The Securities and Exchange Commission recently finalized its rules to conform the definition of "accredited investor" to the requirements under the Dodd-Frank Wall Street Reform and Consumer Protection Act. The SEC's rules clarify the treatment of debt secured by a primary residence in the calculation of an individual's net worth under Regulation D. The SEC also grandfathered into the rules the application of the prior net worth calculation for certain purchase rights, such as pre-emptive rights, existing prior to the enactment of the Dodd-Frank Act in July 2010.

Summary of Changes to Accredited Investor Definition

Regulation D provides that a "natural person whose individual net worth, or joint net worth with that person's spouse, exceeds $1,000,000" is an "accredited investor." Although SEC rules do not define the term "net worth," the SEC has acknowledged that a common understanding of the term is "the difference between the value of a person's assets and the value of the person's liabilities." The SEC's amendments modify this common formulation by excluding an individual's primary residence in calculating net worth for purposes of determining accredited investor status. The amendments also exclude the amount of debt secured by the property, up to the estimated fair market value of the property. Any debt in excess of estimated fair market value is included in the calculation. Thus, any positive equity in a person's primary residence is excluded from the net worth calculation. If a mortgage is underwater, the amount by which the mortgage is underwater is included.

To deter a potential investor from increasing net worth by borrowing against a primary residence prior to making an investment, the SEC amendments reduce the amount of the investor's net worth by the amount of his or her borrowings secured by the primary residence within 60 days prior to the sale, unless the investor incurred the borrowings to purchase the primary residence. This prevents a potential investor from borrowing against a home equity line of credit to increase the investor's cash position (increasing net worth) to satisfy the new accredited investor definition.

The SEC declined to define primary residence, although the SEC stated in its release that a primary residence has a commonly understood meaning as the home where a person lives most of the time. The SEC also declined to provide guidance on determining the fair market value of a primary residence.

Grandfathering for Pre-Existing Rights to Participate in Follow-on Investments

The SEC's rules provide an exception to the new exclusion of a primary residence from the net worth test, so that an existing investor who would no longer qualify as an accredited investor as a result of the exclusion of the primary residence could continue to make subsequent investments pursuant to a right to invest that existed prior to the enactment of the Dodd-Frank Act. To qualify for the exclusion, the investor must have:

  1. held the right to purchase the securities on July 20, 2010 (the day prior to the enactment of the Dodd-Frank Act);
  2. qualified as an accredited investor on the basis of net worth at the time the investor acquired the right to purchase the security; and
  3. held securities of the same issuer, other than the right to purchase, on July 20, 2010.

Trap for the Unwary

A Potential Investor Must Still Otherwise Qualify as an Accredited Investor. While the SEC provided an exception for rights to purchase held prior to enactment of the Dodd-Frank Act, a potential investor must still qualify as an accredited investor at the time of the subsequent sale of securities. The SEC's exception only provides that home equity may be included in measuring net worth at the time of the subsequent sale if the conditions described above are met.

The SEC is required by the Dodd-Frank Act to review the accredited investor definition in its entirety in 2014 and every four years thereafter, and is authorized to engage in further rulemaking as it deems appropriate.

Additional Information

This update is only intended to provide a summary of the SEC's final rule. You can read the full text of the rule at http://sec.gov/rules/final/2011/33-9287.pdf. You can find our other Financial Reform Act updates at http://www.perkinscoie.com/thefinancialreformact/. You can find discussions of other recent cases, laws, regulations, and rule proposals of interest to financial institutions on our Web site.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.