On Dec. 21, 2011, the Securities and Exchange Commission published a final rule amending the definition of an “accredited investor” found in Rules 215 and 501 under the Securities Act of 1933. The amendments implement the requirements set forth in Section 413(a) of the Dodd-Frank Act that an individual exclude the value of his or her primary residence when calculating whether his or her net worth exceeds the $1 million minimum requirement for qualifying as an accredited investor. The final rule also addresses certain interpretive and technical issues and will become effective 60 days after it is published in the Federal Register.
The change primarily affects companies and funds (such as hedge funds, private equity funds and real estate funds) that rely on one of the “private placement” exemptions found in Regulation D (Rules 504, 505 and 506 under the Securities Act) from the registration requirements of the Securities Act in raising private capital from individual investors. Thousands of companies, both public and private, raise capital through private placements primarily to accredited investors under Regulation D. One of the means by which an individual investor may qualify as an accredited investor is by having a net worth of at least $1 million.
Revised Net Worth Calculation
Pursuant to the final rule, in calculating an individual’s net worth:
- the individual’s primary residence cannot be included as an asset;
- indebtedness that is secured by the individual’s primary residence (e.g., a mortgage), up to the estimated fair market value of the primary residence at the time of the sale of securities, will not be subtracted as a liability; and
- indebtedness that is secured by the individual’s primary residence in excess of the estimated fair market value of the primary residence at the time of the sale of securities must be subtracted as a liability.
In a significant change from the proposed rule, indebtedness secured by the primary residence that is incurred in the 60 days prior to the sale of the securities must be subtracted as a liability, unless the indebtedness is a result of the acquisition of the primary residence. This provision applies even if the total indebtedness secured by the individual’s primary residence is less than the estimated value of the primary residence. The SEC noted that this provision is intended to reduce incentives for an individual to increase the debt secured against his or her residence solely for the purpose of making investments and/or qualifying as an accredited investor.
Note that the final rule does not define the terms “net worth” (which the SEC notes is commonly understood to mean the difference between the value of an individual’s assets and the value of his or her liabilities) or “primary residence” (which the SEC notes is commonly understood to mean the home where a person lives most of the time).
Further, the SEC rejected suggestions from a number of commentators that nonrecourse mortgages should be excepted from the requirement to subtract the “shortfall” in estimated fair market value of the primary residence for underwater mortgages. There are no exceptions to this “shortfall subtraction” requirement.
The final rule also includes grandfathering provisions for investment decisions made prior to the enactment of the Dodd-Frank Act (which is also a significant change from the proposed rule). Specifically, the revised net worth calculation will not apply to a purchase of securities in accordance with a right to purchase such securities, provided that: (i) the right was held by the individual on July 20, 2010; (ii) the individual qualified as an accredited investor on the basis of net worth at the time the individual acquired such right; and (iii) the individual held securities of the same issuer, other than such right, on July 20, 2010.
The grandfathering provision also applies to the exercise of statutory rights in connection with an investor’s pre-existing rights to acquire securities (such as pre-emptive rights arising under state law), rights arising under an entity’s constituent documents and contractual rights (such as rights to acquire securities upon exercise of an option or warrant or upon conversion of a convertible instrument, rights of first offer or first refusal‚ and contractual pre-emptive rights).
Funds and companies should revisit their offering documents, subscription documents and investor questionnaires to reflect the revised definition of accredited investor, even if these documents were already updated in light of the Dodd-Frank Act and the SEC’s proposed rule.
For assistance, please contact the following lawyers
Investment Management Partners:
Marion Giliberti Barish
David C. Boch
Lea Anne Copenhefer
Steven M. Giordano
Richard A. Goldman
Steven W. Hansen
Thomas John Holton
Barry N. Hurwitz
Roger P. Joseph, Practice Group Leader; Co-chair, Financial Services Area
Amy Natterson Kroll
Michael P. O’Brien
Nancy M. Persechino
Paul B. Raymond
Toby R. Serkin
L. Kevin Sheridan Jr.
Edwin E. Smith, Co-chair, Financial Services Area
Tim Burke, Co-chair, Financial Services Area
Joshua B. Sterling
Stephen C. Tirrell