The Trump administration came into office with the promise of breaking down regulatory walls, which was music to the ears of the alternatives industry. While the administration has succeeded to some extent — such as by stopping the fiduciary rule from being implemented — changing published rules takes time, concerted effort and buy-in from leadership at the relevant agencies.
Only 17 months into the Trump era, it remains too soon to say how much the regulatory rulebook will ultimately be relaxed. But as the dust settles, the alternative investment industry is optimistic we will see positive results on important issues that will remove the handcuffs from broker/dealers and enlarge the base of investors with access to alternative products.
Key to achieving these goals is expanding the definition of an “accredited investor” (those who can invest in alternatives), loosening the rules on Regulation A+ to enable more funds to be raised without burdensome paperwork, and ensuring any future fiduciary rule does not stifle the investment options that can be presented to investors.
Let’s take a deeper dive into the issues surrounding each of these needed changes.
ACCREDITED INVESTOR RULES
The requirement that only accredited investors can participate in an alternative investment goes back to the Securities Act of 1933. The current rule defining an accredited investor dates to 1982, and has not undergone any substantial review or revision since then. The rule badly needs to be updated for many reasons, including:
- To expand investor pools and capital formation
- To establish a logical and up-to-date definition of investors deemed “sophisticated”
- To expand access to an asset class that has long been unfairly denied to many investors
The act defines an accredited investor as either: (1) a person with an income of $200,000 per year, or a couple with a combined income of $300,000 per year; or (2) a person or couple with a net worth of $1 million or more. The rule presumes the investment sophistication of an individual based solely on an arbitrary monetary threshold unexamined and unadjusted for more than 35 years. Below this threshold, investors do not qualify and are not permitted to invest in Regulation D Rule 506(b) funds, or are at least severely restricted from participating in these products.
The 12.4 million accredited U.S. investors control three-quarters of the country’s wealth, about $65 trillion, according to Seeking Alpha. The rule, however, excludes a very large population of investors who would be considered “sophisticated” under any probative definition. The alternatives industry contends expanding the number of investors permitted to invest in these products would benefit investors and sponsors alike.
How do we increase the population of limited partners for sponsors? One proposal is to expand the current definition of an accredited investor to include U.S. investors who carry active licenses in financial services industry organizations, and to develop a meaningful test of the investment sophistication of those investors who do not meet either the financial threshold or the “active license” threshold.
Adding professional experts would expand the potential investor pool by nearly 1.4 million. That includes roughly 630,000 Financial Industry Regulatory Authority–registered representatives, 85,000 U.S. members of the CFA Institute and 660,000 certified public accountants. These financial professionals are sophisticated potential investors, even though their average salary as a group is well below the $200,000 threshold of the current accredited-investor rule.
There is movement in Congress to expand the definition of an accredited investor.
HELP FOR SMALL BUSINESS
Regulation A+ is about not overburdening small startup companies with paperwork. It has two tiers:
- The original Reg A is Tier 1, which enables funds to raise up to $20 million without providing audited financial statements to the Securities and Exchange Commission, and there is no limit on the proportion of total capital raised from the general public. Tier 1 does require a fund ensure compliance with “blue sky laws” in each state from which it receives funding.
- Reg A+ is Tier 2. This is the newer regulation. Tier 2 allows a startup fund to raise up to $50 million without the need to comply with blue sky laws in states where investments are received. So private companies can raise up to $50 million from accredited and nonaccredited investors, and conduct a “mini-IPO,” subject to prior SEC review. Tier 2 does require funds to submit two years of financial statements to the SEC.
Reg A+ success stories include BrewDog, a Scottish craft beer company, which raised $25 million in its Equity for Punks IV crowdfunding campaign in 2016. The proceeds were to fund the brand’s expansion into the U.S. market. Elio Motors, makers of high-mileage three-wheeled automobiles, raised $17 million from more than 6,000 nonaccredited investors through CrowdfundX.
What these success stories have in common is they are innovative products with a compelling story that appeal to the average nonaccredited investor. They are also relatively small in scale. Real estate projects and other more traditional fund offerings are deterred from using Reg A+ by the $50 million limit.
The industry believes Reg A+ is too restrictive, and the amount of capital companies can raise should be expanded. This is another area in which there is legislative action. The House passed on a bipartisan basis the Regulation A+ Improvement Act of 2017, which would increase the limit to $75 million.
NOT QUITE DEAD YET
Since its introduction in 2010, the Department of Labor’s fiduciary rule has been on a wild ride. That ride may finally have come to an end.
The rule requires those who advise investors, such as registered investment advisers, to act in in the best interests of their clients when providing investment advice for a fee or other compensation. The intent was to ensure financial advisers for retirement funds were motivated by the welfare of their clients rather than by attractive commissions associated with some investment products.
The fiduciary rule requires advisers to act as fiduciaries. Legally, a person acting in a fiduciary capacity is held to a high standard of honesty and full disclosure, and must not obtain a personal benefit at the expense of the client. Any perceived conflict of interest in recommending an investment product could potentially be grounds for legal action, creating a prohibitive liability for advisers selling investment products with sales commissions for retirement accounts.
The fiduciary rule was made effective June 7, 2016. The applicability date was delayed to April 10, 2017, to give financial service companies time to prepare. During that time, the rule was challenged in court and in Congress. Ultimately, the rule went into partial effect in 2017, though the Department of Labor announced it would not enforce it, pending review.
A panel of the 5th U.S. Circuit Court of Appeals struck down the regulation March 15, 2018, calling it “arbitrary and capricious exercises of administrative power.” The alternatives industry believes the fiduciary rule was never in the purview of the Department of Labor and that the appropriate forum for such rule making is the SEC. The sensible next step, should the SEC choose to act, would be for the commission to propose practical rules that would clarify the financial adviser–retirement investor relationship. The Department of Labor, as recently as May 7, 2018, said it would continue to rely on the regulation for now to govern advice in retirement accounts.
CONCLUSION
Smarter policies that will benefit the alternative investment industry and the investors who would benefit from participation in the space are needed. These regulatory changes are a good first step in helping to improve the efficiency and integrity of the alternatives industry. More can still be done. SEC Commissioner Michael Piwowar recently announced to President Trump he is stepping down July 7, 2018, meaning more change is surely afoot for alternatives.
Ned Montenecourt is chief compliance and risk officer, and David Fisher is director of marketing at Phoenix American Financial Services.
