In a release published January 25, 2011, the Securities and Exchange Commission proposed amending its rules to implement the change to the definition of “accredited investor” mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act. Section 413(a) of the Dodd-Frank Act requires the value of an individual’s primary residence to be excluded in calculating the individual’s net worth in determining whether the individual qualifies as an accredited investor under the Securities Act of 1933, as amended.1 While this change took effect upon the enactment of the Dodd- Frank Act, Section 413(a) also requires the SEC to amend its rules to reflect the new standard. The SEC’s proposed amendment can be found at http://www.sec.gov/rules/proposed/2011/33-9177.pdf.
The new accredited investor standard will impact companies seeking to rely on Regulation D to offer and sell their securities without having to register the securities with the SEC. Regulation D contains three rules providing exemptions from the registration requirements of the Securities Act. The availability of two of Regulation D’s rules, Rule 505 and Rule 506, depends, in part, on offering the securities to investors who qualify as accredited investors. Rule 501 sets the standards for accredited investor status under Regulation D.
One of the ways a person can qualify as an accredited investor under Rule 501 is to have individual net worth, or joint net worth with the person’s spouse, in excess of $1 million at the time the securities are purchased. Rule 501 does not define net worth, but it has generally been interpreted as the difference between the value of a person’s assets and the value of the person’s liabilities. Under the previous standard, a person could include the value of the person’s primary residence when calculating his or her net worth. The proposed amendment to Rule 501 would require the person’s net worth to exceed $1 million, excluding the value of the person’s primary residence, “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.”
This change is certain to shrink the pool of accredited investors from whom companies are permitted to raise capital through private offerings under Regulation D. If too much of an investor’s net worth consists of the value of his or her primary residence, a person who previously qualified as an accredited investor on the basis of having a net worth over $1 million might not qualify as such under the new standard. For example, an investor with a net worth of $1.5 million (calculated in the conventional manner by subtracting from the investor’s total assets, including primary residence, the investor’s total liabilities, including any mortgage on that residence) would not qualify as an accredited investor under the new standard if the investor’s primary residence had an estimated fair market value of $1.2 million and a mortgage of $650,000. Before the enactment of Section 413(a) of the Dodd-Frank Act, the primary residence contributed a net amount of $550,000 to the investor’s net worth. Under the proposed rule, the value of the investor’s primary residence is excluded from the calculation, reducing the investor’s net worth for purposes of Rule 501 by $550,000 to $950,000, which is $50,000 less than the amount necessary to qualify as an accredited investor under the rule’s net worth test.