Rule Change Could Require Closer Adherence to Rule 701 Limits
The US Securities and Exchange Commission has adopted a final rule implementing a new requirement that the value of an individual's primary residence be excluded when determining whether the individual is an accredited investor. The Rule (SEC Release No. 33-9287) was adopted December 21, 2011, to take effect on February 27, 2012. However, the substantive exclusion was part of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank"), which took effect immediately on passage of Dodd-Frank on July 21, 2010.
The "accredited investor" standards under the Securities Act of 1933 (the "'33 Act") are used in determining the availability of certain exemptions from registration for certain securities offerings: Section 4(5) of the '33 Act exempts offers or sales by a company solely to one or more "accredited investor" if the aggregate offering price does not exceed $5 million and certain other conditions are met. Under Rule 505 or 506 (pursuant to Regulation D under the '33 Act) a company does not have to satisfy certain information requirements if sales are made only to accredited investors; and sales to accredited investors do not count toward the 35-purchaser limits under Rule 505 and 506.
The definition of "accredited investor" includes any person who fits within any of eight specific categories at the time of the sale (or whom the company believes fits in a category). The category affected by Dodd-Frank and the new SEC Rule is the category of "individuals with more than $1 million in net worth." Under Dodd-Frank and the new SEC Rule, the individual's "primary residence"1 is not included as an asset, and thus cannot be counted toward the individual's net worth. Debt secured by the primary residence (i.e., a mortgage) is excluded as a liability in determining net worth for this purpose, unless the mortgage is "upside down," in which case the amount by which the indebtedness exceeds the value of the primary residence counts as a liability. To discourage people from mortgaging their homes to buy unregistered securities, any mortgage incurred in the 60 days prior to the sale does count as indebtedness, and would thus reduce net worth for the "accredited investor" calculation.
The only transition provision in the new SEC Rule is one that grandfathers "accredited investor" status with respect to rights to purchase securities (e.g., options) held on July 20, 2010 if the individual was an "accredited investor" on the basis of net worth when the right was acquired and the individual also held other securities of the same company on July 20, 2010.
These exemptions for "accredited investors" can also be significant for companies making compensatory equity grants in reliance on Rule 701 for exemption from registration. Rule 701 is not integrated with other exemptions and thus the company can exclude offers and sales under Rule 505 and 506 (and may thus grant equity awards to "accredited investors") without having those awards count toward the limitations on the amount that may be offered or sold under Rule 701. The need to find exemptions outside Rule 701 may arise, for example, on a review of the company's equity awards in anticipation of an IPO or in preparation for being acquired.
Given the high proportion of an individual's net worth that may be represented by his or her primary residence, the exclusion of that value may change the "accredited investor" status of some employees. Some companies may have been relying on certain employees' status as "accredited investors" to award equity in excess of the amount that would be within the ambit of Rule 701. For companies that need to rely on the "accredited investor" exclusion as well as Rule 701, the impact of the new Rule could be significant and, at a minimum, will require the company to re-examine the accredited investor status of employees. The impact will, of course, vary from company to company.
Even where a company relies on "accredited investor" status as well as Rule 701, some individuals may qualify for "accredited investor" status under other criteria (e.g. income of at least $200,000 in each of the two most recent years (or $300,000 together with their spouse) and with a reasonable expectation of reaching the same level in the current year). The determination of these categories of "accredited investor" were not affected by Dodd-Frank. This may mitigate any adverse effect of excluding the value of the primary residence from the net worth calculation.
Dodd-Frank also requires the SEC to review the "accredited investor" definition in its entirety and make further rules as it deems appropriate, beginning in 2014 and every 4 years thereafter. Therefore there could be additional changes to the definition in the future, even without additional legislation.
Footnotes
1. The term "primary residence" does not have a specific definition. The SEC stated in the Release accompanying the new Rule that "primary residence" has a commonly understood meaning as the home where a person lives most of the time.
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