By Joanne Cursinella, J.D.
Before a FINRA audience, Commissioner Hester Peirce contemplated the practical realities of securities law and the role it plays in our rapidly changing markets at the FINRA Certified Regulatory and Compliance Professional Program at Georgetown University. In recent prepared remarks, she said that current SEC private market regulation may be a factor in the under-participation of retail investors in U.S. financial markets. She also noted that legal barriers to employment in the financial industry do not necessarily protect investors and advocated that these be reevaluated for effectiveness in promoting such protection.
Cause of under-participation. Whileour financial markets are among the greatest wealth-generating machines ever developed by any society, only about half of American households own equities directly and only about half of Americans own mutual funds or exchange-traded funds, Peirce reported. This may be a by-product of poor investor education in part, she said, but in 2021 many retail investors have now been getting hands-on financial education. In addition, while the regulator’s first reaction is concern over potential investor losses, recent advances in technology can enable people of limited means to access cheap, convenient, high-quality financial services.
But these "newly minted retail investors" soon discover that a "huge swath" of the market is off limits to them, Peirce claimed. Private markets, not subject to the disclosure mandates applicable to the public markets, are the "gated domain of wealthy individuals and institutional investors," she said. Under the Commission’s accredited investor definition, an individual investor who wants to invest in companies making a private offering generally needs more than a million dollars in net worth, excluding her house, or an annual income above $200,000 (or above $300,000 for a couple), Peirce added.
The Commission’s view has been that wealthy individuals are likely to be more sophisticated about financial matters and are better able to bear the risk of loss from these investments. But the problem with this standard is pretty obvious, according to Peirce, since wealth or income is not always linked to financial sophistication or investing prowess.
Barriers remain. The Commission recently "tweaked" the rules to enable investors to qualify as accredited investors based on defined measures of professional knowledge, experience, or certifications in addition to the existing tests for income or net worth, but, to date, these changes have been limited to a few select financial professionals, Peirce said. And the SEC has announced plans to explore updating the financial thresholds in the accredited investor definition so that presumably even fewer Americans will qualify, she reported. But the accredited investor rules are not the only barriers to the private markets for non-wealthy Americans, however. The Qualified Client and Qualified Purchaser rules under the Investment Advisers Act and Investment Company Act, respectively, play a similar gating role, Peirce claimed.
Solution? As a remedy, some have suggested regulating private markets more heavily to reduce the incentive to stay private or eliminating the ability to be private above a certain size, but this approach is the technocrat’s solution, Peirce said. A simpler approach would be to unlock the existing gates to the private markets so that retail investors can get exposure to them, she added.
Effects of the status quo. The private market gating rules’ pernicious effects go far beyond the individual, Peirce said. For example, a start-up in the Bay Area or in Manhattan may not find it particularly difficult to line up a significant pool of wealthy investors, but a start-up in Cleveland or Biloxi (where incomes are considerably lower) may not be able to locate investors who meet those same standards, which are uniformly applicable across different regions of the country with vastly different income and wealth levels.
"Those thresholds, however, effectively shut out the brilliant, young woman from a low-income background who had to go straight into the workforce to support a family but has a side hustle that could turn into something big if only she could solicit investments in her local community where her industriousness and talent are on display, but where few accredited investors live," Peirce added.
For decades there has been a call for the SEC to create a tailored regulatory framework in which people could act as "finders" to match investors with small businesses, Peirce said. The Commission proposed such a framework last fall and received comments on it, but no action has been taken. Peirce hopes that, whether by exemptive order as proposed or by rule, a way is found to enable finders engaged in helping small entrepreneurs seeking to raise early dollars without a network of wealthy friends to operate without the full weight of broker-dealer regulation.
Financial industry employment barriers. Barriers are also present with respect to employment in the financial industry, Peirce said. Everyone whether in regulatory bodies or in regulated firms, may have an interest in ensuring that the doors to employment and advancement in the financial industry are open to as many people as possible from every background and "We need to ask anew whether these barriers are well tailored to advance those goals while minimizing the significant costs of keeping individuals who pose little or no risk to investors out of the industry we regulate," she said.
Overly punitive? The list of things that will keep an individual or a firm out of the securities industry is long, Peirce claimed. A closer look at some SEC regulation, though, and it becomes clear that even some apparently reasonable bases for disqualification, in practice, may create unreasonable barriers to employment opportunities while doing little or nothing to protect investors. For example, she said, barring felons from working in the industry seems like an easy investor protection win—after all, a felony conviction is a pretty good indicator of moral turpitude or even moral depravity, right? But in fact, in America today committing a felony is remarkably easy So easy, in fact, that a felony conviction may tell us very little about a person’s moral character, Peirce claimed.
She cited research that there is a "dramatic rise" in the percentage of Americans who have felony convictions, from approximately 3 percent of the population in 1980 to over 8 percent of the population today. The same research suggests that a majority of those with felony conviction have served no time in prison.
Further, it is not the government’s place to deprive individuals of the opportunity to show an employer that they deserve a second-chance at a career in financial services and it may be time to begin rethinking whether the law strikes the right balance, Peirce said. While changing the definition of statutory disqualification would require an act of Congress, the Commission could consider the appropriateness of using its broad exemptive authority to limit the scope of the bar to something that is better tailored to the investor protection concerns the requirement was intended to address, she added.
Some of the barriers to employment in the industry come from good-faith attempts to gather information that may be relevant to the investor protection objectives that the statutory disqualification definition is intended to advance, according to Peirce. For example, she cited FINRA’s Form U4 and the Commission’s Form AD, which play central roles in the registration of individuals who seek to associate with broker-dealers or of investment advisers.
While much of the information required in these forms s unquestionably relevant to determining whether an individual should be interacting with customers and handling their money, some questions about criminal history, however, go beyond what the Exchange Act requires and may impose unjustifiable burdens on applicants, according to Peirce. For example, she said, both in the Criminal Disclosure section of Form U4 and in Item 11 of Form ADV, the applicant is required to report past felony or relevant misdemeanor convictions; in addition, the applicant must report if he has been charged with either type of offense. The relevance of these questions from a regulatory perspective is doubtful, Peirce claimed.
Peirce noted that in a recent regulatory notice, FINRA sought public comment in connection with barriers to participation in the broker-dealer industry, including with respect to the possible effects of "collection and publication of registered representative background data." The SEC should engage in similar review, Peirce said.
Compliance officers. Adifferent barrier to entry into the financial industry is legal liability for compliance officers, Peirce claimed. Compliance officers play a key role in helping financial firms apply a very complex set of rules to the unique intricacies of their own firms’ business lines. If, as has sometimes happened in the SEC’s, FINRA’s, and other regulators’ enforcement actions, when a firm violates the law, the regulatory consequences fall in whole or part on the compliance officer, Peirce noted. The Commission and other regulators could help to alleviate concerns about facing liability for someone else’s violations by establishing a compliance officer liability framework similar to what the New York City Bar Association recently proposed.