SEC Update to the Fiduciary Duty Rule Should Expand Opportunities for Mr. and Mrs. 401k

As the SEC Considers a Fiduciary Rule for Retail Investors, it’s Time to Rethink Accredited Investor Limitations, too

Dina Ellis Rochkind

Joshua S. Downer

As the SEC considers raising the standard of conduct applicable to investment advisers with respect to their retail clients, it should also consider loosening the restrictions that inhibit retail investors from gaining access to privately placed securities and other alternative investments.1 Private placements represent the bulk of investment opportunities in the market – particularly those with a relatively high yield – yet mom and pop investors have very limited access to them. Restricting access will no longer make sense in a world where brokers are obligated to act in a fiduciary capacity towards their retail clients. If the SEC follows through on imposing these heightened standards, it should permit investment advisors to facilitate the purchase of privately placed securities that current regulations largely reserve for the wealthy.

By way of background, securities laws and regulations require that a company that offers to sell securities must either register them with the SEC or find an exemption. One set of exemptions is for “private placements,” which require far less onerous disclosures than registered offerings. A trade-off for fewer disclosure requirements is that sales to less weathy  investors are significantly limited. For instance, private offerings over $1 million are restricted to 35 “non-accredited” investors.2 Under SEC rules, any investor who earns less than $200,000 annually (or $300,000 annually for the household), and is not otherwise worth more than $1,000,000, is not an accredited investor.3

Unaccredited investors represent the vast majority of American households, and their options for building wealth are highly constrained. Their primary opportunity to pursue high-yield returns is to buy publically offered equities, yet most working people are notorious losers in the stock market. Retail investors tend to flood into the market on the tail end of a bull run, having missed the bulk of the gains and poised to suffer the worst of the subsequent correction.4 This pattern

appears to be repeating itself today. According to Goldman, recent stock market volatility is primarily the consequence of dramatic increases in trading activity of retail investors.5 Although one might blame this pernicious cycle on their lack of sophistication, the lack of alternative investment options is a significant factor.

As Bob Rice, Managing Partner of Tangent Capital, argues in the “The Alternative Answer,” “the biggest key to long-term wealth is loss avoidance; and, as I bet you’ve noticed, traditional portfolios are subject to periodic, devastating, crashes.” A well-constructed portfolio of a variety of private investment options – such as private REITs, venture capital, private equity and hedging instruments – can provide better gains and the ability to mitigate risk. Certainly, limiting unsophisticated investors’ access to such investments makes sense in the current world, in which adequate standards are not in place to ensure that financial advisors distinguish appropriate investment options for their retail clients. However, that becomes less of a concern if the SEC creates a generalized heightened standard of conduct for financial advisors.

The Dodd Frank Act requires the SEC staff to review the accredited investor definition every four years to determine whether it is in the public interest to modify it.6 Its first report, released on December 18, 2015, the SEC staff recommended that the Commission consider incorporating sophistication criteria other than income and wealth for qualifying as an accredited investor.7 The commissioners have not acted on the recommendation. As the SEC considers a heightened fiduciary rule and prepares to conduct its second review of the accredited investor definition, we suggest that it considering defining any individual advised by a licensed financial advisor acting in a fiduciary capacity to be an accredited investor.

In short, retail investors, advised by an investment professional acting in a fiduciary capacity, should not be restricted by the SEC from pursuing the most fruitful opportunities available to preserve and build their wealth.