NEW YORK (MarketWatch) -- Goldman Sachs Group Inc. /quotes/comstock/13*!gs/quotes/nls/gs (GS 156.13, -1.27, -0.81%) has emphasized in its response to civil fraud charges that the financial institutions it allegedly duped in a complex derivatives sale were sophisticated investors who understood the transaction well.
Although individual investors weren't involved, the case highlights a persistent and vexing question for the investment industry and its clients: Just who, or what, is a sophisticated investor?
It's both a legal distinction and a commonly used description, both of which are subject to interpretation. This category of investor is one of several the Securities and Exchange Commission established to limit access to certain harder-to-understand products.
Sophisticated investors, according to part of the SEC's definition, have enough knowledge and experience in business matters to evaluate the risks and merits of an investment. The SEC exempts small companies from registering certain securities sold to these investors.
A more restrictive category features "accredited investors." These include institutions such as banks, insurance companies and registered investment companies, as well as individuals with a net worth of more than $1 million, including the value of their home, or an income above $200,000 for individuals and $300,000 for couples. These investors can be sold a variety of unregistered securities and vehicles, such as interests in certain hedge funds and private placements of shares in a company.
Individuals in this category could, in theory, invest in other complex instruments such as the synthetic collateralized debt obligations sold in the Goldman case. But the size of these deals, which can involve hundreds of millions of dollars, means those arranging them want relatively few and large investors, typically institutions, that have been involved in similar transactions and can withstand potential losses, according to a structured products consultant.
The thresholds for accredited investors were set in the 1980s, when a $200,000 annual income was less common than today, and it's hard to argue that kind of income guarantees sophistication in financial affairs. The sweeping financial reform bill in the Senate includes a provision for adjusting these levels to inflation and for studying if they need bigger changes. The SEC proposed increasing the thresholds several years ago, but investors who didn't want their options limited protested.
Some investment vehicles, including certain types of hedge funds, require investors to meet a still higher threshold for "qualified purchasers." According to SEC rules, this category includes individuals who own investments valued at $5 million or more.
Brokerage firms defending themselves against claims they sold investors unsuitable products routinely describe those clients as sophisticated investors who understood what they were buying, according to securities attorneys.
The arbitrators who hear cases brought before the Financial Industry Regulatory Authority's arbitration forum rarely include explanations with their decisions. But attorneys said an investor's experience and wealth, or lack thereof, does factor into the decisions.
The multiple standards for investors hinge on the notion that someone who has acquired a sizable amount of money must know something about making money. The guidelines also suggest wealthy investors can afford to take more risk than people who are scraping by and they can afford to hire consultants to help them analyze investments.
But "wealthy" doesn't necessarily mean "financially savvy." Just ask a lottery winner or multimillionaire who inherited her money.
Offering memorandums for private placements describes the objectives, risks and terms of investment. Investors complete and sign a subscription agreement attesting to their suitability for an investment. These documents are meant to both give investors details about the offering and protect the seller from liability.
"The reality is investors should read the prospectus and pay attention to what's going on, whether they're accredited or not," said John Mauldin, who heads investment advisory firm Millennium Wave Investments and writes a newsletter for accredited investors. "They should know what they're investing in. If you don't understand it, don't invest."
