Two Classes of Investor

There are no legal differences between the haves and have nots, right?

Wrong. There are laws on the books going back to 1933 that are still being used to define two classes of investors: accredited and non-accredited. Non-accredited investors make less than $200,000 a year or have a net worth of less than $1 million. Accredited investors make $200,000 or more or have a net worth in excess of $1 million.

These laws are sometimes referred to as “Blue Sky” laws after a quote from the Kansas bank commissioner, J. N. Dolley. Dolley made it his personal crusade to stop the equity scams secured by “nothing but the blue skies of Kansas,” he saw defrauding Kansas residents.

It’s Not 1933 Anymore

While the laws did stop the Kansas fast-talking salesmen, the laws’ utility now, 79 years later, is questionable. Kansas country folk in the 1920s did not have the vast research resources we have now. They could not even know what the towns and facilities of the companies they were investing in looked like. Yet we are still bound by the rules set up to protect them.

The problem – in terms of crowdfunding and investing and financing small businesses – comes down to this: Accredited investors can invest in startups. Non-accredited investors can not. There are some exceptions to this rule that do allow non-accredited investors to get in at a company startup, but there can be only 35 of them, and they have to know the person or people starting the business. Accredited investors have no such limitations. According to the SEC only 6.5% of American households meet the accredited investor requirement.

Increased Risk and Multiplied Rewards

This special status allows accredited investors more access to a very risky, but also sometimes very, very profitable niche of the market. There is a reason why smart venture capitalists spend their time trying to find and fund startups, rather than just stocking their money away into a mutual fund: The startups make more money. Yet with the way the laws are written now, 93.5% percent of US households do not qualify to go into this high-return sector.

Many people think these investor classes are unfair. Financial advisors and politicians like to explain that these classes are set up to protect people so they do not get sold into a bad investment. Yet there are so many examples of colossally poor investments being sold on the trading floors (anyone want to buy Enron? Lehman Brothers? WorldCom?), that the premise no longer rings true.

What Makes a Competent Investor?

The laws also hold a barely shaded implication that people who earn less than $200,000 a year are not as smart as those who earn or have more. If you don’t like the word “smart”, use “competent”. The idea of protecting the incompetent investor is often defended by a statement that the rich can afford to lose more. This logic also fails. The rich are allowed to invest all their money in a venture, which would lead them as broke as a common person. Not only that, but everyone who has even been short on cash knows it only makes you guard what you have more carefully. If common people have less to lose, logically they will be more diligent about protecting what they have.

Who Can and Can Not Invest

With the rules the way they are right now, even an MBA financial investor with 10 years on Wall Street can not be trusted to make safe investments in startups because he does not make more than $200,000 a year, and does not have a million in assets. Under the law, that person has to be protected more carefully by bad judgment than a 24 year old divorcee with no college education, or an elderly man who is no longer capable of caring for himself.

Level the Playing Field

Investor competence should not be tied to income or wealth. If the SEC still feels that investors need to be protected from shady startup ventures, why not implement a test? Almost all mid to high level financial employees are required to pass tests in order to gain their certifications. Why should investors be any different?

Leave a Comment