On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Act"). This sweeping financial reform legislation covers issues from banking and securities regulation to corporate governance. Section 413 of the Act — which takes effect immediately — modifies the net worth standard for natural persons (individuals) in the definition of "accredited investor," as defined under Rule 501(a)(5) of Regulation D under the Securities Act of 1933 (the "1933 Act"). This may require companies to revise their private placement memorandum documents for current offerings if the sale of securities has not closed as of July 21, 2010.
Regulation D is a private placement safe harbor adopted by the U.S. Securities and Exchange Commission (the "SEC"), which is commonly used by issuers of securities to avoid the registration requirements under the 1933 Act. From a regulatory perspective, Regulation D provides small to mid-market businesses one of the most efficient means by which to raise equity capital. Under Rule 506 of Regulation D, an issuer of securities in a private placement may sell its securities to an unlimited number of "accredited investors," with no prescribed information disclosure requirements (other than what may apply under the anti-fraud provisions of the federal securities laws), and straightforward, relatively inexpensive state blue sky law compliance through notice filing (thanks to federal preemption).
Prior to the Act's passage, an individual investor's net worth, or joint net worth with that person's spouse, needed to exceed $1 million for that investor to qualify as an "accredited investor." Under the Act, the $1 million minimum net worth threshold remains the same, but excludes the value of the individual investor's primary residence. Issuers of securities in a private placement now may no longer qualify an individual as an "accredited investor" by adding the value of the investor's primary residence to his or her net worth. Consequently, this revision to the net worth calculation makes it more difficult for an individual to qualify as an "accredited investor" (several other tests under the definition have not changed — an investor need only qualify under one of the tests).
The Act does not specify whether an individual investor's mortgage, or other indebtedness secured by the primary residence, must be accounted for. However, the SEC staff has given interpretive guidance that when determining net worth for purposes of Rule 501(a)(5), the value of the person's primary residence must be excluded. Pending implementation of the changes to the SEC's rules required by the Act, the related amount of indebtedness secured by the primary residence up to its fair market value must also be excluded. Indebtedness secured by the residence in excess of the value of the residence should be considered a liability and deducted from the investor's net worth.
The Act provides that the SEC may not modify the net worth requirement during the four years following the enactment of the Act. However, once this four-year period has passed, the SEC is required to review at least once every four years the accredited investor definition as it applies to individuals, including both the net worth and income tests, and make adjustments to the accredited investor definition as the SEC deems appropriate.
The Act also requires the SEC to issue rules disqualifying felons and other "bad actors" from issuing securities under Rule 506 of Regulation D. Not later than one year after the Act's enactment, the SEC must issue rules for the disqualification of offerings and sales of securities made under Rule 506 of Regulation D by a person that has been convicted of any felony or misdemeanor in connection with the purchase or sale of any security or involving the making of any false filing with the SEC. The SEC's rules must also disqualify any person who is subject to a final order of a state or federal agency barring that person from engaging in securities, insurance or banking business activities, or who is subject to a final order based on violations constituting fraudulent or deceptive conduct within the previous ten years. The new rules will also prohibit Rule 506 offerings by companies that meet, or have officers, directors, partners or 10% owners who meet, a variety of additional "bad actor" criteria set forth in existing SEC regulations.
In light of the above, companies in discussions with potential investors about private offerings will need to confirm that such investors qualify as "accredited" under the new net worth standards or under one of the other standards, such as the income tests, which remain unchanged. In addition, companies may want to ensure that prospective investors who may be "bad actors" do not become a director or 10% owner of the company.
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