On January 25, 2011, the Securities and Exchange Commission ("SEC") issued a proposed rule regarding the net worth standard for accredited investors.
The Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act") enacted on July 21, 2010 contains provisions that impact private offers and sales of securities. The Dodd-Frank Act changes the net worth standard for accredited investors by requiring that the value of an individual's primary residence be excluded from net worth. The standards for determining who is an accredited investor are critical to eligibility for private and limited offerings that are exempt from registration. Under current SEC Rule 501 of Regulation D, an accredited investor includes any person whose individual net worth, or joint net worth with that person's spouse exceeds $1,000,000.
Calculation. Although the new standard for calculating net worth to determine who is an accredited investor became effective on July 21, 2010, the SEC issued a proposed rule to explain the calculation and clarify the treatment of indebtedness secured by the primary residence. Under the proposed rule the amount that must be excluded from net worth is determined by subtracting from the estimated fair market value of the residence the amount of the debt secured by the residence up to the estimated fair market value of the residence. For example, if a prospective investor's primary residence had an estimated fair market value of $800,000 and that person's mortgage was $600,000, then $200,000 must be excluded from net worth. If a prospective investor's primary residence had an estimated fair market value of $1,000,000 and that person's mortgage was $1,200,000, then the net worth of the investor would be unchanged. In that case, a $1,000,000 portion of the secured indebtedness would be netted against the $1,000,000 fair market value estimate. The SEC noted that the proposed calculation should facilitate capital formation for smaller issuers by providing greater specificity. The SEC stated that the proposed interpretation would result in a smaller reduction in the pool of accredited investors as compared to alternative formulations.
Additional Issues. The SEC specifically declined to define the term "primary residence." The proposed rule does not contain any transition provisions for subsequent investments in a company by an investor that was an accredited investor at the time of the initial investment but who no longer satisfies the accredited investor standard.
Technical Amendments. In addition to amending Securities Act rules to conform to the new net worth standard, the SEC also proposed technical amendments to Form D and certain rules to correct inaccurate cross-references to former Section 4(6) of the Securities Act, which has been renumbered as Section 4(5). Comments on the proposed rule are due by March 11, 2011.
Future Studies and Rulemaking. Under the Dodd-Frank Act, the SEC will review the definition of the term "accredited investor" on July 21, 2014 (and each subsequent four year period after enactment of the Dodd-Frank Act) and engage in further rulemaking if appropriate. Additionally, under the Dodd-Frank Act, the Comptroller General of the United States will conduct a study on accredited investors, which is due three years after the enactment of the Dodd-Frank Act.
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The opinions expressed in this SEC Rulemaking Update are the author's and do not constitute legal advice. Legal advice can be given, and an attorney-client relationship can be formed, only on the basis of specific facts discussed between client and attorney pursuant to an engagement to perform legal services.