By Dr. James M. Dahle, WCI Founder
If your investment strategy is 100% publicly traded mutual funds and ETFs, you may never need to know the terms I'm going to discuss in this post. However, if you have an interest in any sort of private investments, such as syndicated real estate or private real estate funds, it would behoove you to be aware of some of the regulatory terms in this space, including what it means to be an Accredited Investor, a Qualified Client, and a Qualified Purchaser.
What Is an Accredited Investor?
Many of my readers are already familiar with the term Accredited Investor. I first wrote about this in 2013 (What Is an Accredited Investor?) and had a follow-up post in 2015 (10 Things to Know Prior to Buying an “Accredited Investor” Investment). To understand this term—along with the other ones we will discuss today—it is helpful to be familiar with the history of securities laws in the United States.
The term Accredited Investor dates back to the first major securities law, The Securities Act of 1933. A major issue leading to the stock market crash of 1929 at the beginning of the Great Depression was a lack of transparency and fairness in our financial markets. As many problems as we have in our markets today, we are head and shoulders above most countries because of this and other laws that were passed as a result of the Great Depression.
The Securities Act of 1933, also called the “truth in securities law,” basically requires investments to register with the government. Specifically, it mandates the disclosure of specific information to investors that will theoretically allow them to make an informed decision about the investment. This information, including:
- a description of the company's properties and business;
- a description of the security to be offered for sale;
- information about the management of the company; and
- financial statements certified by independent accountants,
is filed with the Securities and Exchange Commission (SEC). These forms for US companies (stocks) can be found in the EDGAR Database. There are a few exceptions that do not need to be registered. These include:
- private offerings to a limited number of persons or institutions;
- offerings of limited size;
- intrastate offerings; and
- securities of municipal, state, and federal governments.
In Section 2 of this Act, “an accredited investor” is defined as either:
- a bank . . . an insurance company . . . an investment company . . . a business development company . . . a Small Business Investment Company . . . an employee benefit plan . . . if the investment decision is made by a plan fiduciary . . . which is either a bank, insurance company, or registered investment advisor; or
- any person who, on the basis of such factors as financial sophistication, net worth, knowledge, and experience in financial matters, or amount of assets under management qualifies as an accredited investor under rules and regulations which the Commission shall prescribe.
If you're not a company but still want to be an accredited investor, you need to be EITHER smart enough to make your own investment decisions OR rich enough to be able to lose a bunch of money.
In Section 4 of the Act, transactions that are exempted from registration are defined and include “transactions involving offers or sales by an issuer solely to one or more accredited investors.” The investment still must provide certain specified information to investors, but it is a much easier hurdle to overcome. While the disadvantages of these lower disclosure and reporting requirements are pretty obvious, the advantages may not be. It is simply a lot less work and costs a lot less money to put together an investment that is only offered to accredited investors. That allows the investment to be more nimble and to have lower costs, which can theoretically be passed along to investors for a higher return.
These investments are also frequently called Reg D investments, short for SEC Regulation D and, specifically, Rule 506(c)of Reg D, which says:
“A company can broadly solicit and generally advertise the offering and still be deemed to be in compliance with the exemption’s requirements if:
- The investors in the offering are all accredited investors; and
- The company takes reasonable steps to verify that the investors are accredited investors, which could include reviewing documentation, such as W-2s, tax returns, bank and brokerage statements, credit reports, and the like.”
Note that this rule was put into place in 2012, with the passage of the JOBS Act. Prior to this time, these investments could not be advertised to the public. That's part of the reason private investments were so hush-hush. Nobody wanted to be accused of advertising them. It can obviously be tough to raise money for an investment without advertising it, creating lots of ethical dilemmas. The pre-2012 rule is currently called Rule 506(b), which has one advantage over 506(c) . . . you can include up to 35 non-accredited investors but with the obvious disadvantage of not being able to advertise.
The current definition of an accredited investor, at least for an individual investor qualifying on the basis of being rich, is:
- An income of $200,000 for each of the last two years and an expected income of $200,000+ this year for an individual OR
- An income of $300,000 for each of the last two years and an expected income of $300,000+ this year for a couple OR
- Investable assets of $1 million or more.
Note that these limits were set in 1982 and have not been changed since. If you applied some simple inflation to these numbers, they would be $616,000, $924,000, and $3.08 million, respectively. So, a much larger percentage of the population (including most of my readership at some point in their lives) qualifies now than did in 1982. Interestingly, the SEC has considered proposals to change this definition, but it sounds like the intent is to make it broader so that “financially sophisticated” people with LOWER income and asset levels can still qualify.
Think of an accredited investor as a person with a doctor-like income who is allowed to buy Reg D investments.
What Is a Qualified Client?
There were several other important pieces of legislation enacted after the Great Depression. These include:
This Act created the SEC, which oversees the exchanges, and the Financial Industry Regulatory Authority (FINRA). It mandates reporting for companies with more than $10 million in assets or 500 investors, standardizes required disclosures to investors, requires disclosure of tender offers (5%+ of a company), and prohibits insider trading (yes, it was presumably allowed prior to that).
This act basically regulates the sale of bonds to investors.
This is a really important piece of legislation you may have read about in the writings of Jack Bogle. It basically created and regulates mutual funds as we know them today. While mutual funds in some form may have existed as early as 1774, the first “real one” basically hit the market in 1928. By the time the market crashed the next year, there were 19 open-ended funds and over 700 close-ended funds. They were likely a major contributor to the stock market bubble and bust. You know why all those prospectuses and semi-annual returns contain the same information? You know why Morningstar can actually exist as a storehouse of mutual fund information? Look no further than the Investment Company Act of 1940. Even the rise of the index fund in the 1970s pales in comparison to this event. We'll discuss it more in the Qualified Purchaser section below.
The other piece of investing-related legislation passed in 1940 gives us the term “qualified client.” If an investment advisor has more than $100 million in assets under management, they must register under this act. This allows you to look up an advisor's ADV2 form to learn more about them. It requires advisors to function as fiduciaries and prohibits them in many respects from charging performance-based fees. Note that there are many people out there who either call themselves financial advisors or function somewhat like them but who are not required to register under this act (or function as fiduciaries.)
Per The Investment Advisers Act of 1940, an advisor can only charge a performance-based fee to a “qualified client.” So, how is a qualified client currently defined?
A qualified client
- has $2.2 million investable assets (increased from $2 million in 2016 and $2.1 million in 2021) OR
- has $1.1 million invested with that advisor (increased from $1 million in 2021) OR
- is a “qualified purchaser” (more on this below) OR
- is an officer or director of the fund manager or an employee who participates in the investment activities of the investment advisor.
Since many private investment funds, such as hedge funds or private real estate funds, have a “promote” structure where the advisor earns 10%-30% of profits (usually just profits above and beyond a preferred return), they are charging a performance-based fee. The nice thing about charging this type of fee is it aligns investor and manager interests to encourage the manager to make more profits. I'm not entirely clear why less wealthy people aren't allowed to have this structure as well, but I hypothesize that a promote structure encourages the manager to also take on more risk. Obviously, this sometimes does not pay off, and the less wealthy are less able to absorb the consequences of that occurring.
The available data is also not terribly convincing that managers paid with incentive fees are better managers either, at least in the mutual fund space. Part of the issue is the theoretical argument that the best managers can charge the highest fees and thus all of the alpha produced eventually goes to the managers, not the investors.
At any rate, most of the private real estate investment deals out there have a promote structure, and thus, it will require you to be an accredited investor and a qualified client.
What Is a Qualified Purchaser?
The term “qualified purchaser” actually comes from The Investment Company Act of 1940 discussed above. If you have been involved in a few private investments, like syndications or real estate funds, you may have noticed that they limited the investment to just 99 investors. The reason for this is Section 3(c)1 of the Investment Company Act. Basically, this section says that if there are <100 investors and the investment is not offered publicly, then there is no need to register under the Act. So, it saves money and hassle to keep the number of investors in the double digits. However, what if you want MORE than 100 investors but still don't want to register? Then what? Well, Section 3(c)7 says you can do that but only if ALL of the investors are “qualified purchasers.”
A qualified purchaser is defined as
- an individual (or family-owned business not formed just to buy into this fund) that owns $5 million or more in investments OR
- a trust not formed for the specific purpose of acquiring the interest in the fund which is sponsored by and managed by qualified purchasers OR
- an individual (or any entity not formed just to buy into this fund) which owns and invests at least $25 million in investments (or someone who is acting on account of such a person) OR
- an entity, of which each beneficial owner is a qualified purchaser.
This takes a lot more money than you need to be an accredited investor, but there are a fair number of investments out there with this requirement (even though when I originally wrote this post, I'd only run into one that I was actually interested in). You will generally find that funds with this requirement have higher minimum investments ($250,000+) than funds without this requirement.
Now, let's take a few minutes to talk about some more recent investment-related laws that have been passed.
This Act—presumably put in place after the tech crash and, particularly, the Enron and WorldCom accounting scandals—increased regulatory requirements for accounting firms, corporate boards, and the corporations themselves. While costly, the goal was to protect investors. For instance, it includes a provision that claws back executive compensation after misconduct. It has its proponents and detractors, and it may be responsible for the fact that the number of publicly traded companies has actually fallen since its passage. It was simply easier to take companies private (or never have an Initial Public Offering at all) due to the high cost of regulation.
You may have noticed a trend by now. Shortly after big stock market crashes, Congress passes a new investing law. Dodd-Frank created several new regulatory offices and gave new powers to the FDIC and the Federal Reserve. Most think it has increased financial stability and consumer protection, but it has its political opponents. It was partially repealed in 2018 by The Economic Growth, Regulatory Relief, and Consumer Protection Act.
The Jumpstart Our Business Startups (JOBS) Act of 2012 made it easier to raise money to start new companies. The main effect for most of my readers was mentioned above, basically allowing private investment companies to advertise directly to you, including buying ads on this blog. These types of companies have multiplied like crazy over the last decade. For instance, there are well over 100-200+ crowdfunded real estate companies, and we have private investment companies apply to advertise here at The White Coat Investor every week.
I hope you've enjoyed this tour of the regulatory landscape. I also hope you quickly become an accredited investor, a qualified client, and a qualified purchaser, even if you never have any interest in buying an investment that requires these statuses.
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What do you think? How do you feel about investment-related legislation? Do you think there should be investments that are only available to the wealthy? Comment below!
[This updated post was originally published in 2020.]