On January 25, 2011, the Securities and Exchange Commission (SEC) issued proposed rules that, if adopted, will amend the definition of an "accredited investor" under Regulation D of the Securities Act of 1933 (Securities Act), to exclude the net value of an investor's primary residence from the calculation of net worth for the purposes of determining an individual's accredited investor status. The SEC also provided interpretive guidance regarding the treatment of mortgage debt when calculating the value of a primary residence.
Rules 505 and 506 of Regulation D under the Securities Act are two of several rules that allow issuers to privately raise capital while remaining exempt from the registration requirements of the Securities Act. Rule 505 permits issuers to raise up to $5 million in any 12-month period from an unlimited number of "accredited investors," as well as up to 35 additional investors. Similarly, Rule 506 allows issuers to raise unlimited capital from an unlimited number of "accredited investors," as well as up to 35 additional sophisticated investors. As a result, the availability of the exemption often depends on whether an individual is an "accredited investor." Under Rule 501(a), the definition of "accredited investor" includes, among other categories, any natural person whose individual net worth, or joint net worth with that person's spouse, at the time of his purchase, exceeds $1 million.
Under the proposed rules, the net value of an investor's primary residence must now be excluded when determining an investor's net worth. The primary residence amendment was effective upon the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). The proposed rules also offer interpretive guidance regarding the treatment of mortgage debt when calculating the net value of a primary residence as well as making conforming changes to related rules and forms. If the proposed rules are adopted, an "accredited investor" will be defined as:
- 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.
As an example, consider a potential investor with $2.1 million in assets (including a primary residence with an estimated fair market value of $1 million) and liabilities of $1 million (including $800,000 in mortgage debt secured to the primary residence). Traditionally, net worth would be calculated by subtracting $1 million (total liabilities) from $2.1 million (total assets), leaving a net worth of $1.1 million that includes $200,000 in primary residence value (i.e., $1 million is residence value minus the $800,000 mortgage). Under previous rules, the example individual would qualify as an "accredited investor." However, under the proposed rules, the $200,000 in net residence value must now be excluded, leaving the investor with a net worth of $900,000 and disqualifying him as an "accredited investor."
Alternatively, if the same investor had a mortgage of $1.2 million (i.e., an "underwater" mortgage), the traditional calculation would increase liabilities by $400,000 and assign the investor a $700,000 net worth ($2.1 million in assets minus $1.4 million in liabilities). Given the wording of the new rules, one might calculate the net value of the primary residence by subtracting $1.2 million (debt secured by residence) from $1 million (estimated fair market value of residence) and then exclude $200,000 in liabilities from net worth. This would result in an increase of $200,000 in net worth over the traditional calculation. However, the SEC does not view this result to be appropriate as it would double count the amount of excess mortgage debt. Consequently, the proposed rule limits the exclusion of residence value to the estimated fair market value of the property. Thus, in the case of an underwater mortgage, the net worth calculation would remain the same as under the previous rule ($700,000).
While it is unclear what direction the SEC will take in the future with respect to the definition of an "accredited investor," the exclusion of a natural person's primary residence from the net worth test may significantly affect private offerings that rely on Rule 505 or 506. Issuers considering a private placement where the status of individual investors as "accredited" is being relied upon should review their subscription materials to ensure that each investor's net worth is calculated correctly.