Time to put real teeth on accredited-investor rules

IT IS TIME for the Securities and Exchange Commission to set an even more rigorous net-worth standard for “accredited” investors than the requirements set forth in the Dodd-Frank financial reform law. Prior to the passage of Dodd-Frank, an individual had to meet certain income standards or have a net worth in excess of $1 million — including the value of his or her home — to be deemed “accredited” and therefore eligible to seek the high returns of hedge funds and other investments deemed too risky for less affluent investors. Dodd-Frank, however, mandates that the SEC amend its net-worth requirement to exclude the value of the investor's primary residence.

PROTECTING 'HOUSE RICH'

The change is aimed at protecting those who have seen the value of their homes appreciate over time but are relatively unsophisticated investors. In other words, it is intended to keep average investors who are “house rich” from jeopardizing their financial security by investing money they cannot afford to lose. In a formal rule proposal issued in January, the SEC recommended that the value of an individual's primary residence be “calculated by subtracting from the property's estimated fair market value the amount of debt secured by the property, up to the estimated fair market value.” Essentially, that would ensure that an investor's equity in a primary residence would be excluded from the net-worth calculation and that additional indebtedness in excess of equity would be realized. Considering that up to 27% of existing mortgages were estimated to be underwater at the end of 2010 — a figure that represents about 15 million homes — the commission's proposal to include debt in excess of home equity makes perfect sense and should provide a clearer indication of an investor's ability to withstand any significant losses associated with his or her investment. One failure of the SEC's proposal, however, is that it would allow homeowners to refinance their mortgages and use the proceeds to buy securities. Those securities could then be counted as assets in the net-worth calculation. That approach is likely to encourage unsophisticated investors — particularly seniors who have worked hard to pay off their mortgages — to leverage their homes to invest in in unsuitable private-placement securities. Let's not forget that during the height of the real estate market, it was not uncommon for investors to refinance their home mortgages in order to invest in the stock market, often at the behest of their so-called advisers. We urge the SEC to add provisions in the new accredited-investor guidelines that would discourage investors from artificially inflating their net worth. One way of doing this would be to require that the calculation of net worth be made 90 to 120 days before the sale of securities under Regulation D. That, it seems, would go a long way toward making the practice less attractive. Truth be told, the guidelines completely ignore an even bigger flaw in the existing net-worth standard: the $1 million threshold. Simply put, the threshold is too low to keep “unsophisticated” investors out of investment vehicles that are unsuitable for them.

STANDARDS SET IN 1982

That's because the existing threshold was set in 1982 and has not been revised or adjusted for inflation since. In 1982, just 1.3% of households qualified for accredited-investor status, compared with 9.04% before the passage of Dodd-Frank. Taking the changes imposed by Dodd-Frank into account, 6.55% of households now qualify as accredited investors — a percentage that is still too high to assure adequate protection of people who have worked and saved too diligently to have their financial well-being imperiled. For that reason, we are calling upon the SEC to adjust the threshold for inflation and to readjust it every four years. Adjusted for today's price level, the $1 million threshold would rise to $2.3 million. On an adjusted basis, the alternative net-worth standard — that is, the threshold based on an investor's annual income — would climb to $459,000 ($688,000 for a couple), from $200,000 ($300,000 for a couple). To be sure, no amount of regulation can protect the greedy and stupid from themselves or from dishonest brokers and advisers. At best, the assumption that the size of one's bank account or paycheck — or the value of one's home — is a good barometer of his or her investment savvy is naive. At worst, it is misguided and fraught with risk. Nevertheless, raising the thresholds and pegging them to inflation, as well as excluding home values from net-worth calculations, would mark a vast improvement over current guidelines.