Constitutionality of the Accredited Investor Definition

Last year, after launching the Tech Funding Equity Project in the Aspen Tech Policy Hub, research on the accredited investor definition drew my attention to the 14th Amendment's Equal Protection Clause and the 5th Amendment's Due Process Clause. I believe the accredited investor definition defies both. It's an important topic, because the accredited investor definition constrains capital formation, and has a disparate impact on women and communities of color. Furthermore, history shows it was engineered to do just that.

The Securities and Exchange Commission (SEC) has the authority to define the definition of an accredited investor. Their own Small Business Capital Formation advisory has encouraged the SEC to take leadership in addressing how "capital formation rules may include impediments for minorities and women to access the capital markets," but is this a battle for the courts?

I’ve started asking attorneys with Constitutional Law leanings like the congressional candidate, Shahid Buttar, and Securities / Crowdfunding attorney, Elizabeth Carter, Esq. This discussion is particularly relevant as the SEC's Small Business Forum rolls around again with topics deeply impacted by this rule, including "Finding Your First Dollars," "Doing Your Diligence," "Diversifying Capital Allocators," and "Small Cap Insights" (register here).

Background of the Accredited Investor Definition

The Accredited Investor definition dates back to the Securities Act of 1933 and the Securities and Exchange Act of 1934. These bills were passed in response to the public stock market crash of 1929. The 1934 Act formed the Securities and Exchange Commission and gave it the authority to define "accredited investor."

As described generally on the SEC website:

An accredited investor, in the context of a natural person, includes anyone who:

• earned income that exceeded $200,000 (or $300,000 together with a spouse or spousal equivalent) in each of the prior two years, and reasonably expects the same for the current year, OR
• has a net worth over $1 million, either alone or together with a spouse or spousal equivalent (excluding the value of the person’s primary residence), OR
• holds in good standing a Series 7, 65 or 82 license.

Going into more depth, the actual definition of Accredited Investor is in PART 230—GENERAL RULES AND REGULATIONS, SECURITIES ACT OF 1933, specifically, §230.501(a) It includes "knowledgable employees" of venture capital firms, for example. It also includes qualified institutions and other nuances.

Background of the Equal Protection Clause in the Constitution

The Equal Protection clause was ratified in the 14th Amendment after the Civil War. The primary purpose was to address discrimination against Black people. It is written broadly enough to cover discrimination against other classes, including White, Latinx, Asian, and Indigenous peoples, religious groups, etc.

Equal Protection means that a governmental body may not deny people equal protection of its governing laws. Due process is tied to the Bill of Rights. Due process is required for criminal, civil, and administrative proceedings before depriving anyone of life, liberty, or property. Both the 5th Amendment and the 14th Amendments call for due process - it is the only command made TWICE in the Constitution. The 14th Amendment Equal Protection Clause states: 

"No State shall make or enforce any law which shall abridge the privileges or immunities of citizens of the United States; nor shall any State deprive any person of life, liberty, or property, without due process of law; nor deny to any person within its jurisdiction the equal protection of the laws."

Partly due to the due process reference, "No State" has been interpreted to include the federal government.

How The Accredited Investor Rule Runs Afoul of the Constitution

The accredited investor definition denies accredited investors the same/equal protection that non-accredited investors receive. It also abridges the privileges of non-accredited investors without due process by denying them the liberty to invest in the same opportunities as accredited investors. 

The Accredited Investor, as currently defined, violates the Civil Rights of an economic class, with disparate impact based on popularly understood constructs of gender (sex) and race (ethnic origins). It deprives non-accredited investors of economic liberty under the guise of "investor protection."

Investor protection should be in the form of issuer disclosures and enforcement of rules and regulations under the law. It should not be in the form of discriminatory exclusion of investors or separate and unequal opportunities for issuers and investors.

How to Spot Discrimination

When the federal or state government violates equal rights, citizens have the right to sue for relief. To determine discrimination, the court may use the following considerations: 

Suspect Classification "refers to a class of individuals that have been historically subject to discrimination." According to Cornell Law: "There are four generally agreed-upon suspect classifications: race, religion, national origin, and alienage. However, this is not an inclusive list." It comes into play when a statute discriminates against an individual on the basis of a suspect classification.

Strict Scrutiny is a type of judicial review that is used when discrimination is alleged based on suspect classification or when the government infringes on a fundamental right. It requires the government to show "compelling governmental interest" and must be narrowly tailored. In SCRUTINIZING STRICT SCRUTINY, Roy G. Spece, Jr.* & David Yokum point to how strict scrutiny requires "the government to bear the burden of proving it met each of the elements of that standard: actual purpose, legitimate interest, compelling interest, proper inclusiveness/sufficiently precise classifications, substantial advancement, and necessity."

Intermediate Scrutiny is another test in which the government must show that the deprivation of equal protection/due process "further[s] an important government interest" and "do so by means that are substantially related to that interest."

Rational Basis is regarded as a deferential judicial review and is applied only when no fundamental right or suspect classification is at issue.

Is Economic Apartheid a Compelling Governmental Interest? 

The SEC has not demonstrated that the private market poses more threat or risk to investors than the public market (which does not have an accredited investor rule). In fact, according to the United States Sentencing Commission, of the 5,707 cases of theft, property destruction, and fraud reported to them, only 4.4% involved securities and investment fraud (not limited to the private markets). The number of offenders is less than 250 individuals.

Where is the legitimate, rational evidence the private market is "prone to fraud" as the NASAA claims while lobbying to protect its own interests (regulating financial advisors who steer investors to the public market)?

Are cases of fraud under Regulation D private offerings (or any other) sufficient to justify the widespread economic disenfranchisement of >85% of Americans? 

Does the Risk of Fraud Justify Economic Apartheid? 

Commissioners Allison Herren Lee and Caroline Crenshaw argue: 

"In response to evidence of fraud in the private market, the adopting release argues that “commenters did not provide information that would indicate that any such incidents of fraud in the private markets are driven or affected by the levels at which the accredited investor definition is set.”[13] This quite plainly misconstrues the point: it’s not that the accredited investor definition somehow causes fraud, it’s that it allows more investors to be exposed to the risks of fraud."

This argument forgets that those who commit fraud against accredited investors are unlikely to exclude non-accredited investors just because the SEC does. Who is to say that non-accredited investors are not already at risk or impacted by fraud? One need only look at the case of Bernie Maddoff to see that accredited investors need equal protection, and that non-accredited investors are already exposed to the risks of fraud.

In US West, Inc. v. United States, 48 F.3d 1092 (9th Cir. 1994), the Ninth Circuit Court of Appeals applied Intermediate Scrutiny on a 1st Amendment issue to rule that the government “must demonstrate that the recited harms are real, not merely conjectural and that the regulation will in fact alleviate these harms in a direct and material way.”

The SEC should not continue to codify demonstrable harm because of a conjectural risk of fraud in the private market. There is no indication, even in the SEC's review of allowing non-accredited investors to participate in Reg CF crowdfunded offerings, that fraud will increase substantially because non-accredited investors participate in private offerings.

A More Just, Equitable, and Economically Sound Solution 

All investors are less likely to be subject to fraud when they have robust access to legitimate investment opportunities. This is why, in my policy brief, Removing Barriers to Startup Capital: Democratize Accreditation, I recommend a self-accreditation attestation. By requiring issuers to have all investors complete a Self-Accreditation Attestation, all investors will have equal access to fundamental disclosures and indicators of fraud.

Not only should all investors receive fundamental disclosures and indicators of fraud, the attestation facilitates data collection so that the SEC can better understand how many natural persons participate in private offerings, how they fare, whether the number of offerings indicated by accredited investor attestations aligns with the number of Form Ds, etc.

With more access to information, exposures, and common knowledge, fraudsters will be less likely to dupe uninformed citizens. 

What Say You?

Let the SEC know what you think about the constitutionality of the accredited investor definition during the Small Business Forum May 24-27th (read about the TFE Recommendation here). You can also subscribe to the Tech Funding Equity project to get updated on the status of the formal petition to the SEC to democratize the accredited investor definition. You can also email me on the subject at [email protected].