United States: SEC Adopts Revised Net Worth Standards For Accredited Investors

Last Updated: March 1 2012
Article by Thao Ngo and Alicia C. Thanasoulis

Prior to the enactment of The Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"), individuals were allowed to include the value of their primary residence in calculating their net worth for purposes of determining whether they qualify as "accredited investors." However, Section 413(a) of the Dodd-Frank Act now requires the exclusion of the value of an individual's primary residence when determining whether such individual qualifies as an accredited investor on the basis of having net worth in excess of $1 million. Although this change became effective immediately upon the passage of the Dodd-Frank Act on July 21, 2010, Section 413(a) required the Securities and Exchange Commission (the "SEC") to change the definition of who an "accredited investor" is for purposes of Regulation D under the Securities Act of 1933 (the "Securities Act"), to conform the Securities Act rules to the new accredited investor net worth standard mandated by the Dodd-Frank Act. The SEC adopted the final rule amendments to the net worth standard for accredited investors set forth in Rule 215 and Rule 501 under the Securities Act (the "Rules") on December 21, 2011 (the "Adopting Release").1

The New Net Worth Standard

The SEC's revised net worth standard provides that when a person (individually or jointly with his or her spouse) calculates whether such person has a net worth in excess of $1 million:

  • The person's primary residence2 will not be counted as an asset, thereby excluding any positive equity the person may have in the residence
  • Debt secured by the person's primary residence will not be counted as a liability, except for:
    • The amount of any such debt in excess of the estimated fair market value of the primary residence at the time of the sale of securities
    • The amount of any such debt incurred within 60 days prior to the sale of securities, unless such debt is incurred in connection with the acquisition of the primary residence

All tests under the accredited investor definition are measured "at the time of the sale of securities to that person." Thus, if a person loses his or her status after receiving the offering materials but before buying the securities, that person is not an accredited investor.

Treatment of Mortgage Debt

Underwater Mortgages. If the amount of the mortgage exceeds the value of the primary residence, the excess of the amount of the mortgage over the fair market value of the primary residence is included as a liability for purposes of calculating a person's net worth. In the Adopting Release, the SEC clarified that the excess indebtedness must be counted as a liability in the net worth calculation even if the laws of the state in which the person's primary residence is located would prohibit a lender from seeking repayment from the person's other assets if the person's mortgage goes into default.3

Appraisal. The SEC clarified that the Rules do not require a third-party opinion or valuation for purposes of determining the fair market value of either the primary residence or for any other assets or liabilities, and that all that is required is an estimate of fair market value.

Increases in Mortgage Debt in the 60 Days Before the Sale of Securities. The Rules provide that any incremental debt secured by the primary residence incurred in the 60 days before the sale of securities to a person generally will be counted as a liability, even if the estimated value of the primary residence exceeds the aggregate amount of debt secured by such primary residence. The SEC stated that the purposes of this 60-day look-back is (i) to discourage individuals from manipulating their net worth by borrowing against their primary residence shortly before seeking to qualify as an accredited investor, to take advantage of any positive equity in the primary residence; and (ii) to reduce the incentive for salespeople to encourage individuals to incur additional debt secured by their homes to facilitate a near-term investment in securities.

The Rules, however, provide an exception to the 60-day look-back provision for increases in debt secured by a primary residence where the debt results from the acquisition of the primary residence. Without this exception, an individual who acquires a new primary residence in the 60-day period before a sale of securities may have to include the full amount of the mortgage incurred in connection with the purchase of the primary residence as a liability, while excluding the full value of the primary residence, in a net worth calculation. The 60-day look-back provision is intended to address incremental debt secured against a primary residence that is incurred for the purpose of inflating net worth. It is not intended to address debt secured by a primary residence that is incurred in connection with the acquisition of a primary residence within the 60-day period.

Transition Rules

The revised net worth standard will not generally be "grandfathered" into effectiveness, and it will apply to all investors as of the effective date of the Rules except in certain limited circumstances. Specifically, the Rules permit issuers and investors to use the accredited investor net worth test in effect prior to the enactment of the Dodd-Frank Act for the purchase of securities in accordance with a right to purchase such securities so long as: (i) the securities are sold to an investor pursuant to a contractual purchase right held by the investor on July 20, 2010, the day prior to the enactment of the Dodd-Frank Act; (ii) the investor qualified as an accredited investor on the basis of net worth at the time the contractual purchase right was acquired; and (iii) the investor held securities of the same issuer, other than the contractual purchase right, on July 20, 2010.

In the Adopting Release, the SEC stated that the grandfathering provision applies to the exercise of statutory rights, 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.

Recommendations

Issuers, such as private funds, that rely on the accredited investor standards to determine the availability of certain exemptions from Securities Act registration for private and other limited offerings should ensure that they have a reasonable belief that prospective investors qualify as accredited investors going forward. Accordingly, such issuers should revise their offering documents, subscription documents and investor questionnaires, as applicable, to account for the new accredited investor standards.

In addition, such issuers should consider reviewing the investor qualification standards of their existing entity investors where such entity investors qualified as accredited investors solely because all of their underlying owners are accredited investors in the event that such entity investors seek to make additional investments in such issuers. This is because some of the underlying owners of such entity investors may no longer qualify as accredited investors in light of the new accredited investor standards.

Effective Date

The SEC's new accredited investor net worth rules will be effective February 27, 2012.

Footnotes

1. See Net Worth Standard for Accredited Investors, Securities Act of 1933, Release No. 33-9287 (December 21, 2011), available at: www.sec.gov/rules/final/2011/33-9287.pdf.

2. In the Adopting Release, the SEC does not define "primary residence" but interprets this term to mean the home where a person lives most of the time. See Adopting Release at page 21.

3. The SEC reasoned that if it were to adopt such a view, it would add substantial complexity to the Rules if market participants were required to determine how an anti-deficiency statute would operate in each person's individual circumstances.

This article is presented for informational purposes only and is not intended to constitute legal advice.

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