Qualitative Tests for Accredited Investors: A Comparative Study

[Mehek Wadhwani and Rishi Raj are third-year students of B.A. LL.B. (Hons.) at MNLU Aurangabad]

The Securities and Exchange Board of India (SEBI) recently ushered in the concept of a new class of investors in the Indian securities market, termed as accredited investors or qualified investors or professional investors. On 3 August 2021, the SEBI (Alternative Investment Funds) Regulations, 2012 were amended and notified.  On 26 August 2021, SEBI notified the ‘Modalities for implementation of the framework for Accredited Investors’, wherein it issued certain guidelines on the eligibility criteria for accredited investors, the procedure for validation of accreditation, the procedure to avail benefits linked to accreditation and flexibility of the investors to withdraw their “consent.” 

Before we proceed with our scrutiny of the perceived benefits and a comparative analysis of eligibility criteria, it is necessary to briefly describe this concept. Accredited investors are essentially a class of persons or entities (including family trusts, sole proprietorships, partnerships firms, trusts, and corporate bodies) that are commonly identified by their income and net worth, and are exclusively allowed to invest in those types of securities that are not listed on stock exchanges. It is reckoned that these investors have the sophistication and financial stability to take risks and invest in such unregulated or lightly-regulated investment products. 

Benefits of accredited investment

The benefits specified by SEBI include flexibility for the investors in minimum investment amount (lower ticket size) and exemptions from regulatory requirements applicable to certain investment products. Further, the inclusion of accredited investors in the capital markets will strengthen the management of alternative investments funds (AIFs). This is due to the flexibility in the regulatory framework while trading in various investment products and services that may be beneficial to the expansion of the Indian securities market. It will also ultimately encourage the participation of investment advisory businesses and AIFs to both domestic as well as foreign investors.  AIFs are a vital part of the Indian capital market, and therefore the introduction of the concept of accredited investors within a proper framework has expanded the pool of investors qualified to invest in AIFs. 

The concept of accredited investor will offer up a new investment avenue, allowing more money to flow into the Indian capital market at a time when the country’s economy is recovering at a slower pace due to the ongoing pandemic. As start-ups are unable to raise capital in their early stages, accredited investments through innovative financial products and services are an appropriate solution. Though the market is being opened up to new products and services, the goal is to attract accredited investors rather than smaller individual investors who may not recognize the risk or lack financial funds to invest or bear the risk.

Comparative analysis of eligibility criteria for the accredited investors

In determining whether the framework introduced by SEBI is consistent with other selected jurisdictions, we have undertaken a comparative analysis of the eligibility criteria for accredited investors. Our primary goal is to determine whether the parameters provided under the Indian framework need to be modernized to bring it at par with the other jurisdictions.

The Indian position 

In India, the qualifying criterion stipulated under the amended regulation 2 of the SEBI AIF Regulations, 2012, is based on financial parameters such as annual income and net worth. We believe that such minimum thresholds are in place to protect the investors lacking adequate financial stability from unsuitable investment products. In the case of an individual, Hindu undivided family (HUF), family trust, or sole proprietorship, the requirements to be granted the certificate of accreditation include (a) an annual income of INR 2 crores, or (b) net worth of INR 7.5 crores, with at least INR 3.5 crores being in the form of financial assets, or (c) annual income of INR 1 crore with a minimum net worth of INR 5 crores, out of which at least INR 2.5 crores is in the form of financial assets.  In the case of a body corporate and trust other than a family trust, the minimum net worth required is INR 50 crores.  Further, in the case of a partnership firm, every partner independently must meet the eligibility criteria for accreditation. 

Apart from these parameters, the amended regulations also provide for a deemed accredited investor status to certain specified entities. These deemed accredited investors are not required to obtain certification from the accreditation agency. Prima facie, we see that in the current definition of accredited investors, except for the deemed accredited investors, the eligibility criterion for individuals is based entirely on the monetary thresholds. In our opinion, apart from the quantitative criterion, the knowledge and acumen of the investor must also be considered.  Our opinion finds favour in the proposal made by the  Alternative Investment Policy Advisory Committee (AIPAC) in the AIPAC report 2, wherein a ‘qualitative eligibility test’  based on acumen and knowledge, was recommended in order to make the regime more inclusive. A 15-question test to ascertain the knowledge of the investor was proposed. Such qualitative criterion is explicitly lacking in the current framework, and herein lies the difference in the Indian framework, from that of the other jurisdictions.

The US position 

In the US, the Securities and Exchange Commission (SEC) has modernized the definition of accredited investors through the 2020 amendment of the Securities Act of 1933 (Act), prior to which the definition of accredited investor had hardly changed for over 35 years. Earlier, to qualify as accredited investors, there were only two paths: firstly, the wealth test, and secondly the income test. The income test requires that an accredited investor has had an individual income of at least $200,000 in each of the previous two years, or a minimum of $300,000 combined income with a spouse. The wealth test requires an accredited investor to have a net worth of more than $1 million, excluding the value of the home residence. It is noteworthy that the inclusion of these tests was considered to be a ‘numb and check’ test of an accredited investor’s financial acumen, financial stability, and ability to absorb possible financial losses. 

The newly added definition under rule 215 and 501(a) of Regulation D of the Act provides that irrespective of a person’s wealth, she can qualify as an accredited investor if she: firstly, has certain certification, designations, and other credentials which are issued by an accredited educational agency or, secondly, has the expertise or past experience and previous knowledge of trading in private securities. The logic employed in the first test is that those individuals who have obtained such certifications (Series 7, Series 65, Series 82) and have maintained them in good standing, possess the required financial sophistication. Further, a recent Bill, i.e. the Equal Opportunity for All Investors Act of 2021, deliberates on certification exams for accredited investors, to measure their financial acumen. In light of these certifications, it must be noted that the AIPAC 2 report had deliberated on the requirement of comparatively similar qualitative eligibility tests. 

The UK position

The term “elective professional client” is synonymous with the US term “accredited investor”.  The Financial Conduct Authority (FCA) regulates the working of “elective professional clients”. The FCA stipulates that an individual may be classified as an elective professional client if she fulfils at least two out of three quantitative criteria mentioned in the FCA’s handbook. The criteria provide that an individual has to: firstly carry out a transaction of significant size in the relevant market; secondly, individual’s financial instrument portfolio should be more than EUR 500,000; thirdly the individual must have past expertise of at least one year as a financial professional, which requires knowledge of the transaction. 

It is noteworthy to observe that the quantitative criteria in the UK are similar to the newly added provisions of the Act. However, the UK adopts a hybrid test since it contains monetary criteria and might also consider financial sophistication when classifying a person as an elective professional client.

Conclusion

In our opinion, using only a binary test of wealth or income is disadvantageous to the individual investors who do not meet the wealth tests, but possess the financial sophistication, knowledge, and expertise to thoroughly understand the risks involved. We believe that expanding the definition, as seen in the US and UK,  to include an alternative to the wealth test for natural persons is a credible move to bring flexibility to the definition and to ensure that the qualifying individuals and entities demonstrating adequate financial sophistication are not excluded from availing the benefits of being deemed as accredited investors. 

Our observations and recommendations herein have been made while keeping in mind that the depth of the more developed capital markets, the sophistication of the investors, and the role of the market regulators in the selected jurisdictions are significantly different as compared to India. The most noteworthy roadblock in replicating the described qualitative tests in the Indian markets is the traditionally conservative approach that SEBI has been known to take, which compels it to adopt the current framework where accreditation is based on financial tests alone. However, we believe that incorporating the qualitative test in the Indian market has the potential to expand the pool of accredited investors and amplify the benefits envisaged by SEBI. Therefore, we suggest that within reasonable limits, SEBI must ensure that it updates its definition of accredited investors in due time to bring it in line with the modernized definitions. Additionally, they must also reflect upon the latest deliberations regarding the plans to update the financial thresholds in the definition of accredited investors.  

Mehek Wadhvani & Rishi Raj

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