors can efficiently identify and avoid brokers in this area who fail to protect them from fraud." But, Jackson argued, that idea is not supported by the data that his office has amassed. Rather, the data showed that "brokers who put investors in private securities are unusually likely to be the subject of both customer complaints related to sales practices and regulatory inquiries about misconduct," and that "past investor harm facilitated by brokers in our private markets is highly predictive of investor harm in the future. That means that even supposedly sophisticated investors under our current standards have difficulty avoiding high-risk brokers in the private-placement market. And if investors are already struggling to sort good brokers from bad in these markets, it's far from clear why we should expose even more investors to those risks."
Lee criticized the proposal for changing the definition of accredited investor in only one direction—"toward expanding the pool of investors in the opaque, and indisputably high-risk, private market" and, again, without adequate data as support. Her main concern, however, was the failure to adjust the income and wealth thresholds for inflation. She views that issue as a serious risk for investors, especially the elderly, who may meet the test as a result of having accumulated their savings over a lifetime. While the financial tests may be under-inclusive in some respects and represent a "clumsy proxy" for sophistication, in Lee's view, the thresholds are also "indisputably over-inclusive, capturing investors with little to no ability to assess or bear the risks of private offerings. Consider, for example, a person who contributes a modest $200 per month to retirement over a 50-year period with an average return of seven percent. That person will have spent a lifetime accruing $1 million in retirement assets." But the proposal does not index for inflation to address "the toll that 37 years of inflation has already taken.... Let's look at some numbers using an estimated annual and constant growth rate for inflation of 1.51%: In ten years, approximately 22.7%; in 20 years, 39.32%, and in 30 years, 57.3% of U.S. households will have to 'fend for themselves.'" Indeed, over 37 years, inflation has led to a "550% increase in the number of qualifying households." Indexing for inflation has the broad support of a number of groups, she said, including some at the SEC, as well as "investors and their advocates, industry groups, state regulators, crowdfunders, and a diverse group of academics." The release, she observes, indicates that it would be "more appropriate to consider inflation during the four-year review of the accredited investor definition mandated by Dodd-Frank." But, Lee counters, there was no adjustment made during the last review in 2015, recommendations notwithstanding. Yet it is known that the private markets "come with much higher risk and must less transparency about the nature of that risk. It appears that the failure to update these thresholds may be less about providing American investors access to lucrative private markets, and more about providing private markets access to potentially vulnerable American investors."
On the other hand, Commissioners Hester Peirce and Elad Roisman had quite a different take on the issue. Peirce, in particular, viewed the current definition of accredited investor as "one of the more offensive concepts lurking in our federal securities laws" because, while it is "cloaked in a mantle of investor protection," it implies that an individual can't be trusted to make investments unless he or she is high income. The result is a "corrosive effect on an individual's economic liberty." Although she finds the definition as a whole condescending, and criticized the proposal for not taking on that issue, she viewed the proposed reforms favorably. For example, she approved of the concept, reflected in a question, that, because of income disparities between the populations in different geographic regions (the coasts and the non-coasts), there should be adjustment to the thresholds to account for geographic differences. She also approved of the proposal's first steps toward allowing actual sophistication to govern and expressed her hope for eventual consideration of other credentials and degrees.
Roisman also views the current definition as a questionable barrier and crude way to assess financial sophistication that shuts out all but the wealthy. He made his point clear by remarking that he, with all the financial sophistication of an SEC Commissioner, is not an accredited investor—not even under the rules as proposed. Nor are many of the staff at the SEC. On that basis, he wondered whether the proposal may have "missed the mark." He also welcomed the proposed changes as a way to enhance capital formation by increasing the pool of accredited investors.
Resource Extraction Rules
As you may recall, the resource extraction rules have had a long and troubled history. The proposal for new resource extraction rules represents the SEC's third attempt at implementing these rules, and today is apparently the ninth anniversary of the original proposal. Will the third time be the charm? Originally adopted in 2012 under Section 1504 of Dodd-Frank at the same time as the conflict minerals rules, the resource extraction rules faced an immediate challenge in litigation brought by the American Petroleum Institute and the Chamber of Commerce. They had contended that the rule compelled U.S. resource extraction companies to engage in speech in violation of their First Amendment rights. (Sound familiar? See this PubCo post and this PubCo post .) They also maintained that the SEC had misinterpreted the mandate of the statute which, they argued, required only a compilation of aggregate information, not a separate report for every foreign project. As a result of this misinterpretation, they contended, the rule required U.S.-based companies to disclose sensitive commercial information that competitors could use to their benefit. (See this news brief.)
The U.S. District Court, in a fairly scathing opinion, vacated the SEC's rule, contending, among other things, that the SEC fundamentally "misread" the requirements of the statute by mandating public disclosure of each report (rather than a compilation of reports) and that, in rejecting companies' request for an exemption from disclosing payments to countries that prohibited disclosure of payment information, the SEC was "arbitrary and capricious." (See this news brief. ) The SEC declined to appeal the ruling, accepting the conclusion that it would need to rewrite the rule. (See this news brief.) However, the timetable for a new rule proposal was delayed several times, and, finally, Oxfam America sued the SEC to compel it to complete the rulemaking.
Oxfam succeeded. (See this PubCo post.) Final rules were adopted in June 2016, and resource extraction issuers would have been required to comply with the final rule and form for fiscal years ended on or after September 30, 2018. (See this PubCo post.) However, relying on the rarely used Congressional Review Act, Congressional Republicans took the ax to the new rules. According to the Washington Post, the first piece of legislation signed into law by the new administration was the bill tossing out the resource extraction payment disclosure rules. However, this article in the WSJ indicates that, in the absence of repeal of the Dodd-Frank mandate, the SEC had a year to issue a new rule on the same topic because the regulation was mandated by Congressional statute. (See this PubCo post.) The proposal comes just a few years late!
Because the rules were disapproved under the CRA, the SEC is required to comply with the CRA requirement to propose a rulemaking that is not "substantially the same" as the rules that were disapproved. Unfortunately, there is no case law or guidance as to the meaning of that term. In developing the new proposal, the staff took into account the concerns expressed by Congress, which related principally to the high costs of compliance and potential anti-competitive effect. As described in the press release, '34 Act reporting companies that engage in the commercial development of oil, natural gas or minerals would be required to disclose company-specific, project-level payments made (by the company, its subs or controlled entities) to a foreign government or the U.S. federal government. Some of the differences that distinguish the proposal from the disapproved 2016 rules are as follows:
- "revise the definition of the term 'project' to require disclosure at the national and major subnational political jurisdiction, as opposed to the contract level;
- revise the definition of 'not de minimis' to include both a project threshold and an individual payment threshold so that disclosure with respect to payments to governments that equal or exceed $150,000 would be required when the total of the individual payments related to a project equal or exceed $750,000;
- add two new conditional exemptions for situations in which a foreign law or a pre-existing contract prohibits the required disclosure;
- add an exemption for smaller reporting companies and emerging growth companies;
- revise the definition of 'control' to exclude entities or operations in which an issuer has a proportionate interest;
- limit the liability for the required disclosure by deeming the payment information to be furnished to, but not filed with, the Commission;permit an issuer to aggregate payments by payment type made at a level below the major subnational government level;
- add relief for issuers that have recently completed their U.S. initial public offerings; and
- extend the deadline for furnishing the payment disclosures."
[Below is based in part on my notes, so standard caveats apply.]
As is his wont, Jackson contended that the proposal was based on too little data about the potential impact of the changes. For example, he was concerned about the potential implications for the final rules of a request for comment in the release regarding the possible submission of confidential aggregated reporting, where companies would submit the data confidentially to the SEC, which would then aggregate and anonymize the data before making it public. He contended that, if that approach were taken, the rule would be weakened and could seriously harm investors. Yet, he maintained, the SEC did not adequately consider the impact of confidential reporting on the behavior of insiders or the effect of inadequate information on the protection of investors that may want to invest on the basis of this information. Moreover, the SEC did not take into account the long-held SEC view that aggregated data did not satisfy Section 1504 and, although Congress had disapproved the rules in 2016, it did not repeal the provision. He also objected to the new de minimis threshold which, he said, "would keep many payments in the dark."
Similarly, Lee argued that the proposal did not further the goal of Section 1504, failing to provide the type of disclosure mandated by international laws or the level of transparency necessary to advance the statute's anti-corruption goals. In her view, the proposal appeared to take the position that the CRA required a reversal of all the significant provisions of the 2016 rules. Instead, she argues, the proposal should have provided for contract-level disclosure (through the definition of "project") and should have included lower thresholds in the definition of "de minimis." These thresholds, she contended, were not selected based on supporting data and permitted exclusion of too much information that could be important to investors. In her view, a better way to minimize compliance costs would be to conform the rules to existing international disclosure regimes.
Peirce opened by joking that these rules have certainly extracted a lot of resources from the SEC building. But the joke actually captures to some extent her fundamental objection to the proposal. Although she voted in favor of the proposal, she considers these provisions of Dodd-Frank and the related rules to be a misuse of the securities laws for inappropriate non-securities law purposes. The tortured history of the rule illustrates "the perils of permitting civil society—as this proposing release so eloquently dubs the groups that championed this rulemaking—to use the federal securities laws as an appropriate vehicle for accomplishing their own, non-securities purposes. As noble as these purposes are, the securities laws are not an appropriate Christmas tree on which to hang them." That said, she considered the proposal to represent an improvement over prior rules. For example, by including exemptions for disclosures that were prohibited by law or preexisting contracts, the proposal addressed problems that been raised by issuers in connection with prior rules. She also appreciated the exemption for emerging growth companies and smaller reporting companies. In addition, she noted that the text of the statute was silent on whether the information was required to be made public, allowing for the possibility of an anonymized SEC public compilation, as suggested by the SEC's request for comment on the alternative approach to disclosure. Roisman agreed that the proposal did not further the SEC's "tripartite mission: protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation." And perhaps the past failures to implement final rules could be read as a sign that the SEC not the best agency to carry out the rulemaking.
To that point, Lee contended that the proposal was all about the fight against global corruption, a fight in which the U.S. has long been a leader. Anti-corruption laws, as reflected in Section 1504, were well within the SEC's purview and mission, as reflected in the Foreign Corrupt Practices Act. Chair Clayton agreed.
Happy holidays everyone!
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