On October 11, 2010, I wrote an article about the Obama Administration’s sweeping changes to financial regulation in the Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203, H.R. 4173 (the “Act”).
In particular, I focused on Section 413(a); a subtle, yet significant revision to the definition of “Accredited Investor” in the Securities Act of 1933, Rule 215 and Regulation D, Rule 501(a)(5).
Prior to July 21, 2010, “any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of the purchase [of securities] exceeded $1,000,000.00,” qualified as an Accredited Investor.
At the time of my first article, all we knew was that the Act required issuers and investors to start excluding the value of the investor’s primary residence when determining their net worth. It was not clear, however, as to how issuers and investors were supposed to “value” the primary residence, and how to account for any equity or debt with respect thereto.
Issuers were left waiting and guessing how the Securities and Exchange Commission (the “SEC”) would actually enforce this new legislation, leaving reliance on this Accredited Investor standard a risky endeavor for issuers hoping to conduct private offerings pursuant to exemptions from securities registration under Regulation D. Whether or not a potential investor was an Accredited Investor under the net-worth standard depended on how one chose to do the math.
Finally, the SEC has recently issued a Final Rule on the subject of net worth standards for Accredited Investors, giving issuers clarity and certainty on how to determine whether certain potential investors qualify as Accredited Investors. The final rule is as follows:
To be an Accredited Investor under the net-worth standard, an investor must be:
“… a natural person whose individual net worth, or joint net worth with that person’s spouse, exceeds $1,000,000. For purposes of calculating net worth under this paragraph: (i) The person’s primary residence shall not be included as an asset; (ii) Indebtedness that is secured by the person’s primary residence, up to the estimated fair market value of the primary residence at the time of the sale of securities, shall not be included as a liability (except that if the amount of such indebtedness outstanding at the time of the sale of securities exceeds the amount outstanding 60 days before such time, other than as a result of the acquisition of the primary residence, the amount of such excess shall be included as a liability); and (iii) Indebtedness that is secured by the person’s primary residence in excess of the estimated fair market value of the primary residence at the time of the sale of securities shall be included as a liability.”
The rule itself is complicated, but stated as simply as possible, positive equity in one’s primary residence does not count toward the $1,000,000 threshold. If you have a $1M primary residence, and even if it is fully paid for, it does not count towards your net worth. On the flip side, debt secured by the primary residence does not count against your net worth, except where it exceeds the fair market value of the home (by reducing your net worth dollar-for-dollar), or where the debt secured by your home has increased in the 60 days prior to the sale of the Securities, the increase in debt shall count against your net worth (by reducing your net worth dollar-for-dollar).
A very limited exception to this new rule exists for investors who qualified as Accredited Investors under the previous net-worth definition, owned securities of the issuer as of July 20, 2010, and held a right to acquire additional securities of the issuer as of July 20, 2010. This exception offers no relief from the heightened net-worth requirements imposed by the Act for first-time issuers, newly formed funds and in the case of investors looking to diversify their portfolios with new investments.
Clearly, the Act’s tighter standards and the SEC’s accompanying rules provide a frustrating obstacle to investment for both issuers and investors alike. Issuers and investors can no longer consider the investor’s primary residence, often their most valuable asset, for purposes of determining whether they can participate in a private offering. This means far fewer people will be able to participate in Regulation D private offerings, limiting their investment options. It also means that issuers will have a smaller pool of potential investors to bring into their private placements.
On the other hand, if there are any positives that come out of the new SEC rules, its that the new net-worth standard is now clear, and the easier to apply, making it easier for issuers to rely on.
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.
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 SEC Final Rules. 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 include the specific language of the new SEC Final Rules. Issuers with open and/or pending private offerings should obtain updated Accredited Investor representations from their investors who have invested based on qualification under the new net-worth standard.