Accredited Investor Rules - Important Safeguard or Perpetuating Inequity?
An analysis of the Accredited Investor Rules and their impacts on digital assets.
More often than not, when people hear the term “Accredited Investors,” their minds leap to shadowy transactions and investment practices available only to the elite and enormously wealthy — but what exactly makes an Accredited Investor? Who decides who gets in the club? And what impact could these rules have on crypto investors? Are they helping consumers or perpetuating financial disparity? In order to understand the modern definition of an accredited investor, we must first understand its history.
History of Accredited Investor Laws in the US
Like most federal financial regulations, the earliest iterations of the Accredited Investor Rules trace their birth back to a single dark day in October of 1929 – The Great Wall Street Stock Crash – and the resulting Securities Act of 1933. The Federal Securities Act was begotten out of necessity and was the first federal legislature of its kind, intended to regulate the irresponsible and polluted investment practices of the “Wild West” era of early 20th century speculation. John Doerfer of Marquette Law may have summarized the situation best, saying:
“Many investors, that is those who were interested in conserving their savings as distinguished from pure gamblers, thought they had exercised sound judgment or acted upon competent advice in the selection of their purchases. Many had purchased upon pure hunches or else "hot tips." Regardless of the character of the information, it invariably came from a stream polluted at the source. Abuses had crept into the marketing of securities that called for immediate correction. The Securities Act was a belated attempt to curb these abuses. Prevention rather than punishment is its key note.” (Source: “The Federal Securities Act of 1933” by John C. Doerfer, The Marquette Law Review, 1934)
Often referred to colloquially as the “Truth In Securities'' law, this act laid the foundation for modern day investment regulations. Mandatory disclosures, new levels of liability for bad practice, and severe penalties for intentional deviation were among the main tenants of the young law, and were certainly the most glorified. But buried deep in the language of the latter part of the act, in what would eventually become Rules 506(b) and 506(c) of Regulation D (1980), the basis of the Accredited Investor’s rules were formed. So what are these rules – and how do they work?
The Rules of the Game
The simple definition of an Accredited Investor is as follows: “An accredited or sophisticated investor is an investor with a special status under financial regulation laws.” Essentially, the Accredited Investor rules were created to ensure that unqualified investors could not take on disproportionate risk or over-leverage themselves due to lack of experience and knowledge. The initial concept was viewed as a limitation of freedom, and anti-capitalist. This is how many regulatory laws are viewed at first. Once the initial anger had subsided though, the rules were generally embraced for a time. It wasn’t long, however, before a “grass is always greener” mentality began to set in. Accredited Investors became a mysterious and exclusive club – or so some believed – that was intended not to protect common investors, but rather to exclude them.
Reality is rarely the black or white that opposing sides believe it to be…but almost always a muddy mix of the two. With the language of the code being simple enough to be impossible to accuse of being intentionally withholding - yet simultaneously ambiguous enough to be easily manipulatable - the Accredited Investors Rules are at once a protective measure and a veil behind which some less-than-legal trading does occur. Keep in mind that the riskiest investments have the highest upside. Those securities that are tradeable outside of Section 5 of the Securities Act can indeed be massively profitable – if approached correctly (and only if your pockets are deep enough to get you in the door). These types of issues are still widely prevalent in modern trading – especially in Crypto. Being that the space is still so young, volatility and high-risk/high-reward speculation is rampant. We’re going to get that – bear with me just a little longer.
Joining the Club
So how does one become an Accredited Investor? Rule 144A of the Securities Act outlined what a “Qualified Institutional Investor” should look like, and set specific qualifying benchmarks to define what these accredited investors should be, stating the following:
“Any dealer registered pursuant to section 15 of the Exchange Act, acting for its own account or the accounts of other qualified institutional buyers, that in the aggregate owns and invests on a discretionary basis at least $10 million of securities of issuers that are not affiliated with the dealer, Provided, That securities constituting the whole or a part of an unsold allotment to or subscription by a dealer as a participant in a public offering shall not be deemed to be owned by such dealer.” (Source: 17 CFR § 230.144A)
The definition has been amended numerous times, most recently in 2020, to accommodate for fluctuations in investor sentiment and capability. In years past, it was outlandish for someone without a profound financial or educational background to claim the title of “Sophisticated Investor”. How could they have? Where could they have acquired the knowledge and experience without those dusty old volumes and endless streams of ticker tape classically associated with “Old Finance”? Now, with the advent of the internet and massive caches and libraries of publicly accessible data and information, becoming a knowledgeable investor is easier than ever. Acquiring the wealth to meet the specifications set by these rules, however, remains the greatest barrier to entry. So although these amendments have been made with the “intent” of making it easier to become an Accredited Investor…take a look at the following excerpt and see if it seems any easier to you:
“The amendments [of 2020] expand the definition of “qualified institutional buyer” in Rule 144A to include limited liability companies and RBICs if they meet the $100 million in securities owned and invested threshold in the definition. The amendments also add to the list any institutional investors included in the accredited investor definition that are not otherwise enumerated in the definition of “qualified institutional buyer,” provided they satisfy the $100 million threshold.” (Source: Cornell Law)
We can see that it’s true that amendments have been made…but who do they really benefit? Giving the wealthy exclusive access to these riskier investment opportunities seems only to benefit the wealthy – and it certainly doesn’t seem to encourage an equal playing field. The question remains: are these rules meant to benefit the average investor, or to estrange them?
Implications for Web3
Now onto the question on everyone’s mind: how does this affect Crypto? Does it affect Crypto at all? The answer is yes…and no. The chairman of the SEC, Gary Gensler, has continually stated his concerns over the potential of harm for crypto investors given the volatile and understudied nature of these young markets. The issue at hand is how these assets are defined, because Crypto assets and Blockchain technology haven’t just changed the medium of trading, they’ve also changed the essence. These assets aren’t traded the same, they aren’t valued the same, and they certainly don’t appear to follow the same technical analysis trends that established stocks and securities classically follow. So does the SEC have jurisdiction here? Gensler thinks yes, saying:
“I believe we have a crypto market now where many tokens may be unregistered securities, without required disclosures or market oversight,” Gensler said. “Make no mistake: To the extent that there are securities on these trading platforms, under our laws they have to register with the Commission unless they meet an exemption. Make no mistake: If a lending platform is offering securities, it also falls into SEC jurisdiction.” (Source: InvestmentNews)
Gensler claims that, because cryptocurrencies are often part of investment contracts, they meet the definition of a security according to current laws (which would inherently make the Accredited Investor’s Rules applicable as well), but not everyone agrees. Take for example the beliefs of George Mason University professor of law J.W. Verret, who holds that digital tokens actually don’t meet the definitions of a security, as they fail to satisfy all four elements of the Howey Test – and as such should not be treated as one or regulated as one. He even goes so far as to assert the following:
“Aggressive application of [current securities rules] could ‘blow up in your face’ and result in legal action.”
You can hear more from J.W. Verret here, where he discusses his time at the SEC, regulation, and web3 with Jacob Robinson of the Law of Code podcast.
The Road Ahead
So where do we go from here? Hesitance and fear on behalf of the public could likely be eased if the SEC were to officially enact jurisdiction over the Web3 community at large…but it can be argued that doing so would entirely defeat the premise of decentralization. Is it not the point of decentralized finance to live outside these regulations? To live and die according to “our terms”, not “theirs”? Yes, adoption would likely skyrocket if there was more government protection, but at what cost to the heart of these concepts? The fact of the matter is, if Cryptocurrencies are to not only survive, but grow, there will likely have to be some sort of regulations put in place to ease the minds of wary investors. Remember, the Securities Act of 1933 was composed in order to ensure an event like the great crash of 1929 couldn’t ravage the American Public again. This doesn’t mean that these new assets should be shoved into a box created for classical securities though, especially when many of them do not appear to meet the requirements set forth by the Howey Test.
Such is the issue facing legislators right now, with the Biden Administration issuing an Executive Order on Ensuring Responsible Development of Digital Assets March 9th 2022. In this order, President Biden and his administration officially acknowledged the economic impact of the digital assets sector, noting the industry had reached a $3 Trillion dollar market cap – and isn’t showing signs of slowing down. (The collapse of UST & Terra has since impacted these numbers).
Though not decisive by any definition of the term, the order is essentially a call for legislative bodies to assess the potential risks and benefits of digital assets and their underlying technologies. Specifically, he calls upon these bodies (such as the Federal Reserve, Financial Stability Oversight Council, and Department of Commerce, among others) to do the following:
Protect U.S. Consumers, Investors, and Businesses.
Protect U.S. and Global Financial Stability and Mitigate Systemic Risk.
Mitigate the Illicit Finance and National Security Risks Posed by the Illicit Use of Digital Assets.
Promote U.S. Leadership in Technology and Economic Competitiveness to Reinforce U.S. Leadership in the Global Financial System.
Promote Equitable Access to Safe and Affordable Financial Services.
Support Technological Advances and Ensure Responsible Development and Use of Digital Assets.
Explore a U.S. Central Bank Digital Currency (CBDC) by placing urgency on research and development of a potential United States CBDC, should issuance be deemed in the national interest.
These are certainly steps in the right direction, but the road ahead will be long and arduous. Reconciling the inherent objectives of decentralization with government regulations will be no walk in the park, especially while we await definitive regulatory authority designations as the SEC & CFTC wage battle.
Despite that, however, I would imagine that somewhere in this young decentralized world, there are teams of very intelligent and capable individuals working hard to create new laws and regulations tailored specifically to crypto assets, so that the essence of decentralization can be maintained while also providing some oversight and protection. And if there isn’t, there should be. Maybe it could even be you.
A note from the author: Thank you, first and foremost, for taking the time to read this piece. If you have any thoughts, compliments, insults or objections related to the content above, please reach out to me to continue the discussion! I can be reached via twitter, @Kyler56, Discord, or by simply emailing the Around the Blockchain Substack. As a student of the space, I am always eager to learn more.