Amendments to Net Worth Standard for Accredited Investor Status Impact Private Placements of Securities

The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd Frank Act”) which became law on July 21, 2010, changed various rules governing private and other limited sales of securities exempt from the registration requirements of the Securities Act of 1933, as amended (the “Securities Act”). Specifically, Section 413(a) of the Dodd-Frank Act requires the United Stated Securities and Exchange Commission (the “SEC”) to adjust the net worth standards for a natural person qualifying as “accredited investors” to greater than $1,000,000, excluding the value of the primary residence of the natural person. Previously, these standards required a net worth of more than $1,000,000, but permitted the primary residence to be included in calculating net worth. The change to remove the value of the primary residence from the net worth calculation became effective upon enactment of the Dodd-Frank Act.

Section 413(b) authorizes the SEC to undertake a review of the definition of “accredited investor” as it applies to a natural person and requires the Commission to undertake a review of the definition, in its entirety, every four years, beginning four years following the enactment of the Dodd-Frank Act.

Conforming Rule Changes Proposed by the SEC

On January 25, 2011, the SEC proposed amendments to its rules proscribing accredited investor standards in order to conform such rules to the requirements of the Dodd-Frank Act. The proposed rules are available here. Other than providing clarification of the elimination of the value of a natural person’s residence from the calculation of net worth, the SEC has not proposed any other modifications to the accredited investor standards at this time.

The change to the natural person accredited investor standard mandated by the Dodd-Frank and any additional modifications which may be proscribed by the Commission in the future, are likely to cause fewer individuals to qualify as accredited investors and may thereby reduce available private capital to entrepreneurs and smaller companies.

Regulation D, adopted by the SEC in 1982, was designed to facilitate capital formation by providing “safe harbors” for qualification under various exemptions from the registration requirements under the Securities Act. Rule 506, frequently relied upon for private placements of securities, is a safe harbor under Section 4(2) of the Securities Act and provides an exemption without a limit on the offering amount, so long as sales are made without general solicitation or advertising and sales are made only to accredited investors and a limited number of non-accredited investors.

The proposed amendment to the definition of accredited investor in Rule 501 of Regulation D and also in SEC Rule 215 would define an accredited investor as, among things:

Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of purchase, exceeds $1,000,000, excluding the value of the primary residence of such natural person, calculated by subtracting from the estimated fair market value of the property the amount of debt secured by the property, up to the estimated fair market value of the property.

While the new net worth test for individuals is more restrictive, currently natural persons may still qualify as accredited investors under existing Rule 501 of Regulation D if the issuer reasonably believes the person is within one of the following categories:

• any director, executive officer or general partner of the issuer of the securities being sold,
• or any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years, and has a reasonable expectation of reaching the same income level in the current year.

In its proposing release, the SEC stated that the proposed modified net worth standard clarifies that net worth is calculated by excluding only the investor’s net equity in the primary residence. The SEC explained that this is consistent with the purpose of Section 413(a) of the Dodd-Frank Act because it reduces the net worth by the amount that the primary residence contributed to an investor’s net worth prior to the enactment of the law.

What action is required now? Companies engaged in private placements of securities should revise their investor questionnaires and investor representations and warranties in forms of subscription documents to reflect the new net worth standard for individuals.

This alert was written by Lawrence A. Goldman, a Director in the Gibbons Corporate Department in its Newark office.