One of the biggest limitations for newcomers to real estate investing is the accredited investor rule. Accredited investors don’t qualify by virtue of their specialist knowledge about investing, finance, or business. In fact, they don't need any of the above. The rule is solely based on wealth and income. If you have a lot of either, you are permitted to invest in private securities like syndicated mortgages, partnerships, and a joint ventures. If you don’t, these investment opportunities are officially prohibited. So, what’s a Private Security?
A private security is one that’s not sold on a public stock exchange like the TSX in Canada), and the NASDAQ and New York Stock Exchange in the U.S.. Air Canada, Royal Bank and Tim Hortons are random examples of public companies whose shares you can buy on the TSX. Each must abide by the rules of a publicly listed company, which include using common accounting standards, producing financial results four times a year, and holding shareholder meetings. Publicly-traded companies are meant to be transparent and rules-driven so that investors can make decisions about which of them they would like to invest in. The drive to create open information about the financial performance of public companies began after the cataclysmic crash of the US stock market in 1929 which sparked general economic collapse and The Great Depression. The stock market crashed because there were no rules preventing companies from being honest about the strength of their businesses. Many listed companies were bogus and had little or no revenue. People who bought their shares didn’t know these companies were scams, because there was no way to find out. There is a parallel here to many crypto coins. As the economy softened in the late 1920s, weak companies went bust and every other publicly listed corporation – even the financially strong ones – were dragged down with them in an explosive and destructive freefall. This is similar to the subprime mortgage crisis in 2008 when assets across the board got caught up in the downdraft caused by all the U.S. mortgage loans that were defaulting. Borrowers were defaulting because they never had the creditworthiness to be given a mortgage in the first place. Lending standards by American financial institutions leading up to 2008 were criminally lax. Back to 1929 & The Great Depression To prevent a repeat of the 1929 collapse of the stock market, the Securities and Exchange Commission (SEC) was created. Its mandate was to police publicly-listed companies by setting standards of disclosure and organizational certitude so that those investing them would feel secure in knowing their claims about revenue and expenses were accurate. Of course, if it had been doing its job, the 2008 subprime mortgage crisis would never have happened. Nor would the Bernie Madoff Ponzi scheme. So, let's just say, the SEC tries to regulate U.S. public markets. Back to being an accredited investor If you are investing in real estate joint ventures and partnerships, you must be an accredited investor if you are not wealthy or have a large income. So, how wealthy and how large? Unlike the United States, where the SEC oversees all publicly listed exchanges, Canada does not have a national body that enforces securities law. We have provincial bodies and they often don’t collaborate. There have been many examples of fraudsters scamming investors in one province only to move somewhere else and do it all over again and the provincial oversight body had no idea they were dealing with a serial offender. The federal government has come close to creating a national investor protection body but some provinces refuse to give up their provincial powers and want to keep the status quo. This issue has dragged on for years and has proved an impossible nut to crack. British Columbia’s Securities Commission defines accredited investors the following way:
In short, to be an accredited investor, you must be either wealthy or have a large income. When doing private real estate deals, the BC Securities Commission also sets standards for what it terms ‘unfair practices’:
Serious stuff. And fair enough too. These rules exist to protect investors because private securities (like real estate deals) by unregistered dealers are opaque investments and their risk level is hard to determine because the issuer (the person offering the JV or partnership) does not need to provide an offering memorandum or abide by any of the other disclosure rules that publicly-traded companies are required to. This lack of transparency makes private securities high-risk investments. But their opaque and niche nature also makes them some of the most lucrative opportunities you will ever find. Trust is key. Well-constructed contracts that protect the rights of all signatories are essential. But I’ve met scammers who would sign any contract put in front of them knowing full well that they never plan to honour the terms. In addition to well-constructed contracts, you need business partners to have honest intent and to be honorable people in their personal and professional dealings. I have a Major Problem with how Securities Law Determines Accredited Investor Status I’m not a fan of how accredited investors are defined. What’s meant to protect unsophisticated investors from putting money into ventures they don’t understand harms them in other ways. In practice, this securities law creates regulatory capture. It helps rich people to get richer and blocks those aspiring to create wealth from accessing lucrative business deals. There is no correlation between the amount of money someone possesses and their financial sophistication. What accredited investor rules really mean is that you are permitted to invest in private business deals because you already have a lot of money and it won’t hurt too much if you lose some of it. I know many people who are financially literate but prohibited from buying private securities. The only exception for unaccredited investors is if the deal they are being offered comes from “a family member, friend or close business associate”. These are private securities exceptions in British Columbia and many other jurisdictions. In other words, unless my best buddy, my sister, or a close associate at work is offering an unaccredited investor a real estate investment deal, they can’t take part. But if they have a well-paying job or a lots of cash, have at it! That could be about to change. Maybe. A glimmer of hope exists. And it’s coming from south of the border. The United States led the way in investor protection by creating the SEC in the 1930s. Now a (gentle) push is underway to redefine what an accredited investor is. In the U.S., only people with $200,000 or more in annual income or $1 million in net worth, excluding the value of their home, are accredited investors. In a rare example of bipartisanship, two bills have passed through the U.S. House of Representatives that seek to remove the wealth-exclusiveness of the accredited investor club. One bill called the Fair Investment Opportunities for Professional Experts Act recommends that those with certain licences and job experience should be accredited. This would likely include investment advisors, brokers, and ither professions. Here is the exact wording: ‘any natural person the Commission determines, by regulation, to have demonstrable education or job experience to qualify such person as having professional knowledge of a subject related to a particular investment, and whose education or job experience is verified by the Financial Industry Regulatory Authority or an equivalent self-regulatory organization (as defined in section 3(a)(26) of the Securities Ex- change Act of 1934)’ You can see the full Fair Investment Opportunities for Professional Experts Act here: https://docs.house.gov/billsthisweek/20230605/H835_SUS_xml.pdf The other bill to pass the House in June 2023 was the Accredited Investor Definition Review Act. Its intent is similar to the above Fair Investment Opportunities for Professional Experts Act, so I don’t know why we need two bills to be launched that are trying to achieve the same outcome. But both received bipartisan support and were approved by voice votes. The second bill worded its request this way: ‘an individual holding such certifications, designations, or credentials as the Commission determines necessary or appropriate in the public interest or for the protection of investors’ The full bill can be found here: https://docs.house.gov/billsthisweek/20230605/H1579_SUS_xml.pdf These two bills have moved to the Senate and it’s anyone’s guess if they will be supported there. There is very little Democrats and Republicans agree upon, and even if they do, U.S politicians usually find ways to nullify bipartisan agreement through tribal beliefs and blood feud allegiances that are kindly referred to as differences in ideology. Really, it’s a cut-off-my-nose-to-spite-my -face parochialism. It’s the Hatfields versus McCoys: if they propose it, I’ll oppose it, even if I agree with them. Nonetheless, we should be glad a conversation has started about what it means to be an accredited investor. This conversation, as tepid as it is, is important because if changes are made in the U.S., similar legislation could be proposed here in Canada. Canada is a more difficult jurisdiction to achieve change however. The absence of a national markets regulator like the SEC means investor laws would have to be changed province by province. But if the U.S. changes to its accredited investor rules, so should we. In fact, why wait. Canada, do it now! Those with financial acumen should be allowed to invest in private securities, no matter their level of wealth. A Much Better Solution The two American bills currently under consideration ask for people who possess certain licences and professional designations to be accredited. That is still discriminatory. The best answer would be creating an accredited investor curriculum. Anyone could study the curriculum and take an exam. Pass it and you would be an accredited investor, no matter your age, gender, or socio-economic status. This would be fairer. It would open up new investment opportunities for the educated who would now have the certified skills to assess the risk of their investments. And it would create a larger pool of money that could be invested in private real estate deals, start-ups, and other entrepreneurial endeavours. Win-win.
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Cameron MorrellBusiness Educator Archives
November 2024
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