In a previous post, I discussed the impact of the Dodd-Frank bill on the rules governing private securities offerings. In January, the SEC released a proposed rule amending one part of the definition of “accredited investor” under Regulation D. The full text of the SEC release can be found here. Note that this release did not propose any other changes to the definition of accredited investor or Regulation D. Although Dodd-Frank requires the SEC to consider new standards at some point, the SEC indicated in the release that a study by the Comptroller General will be conducted prior to any such rulemaking and that such study must occur within three years of the enactment of Dodd-Frank. Therefore, it appears that major changes to the accredited investor standards will not occur for several years.
The SEC release contains a proposed change in the net worth standard for individuals qualifying as accredited investors. The new net worth standard for individual accredited investors would read as follows:
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.
For companies seeking equity financing through private securities offerings, the main things to note are as follows:
- In determining whether a natural person has a sufficient net worth, the total net worth of the investor should be reduced by the net value of the investor’s primary residence. For example, if the estimated value of the residence is $800,000 and the residence is secured by a $600,000 mortgage, the investor’s net worth would be reduced by $200,000.
- However, if the value of the investor’s primary residence is “underwater” (the amount of secured debt exceeds the estimated value), a portion of the indebtedness will reduce the amount of the investor’s net worth. For example, if the estimated value of the residence is $600,000 but the residence is secured by a $800,000 mortgage, no deduction from net worth would occur for the value of the residence (since there is no equity value) and the $200,000 in mortgage indebtedness should already have been deducted in the net worth calculation.
- Disclosure documents, including private placement memorandums, subscription agreements, investment representation letters, etc. should be changed to reflect the reduction of the investor’s primary residence from the calculation of net worth.
The ABA has submitted a comment letter to the SEC regarding the proposed rule. The ABA letter offers suggested language for the net worth standard which is different from the SEC’s proposed language. In my opinion, the ABA’s proposed language is much easier to understand and implement. In addition, the ABA made an important request regarding the impact of the new standard on individuals who are currently investors in private companies and funds. Such investors often have the opportunity (and sometimes are required) to make “follow-on” investments after the initial investment. Accordingly, the ABA recommended that the SEC provide transitional relief for investors who previously qualified as accredited investors before the enactment of Dodd-Frank so that such investors may continue to qualify for purposes of subsequent “follow-on” investments.
It is unclear when the SEC will issue a final rule regarding the net worth standard. However, we will continue to follow this topic until a final rule is implemented.
-Wythe Michael
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