In the wake of the 2007 Wall Street crash and economic recession, the Obama Administration has responded with attempts to reform financial regulation in America. The most sweeping changes to financial regulation can be found in the Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203, H.R. 4173 (the “Act”), which was enacted into law on July 21, 2010.
Proposed in December of 2009 by Congressman Barney Frank and Senate Banking Committee Chairman Chris Dodd, the Act, among many other reforms, makes a subtle, yet significant revision to the definition of “Accredited Investor” found in the Securities Act of 1933, Rule 215 and Regulation D, Rule 501(a)(5), for the “protection of investors, in the public interest, and in light of the economy.”
Prior to July 21, 2010, under Regulation D, Rule 501(a)(5), “any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his purchase [of securities] exceeds $1,000,000.00” qualified as an Accredited Investor.
While that is still technically true, the Act requires that one “exclude the value of the primary residence of such natural person [1. In general, the Commission shall adjust any net worth standard for an accredited investor, as set forth in the rules of the Commission under the Securities Act of 1933, so that an individual net worth of any natural person, or joint net worth with the spouse of that person, at the time of purchase, is more than $1,000,000.00 (as such amount is adjusted periodically by rule of that Commission), excluding the value of the primary residence of such natural person, except that during the 4-year period that begins on the date of enactment of this Act, any net worth standard shall be $1,000,000.00 excluding the value of the primary residence of such person. H.R. 4173 § 413(a)]” when determining whether their net worth exceeds $1,000,000.00. Put simply, issuers and investors can no longer consider the investor’s primary residence, often their most valuable asset, for purposes of determining whether they are an “Accredited Investor” for compliance with the rules and regulations governing private offerings of securities. This makes it a bit harder for entrepreneurs and new small businesses who are raising capital through private offerings to find investors and raise money, because it is now harder for people to qualify as Accredited Investors.
To avoid the registration requirements of the Securities Act of 1933, issuers must comply with a number of different rules and regulations such that their private offering and securities will be deemed exempt from registration. Issuers who rely on Rule 4(6) (transactions involving offers or sales by an issuer solely to one or more Accredited Investors), or Regulation D, Rules 505 and 506 (which discount Accredited Investors for purposes of satisfying specific limitations on the number of purchasers allowable in an offering), must now reevaluate potential investors and whether they still qualify as an Accredited Investor for purposes of their securities offerings.
While there are still other ways to qualify as an Accredited Investor, many individuals will no longer be allowed to participate in private offerings by Hedge Funds, partnerships and other joint ventures. Homeownership used to open doors to such investment opportunities, but now, the government has determined that merely owning a home that pushes you over the $1,000,000.00 threshold does not mean you are sophisticated or investment-savvy enough to manage your own money. The number of Accredited Investors just shrunk, meaning small businesses have less options in raising capital, and many Americans have less opportunities to finally see the money they’ve worked hard for finally turn around and work for them.
The Securities Exchange Commission (“SEC”) recently commented on the Act’s impact on its rules and regulations. Noting that the Act does not define the term “value” regarding the purchaser’s primary home or residence, nor does it address the treatment of mortgage or other indebtedness secured by the residence for the purposes of the net-worth calculation, the SEC stated that “the related amount of indebtedness secured by the primary residence up to its fair market value may also be excluded. Indebtedness secured by the residence in excess of the value of the home should be considered a liability and deducted from the investor’s net worth.[2. http://www.sec.gov/divisions/corpfin/guidance/securitiesactrules-interps.htm] ”
We can expect the SEC to issue amendments to its Rule 215 and Regulation D, Rule 501(a)(5) to conform them to the adjustment to the Accredited Investor net worth standard made by the Act. The Act goes further in granting the SEC the authorization to review and revise the Accredited Investor definition as it applies to natural persons.[3. Note, however, that the SEC cannot change the net worth standard of $1,000,000.00 for 4 years from the date of the Dodd-Frank Act (July 21, 2010). After 4 years, the SEC must review and reconsider the Accredited Investor standards at least once every 4 years thereafter. ]
In the meantime, the revisions to the Accredited Investor Standard are effective immediately, and any private offering that has not closed prior to July 21, 2010 must comply with the new standard.
Issuers of securities hoping to conduct private offerings that are exempt from the registration requirements of the Securities Act of 1933 should consult with their corporate counsel to make sure they’re complying with the new laws. All “standard” Accredited Investor Questionnaires and Accredited Investor Representations and Warranty provisions in Subscription Agreements and Private Placement Memorandums will need to be revised to reflect the new restrictions on the definition of Accredited Investor. Issuers with open and or pending private offerings may want to consider obtaining updated Accredited Investor representations from their investors that clearly identify the new standard, as it is unclear whether or not it would be reasonable for an issuer to rely on the standard pre-July 21, 2010 representations and warranties concerning net worth.
It is important to note that the penalties for failing to qualify for an exemption on a private offering can be severe, and may result in the need to conduct a costly rescission offer (i.e., giving investors the right to get their money back, plus interest), injunctive relief, fines and penalties, and possible criminal prosecution.
In my view, as a corporate/securities lawyer working with clients that want to raise money to get their businesses off the ground, this is one element of financial regulation reform in America that doesn’t seem well-suited towards getting the economy back on it’s feet. Investments in small businesses will inevitably be hampered by this revision to the Accredited Investor standard. How badly? I’m not sure, but in a struggling economy that needs private-sector job creation, regulations that keep any amount of private capital on the sidelines are not helpful.