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Just when you thought that bi-partisanship was dead in the United States, a strong bi-partisan consensus is showing up in an unexpected place. This consensus relates to provisions buried in the proposed Restoring American Financial Stability Act of 2009 recently introduced by U.S. Senate Banking Committee Chairman Christopher Dodd. The impact of these provisions has been described - in the Huffington Post, no less - as if someone from another country got into the bill writing process and came up with a way to sabotage the American creative dream machine by slipping in a little poison and the death knell of American leadership in the world. This from a mouthpiece that is broadly supportive of the current administration and the core provisions of Senator Dodd's bill.
The groundswell of bi-partisan opposition in recent weeks centered primarily around three provisions that many feared would have a dramatic negative effect on the amount of angel capital financing. Essentially, the provisions would have:
- increased the financial thresholds for qualification as accredited investors, who are, generally speaking, wealthy investors whose investments are not subject to significant federal securities regulation;
- allowed the Securities and Exchange Commission (SEC) to make certain angel financing transactions subject to state regulation (previously, all so-called Rule 506 offerings, which were commonly used for angel financings, were preempted from state regulation); and
- required that those Rule 506 offerings that remain preempted from state regulation nonetheless be subject to a 120 day review process with the federal SEC.
Fortunately, Senator Dodd's bill appears likely to undergo a number of changes in the coming days, and according to various news reports (including an April 21 news release from the Angel Capital Association), it now appears that items (2) and (3) described above will be scrapped. This is great news for entrepreneurs and the angel investors who finance them - to say nothing of the overall U.S. economy, which is driven in no small part by the innovation of early-stage companies and the jobs they create.
However, the proposed increase in the thresholds for qualification as an accredited investor remains in Senator Dodd's bill. By way of background, an individual is presently considered accredited if he or she has a net worth of $1 million, or either an individual annual income in excess of $200,000, or a combined annual income together with his or her spouse of $300,000, in each case in each of the two most recent years. Sales of securities to such investors are largely unregulated at the federal level, and if such sales qualify under Rule 506 they are preempted from virtually all state regulation as well. Thus, the sale of securities in Rule 506 offerings to accredited investors has been an essential, time-honored tool for the accumulation and deployment of investment capital from individuals wealthy enough to safely bear the risk of unregistered investments in speculative, early-stage enterprises.
Current reports suggest that the pending bill will adjust these accredited investor financial thresholds prospectively for inflation. These thresholds were originally established in 1982 with the adoption of Regulation D, which essentially allowed companies to sell their securities to specified entities and wealthy individual investors in unregistered offerings, in some cases without being subject to any limitations on the amounts raised or requirements concerning specific disclosures. It is estimated that at the time of Regulation D's adoption in 1982 approximately 1.87% of all U.S. households qualified as accredited under those thresholds, representing approximately 1,569,267 households. By 2003, the number of accredited households had grown to 9,486,400, representing approximately 8.47% of all households.
When Senator Dodd's bill was originally proposed, it was unclear whether the inflation adjustment would be purely prospective or whether it would adjust for inflation since 1982. The original bill merely directed the SEC to increase these financial thresholds to amounts appropriate and in the public interest, in light of price inflation and to adjust those thresholds not less frequently than once every five years, to reflect the percentage increase in the cost of living.
This ambiguous language caused some to paint a bleak picture of the future of angel financing. Scott Shane, writing for Bloomberg's Business Week, posited that the adjustments to the thresholds would be based on inflation since 1982 and that the annual income requirements for accredited investor status would become $449,000 if the investor were single and $674,000 if the investor were married, while the net worth requirement would become $2.25 million. Mr. Shane estimated that these adjustments would result in a 77% decrease in the number of accredited investors.
Thankfully, available reports suggest that the actual inflation adjustment will be more in line with the SEC's proposal in 2007 to adjust the thresholds to reflect any changes in the value of a specified price index from December 31, 2006. Such a prospective inflation adjustment will not likely have a significant immediate effect on the thresholds. However, it should be noted that if the thresholds are to be adjusted periodically, as it appears they will (reports indicate the adjustment will be every four years), one might expect that the growth in the percentage of households that qualify as accredited will level off at its present levels. In addition, the Dodd bill would modify the standard for net worth of $1 million to exclude the investor's primary residence, which would likely cause the number of accredited investors to decrease.
Some may ask, why adjust the accredited investor thresholds at all? If the proposed changes were somehow connected to the current financial crisis, they would be understandable - if still misguided. But no one has suggested any connection between the recent meltdown of the financial system and the current accredited investor thresholds. It does not appear that there is anything broken about the current regulation of angel financing. To the contrary, many would say it has worked beautifully in facilitating the flow of risk capital in entrepreneurial innovation and that America's risk capital investors and entrepreneurs are the envy of the world in terms of fostering innovation and creating wealth.
Not surprisingly, this aspect of the Senator Dodd's bill has prompted many to ask: If it is not broken, why try to fix it?
Chad Bartell, Paul Jones and Greg Lynch are attorneys in the Madison office of Michael Best & Friedrich LLP, where they are members of the firm's Venture BestSM practice group focusing on the representation of high-growth, emerging companies in biotechnology, information technology and software, medical device, electronics, and other high-technology sectors.
The opinions expressed herein or statements made in the above column are solely those of the author, and do not necessarily reflect the views of Wisconsin Technology Network, LLC. WTN accepts no legal liability or responsibility for any claims made or opinions expressed herein.