By Chris Donahoe
An evolving and maturing market naturally requires a periodic refreshing of the regulations and public policy that shape it. As market participants develop new and innovative ways to provide capital to growing businesses, entrepreneurs, and other job creators, lawmakers must keep up or risk creating bottlenecks for capital flows.
Currently, an appetite in the U.S. Congress for targeted and commonsense improvements to financial policy is creating opportunities for securities reform for alternative investments. The Institute for Portfolio Alternatives (IPA) has been actively engaged on several potential changes to securities law that have the dual benefit of improving the regulatory environment for market participants, allowing them to provide more capital and investment opportunities, while also building bipartisan support in Congress.
A pragmatic approach to reform
While some of the more conservative members of Congress, such as House Financial Services Committee Chairman Jeb Hensarling (R-TX), have been calling for repeal of the Dodd-Frank Act, most policymakers in Washington have been taking a more pragmatic approach by leaving Dodd-Frank’s overarching regulatory framework in place while modifying policy around the edges where a good case for improvements can be made. This approach enjoys the support of the Treasury Department, including Treasury Secretary Steven Mnuchin, while it is also behind the success of recent legislative proposals in the Senate that have bipartisan support and are making headway as a result.
“We have started to see a real shift in how policymakers are thinking about the industry’s very real impact on the economy and, in the case of Congress, their local communities back home,” says Kamal Jafarnia, managing director at Provasi Capital Partners and co-chair of IPA’s Government Affairs and Policy Committee. “More than ever before, we’re seeing legislators from across the political spectrum willing to sit down and have constructive conversations about how to create new opportunities for investors and drive financing to small businesses.”
In this environment, among other things, the Portfolio Diversifying Investments (PDI) industry, led by the IPA, is pursuing three specific opportunities to improve securities regulation for all market participants, including retail investors, as well as the small- and medium-sized businesses that depend on access to capital. Should the IPA’s efforts be successful, this year could see a modernized regime for business development companies (BDCs), an improved definition of an accredited investor, and an important improvement to safe harbors for private funds and private companies.
To understand the situation today, it is important to go back to 2012 and the passage of the Jumpstart Our Business Startups Act (JOBS Act). The legislation was a package of bills in the wake of the Dodd-Frank Act with the goal of improving capital availability and providing additional flexibility for small businesses, private enterprises and entrepreneurs.
Many of the changes ushered in by the new law were positive for the alternative investments industry. The new law also brought new awareness to the contribution the industry makes to the broader economy, while also making practical improvements to the securities regime, including expanding some of the safe harbors available to market participants. Among other notable improvements, the new law created a safe harbor for raising the shareholder threshold for registration with the SEC as a public reporting company under Regulation D to 2,000 investors, up from the previous threshold of 500.
New opportunities for securities reform
Now, six years after the JOBS Act became law, the industry has seen what has worked, what has not, and where there are opportunities to make targeted improvements to current securities law.
The focus for the IPA and its membership this year is on three important legislative reforms designed to bring regulations governing alternative investments up to parity with the rest of the securities industry, to lower regulatory overhead for market participants — allowing more of investors’ money to be put to work, and providing for technical, common-sense fixes to rules for accredited investors and private placements.
According to Jafarnia, the overall industry’s focused and proactive approach is contributing to its success. “We don’t simply say no to bad regulation. Instead we’re always trying to offer an effective solution in the process and bring fresh ideas to the table,” he says. “Identifying targeted improvements to the law, building a strong case for improvement, reaching out to all stakeholders, and then showing up at policymakers’ doorsteps with those ideas and proposed solutions is proving to be an effective way to get things done.”
The industry’s push for these changes comes at an opportune time in Washington. There is a renewed bipartisan focus on finding ways to spur economic growth, particularly for small- and medium-sized businesses, and the current presidential administration is keen to identify targeted and simple reforms to improve the regulatory environment for businesses and investors alike.
To accomplish these goals, the IPA is focused on advocating for three specific securities reforms in 2018:
(1) Business Development Company (BDC) regulatory modernization
(2) An improved definition of an accredited investor
(3) Fixing section 12(g) of the Securities and Exchange Act of 1934
BDCs have continued to grow, but the regulatory framework has held them at a disadvantage for years — something the IPA is working to change. The IPA, a long-time supporter of BDC modernization, sees opportunity to take its proposals across the finish line this year.
The House Financial Services Committee passed the Small Business Credit Availability Act (H.R. 4267) earlier this year with strong bipartisan support. Now a bipartisan companion bill has been introduced in the Senate. The legislation would allow a modest increase in leverage for BDCs, from 1:1 to 2:1, and would ease certain registration requirements, reducing overhead costs, which impact investor returns. IPA attributes the recent success of these BDC modernization proposals to the simplification of proposals that had been put forward in prior years. By streamlining the legislation to focus on reforms that will add the most value to the industry and investors, the bills have garnered substantial support.
“The strong bipartisan support in both the House and the Senate creates good momentum for this bill and gives Congress an opportunity to pass it into law this year,” says Anya Coverman, IPA’s general counsel and senior vice president for government affairs.
Ultimately, the legislation would mean that more of a retail investor’s money would be put to use investing in and financing small businesses rather than covering unnecessary compliance costs.
Accredited investor definition
The definition of an accredited investor has remained largely unchanged since it was established nearly 40 years ago. For decades, the government’s method for determining an investor’s sophistication has been to look to his or her income level or net worth. Those thresholds currently sit at $200,000 of income ($300,000 for a couple) or $1 million in net worth, excluding the value of one’s primary residence.
However, these thresholds are arbitrary and exclude other sophisticated investors who may not meet these overly simplistic requirements, leaving them unable to pursue valuable opportunities.
This year, the IPA is pushing in Washington for a new accredited investor definition — one that, while preserving income and net worth as potential qualifications, also incorporates other commonsense gauges of sophistication. Examples include a Series 7, CFA or similar credential. Similarly, the IPA has also proposed a test be available for all investors, so that someone who might not meet one of the accreditation qualifications above could still become accredited by exhibiting an understanding of the risks of investing in non–public offerings that are exempt from registration.
Another of the IPA’s reform priorities stems directly from changes made by the JOBS Act. For alternative investments, one of the law’s most important changes was Section 501, which raised the registration threshold for public reporting companies from 500 to 2,000 investors. This reform held the promise of opening up significant new channels for raising capital.
Unfortunately, in implementing the rule, the SEC made changes to Rule 12(g) of the Securities and Exchange Act of 1934, which changed the requirements for accrediting investors in a way that negated the benefit of the new law. The Commission mandated that funds with more than 500 investors need to annually re-evaluate the accredited status of their investors. Prior to this change, funds were only required to determine an investor’s accredited status at the time of investment, which is when the securities were sold.
Because of the high cost of becoming a public reporting company and the seemingly daunting challenge of annually determining and renewing the accredited status of investors from a practical standpoint, the industry has been reluctant to take advantage of this important change in the law. The result has been that private companies and funds have only been able to tap a fraction of the capital promised by Section 501.
The IPA has called attention to this limitation for years and is already engaged in a big push for a legislative fix in 2018. Returning the verification of accredited investor status back to the time of sale — the long-time standard — instead of annual reaffirmation will substantially decrease compliance costs for fund sponsors while not increasing risk for investors. The result will be the healthy pipeline of capital that Congress originally intended.