SEC Adopts Final Net Worth Standard For Accredited Investors
The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”)1 changed the investor net worth standard that applies to natural persons (individually or jointly with their spouse) to exclude the value of the primary residence for purposes of determining whether the persons qualify as an “accredited investor” on the basis of having a net worth in excess of $1.0 million. This change to the net worth standard became effective on July 21, 2010. Dodd-Frank also required the SEC to revise its rules under the Securities Act of 1933 (the “Securities Act”) to conform to the new standard.2 The SEC has now amended its rules to conform them to Dodd-Frank and to clarify the treatment of debt secured by a person's primary residence for purposes of the net worth calculation.3 The amended net worth standard will be effective February 27, 2012 and as discussed in greater detail below issuers will likely need to revise investor questionnaires for any Regulation D offers or sales on and after that date (including sales to existing investors).
The “accredited investor” definition is set forth in Securities Act Rules 215 and 501. The changes to the accredited investor definition are of significant importance to issuers as various exemptions for private or other limited offerings of securities under the Securities Act and state “blue sky” laws depend on whether participants are “accredited investors.” One of the bases on which an individual may qualify as accredited is having a net worth of at least $1.0 million, either alone or together with their spouse. Section 4(5) of the Securities Act exempts transactions involving offers or sales by an issuer to one or more accredited investors if the aggregate offering price does not exceed $5.0 million so long as no advertising or general solicitation is present. Non-accredited investors who participate in private offerings under Rule 505 or Rule 506 of Regulation D must receive financial and other information that is not required to be given to accredited investors, and in offerings relying on Rule 506 there is a limit of 35 non-accredited investors. Moreover, accredited investors are not subject to the “sophistication” requirement that Rule 506 imposes on non-accredited investors.
In addition to conforming Regulation D to Dodd-Frank's exclusion of the value of a person's primary residence for purposes of calculating net worth, Rule 501(a)(5) now also provides that indebtedness secured by a person's primary residence, up to the estimated fair market value of the primary residence, is not treated as a liability. Any secured indebtedness in excess of the property's estimated fair market value must be treated as a liability for purposes of calculating net worth.
The amendments also require that any borrowings incurred by an investor in the 60 days preceding the purchase of securities in an exempt offering that are secured by the primary residence but are not used to purchase the residence must be counted as a liability in the net worth calculation. The SEC explained that this new provision is intended to prevent manipulation of the net worth standard by eliminating the ability of individuals to artificially inflate net worth via home equity loans shortly before participating in an exempt securities offering.
To summarize, in determining an investor's net worth (assets over liabilities):
- First: Exclude an investor's primary residence as an asset;
- Second: Exclude any debt secured by the primary residence, up to the estimated fair market value of the residence;
- Third: Include the amount of any increase in the debt secured by the primary residence incurred within 60 days prior to the purchase of the securities (unless incurred in connection with the acquisition of the primary residence); and
- Fourth: Include all debt secured by the primary residence in excess of the fair market value of the primary residence.
Citing investor protection concurs and the fact that issuers have operated under the new rule for over a year, the SEC did not adopt a grandfathering provision permitting investors to participate generally in follow-on offerings if the investors are no longer accredited under the new net worth standard. The exception is that an investor will be considered accredited for purposes of purchasing securities pursuant to a pre-existing purchase right that the investor held as of July 20, 2010, as long as the investor qualified as an accredited investor on the basis of net worth at the time he acquired such right, and held securities of the same issuer (other than such right) on July 20, 2010.
The new net worth standard must remain in effect until July 21, 2014, four years after enactment of Dodd-Frank. Beginning in 2014, the SEC is required to review the “accredited investor” definition every four years and engage in further rulemaking to the extent it deems appropriate.
What to Do?
Because Regulation D requires that “accredited investor” status be determined and documented at the time of investment, investors relying on the $1.0 million net worth test must confirm that their net worth is calculated without including the value of their primary residence.
Although many issuers have already modified their subscription documents to require investors to calculate and certify net worth excluding the value of the investor's primary residence, and excluding any mortgage on the primary residence up to the value of the home, after effectiveness of the new provisions calculations of net worth should also include as a liability any increase in debt secured by the investor's primary residence (which was not incurred in connection with the purchase of the home) in the 60 days preceding the purchase of securities in the Regulation D offering.
This Alert has been prepared for general informational purposes only and is not intended as specific legal advice and no legal or business decision should be based solely on its content.
- The Dodd-Frank Wall Street Reform and Consumer Protection Act is available at: http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=111_cong_bills&docid=f:h4173enr.txt.pdf.
- Dodd-Frank §413(a).
- Net Worth Standard for Accredited Investors, SEC Release No. 33-9287 (December 21, 2011) (available at: http://www.sec.gov/rules/final/2011/33-9287.pdf).