SEC Proposes Revised Minimum Net Worth Standard for Accredited Investor Status

February 2011Newsletters Small Cap Securities Update

Section 413(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) increased the minimum net worth required for a natural person to be considered an “accredited investor” under Regulation D under the Securities Act of 1933, as amended (Securities Act). Specifically, the value of a natural person’s primary residence must be excluded in determining whether the net worth of such person, or joint net worth together with the person’s spouse, exceeds the $1 million threshold required for such person to be considered an “accredited investor.” Section 413(b) of Dodd-Frank directs the SEC to review the definition of “accredited investor” every four years. On January 25, 2011, the SEC proposed to formally amend the definition of “accredited investor” to comply with Dodd-Frank. The SEC is not proposing to make any additional revisions to the definition of “accredited investor.”

Background

SEC Rule 501 defines an “accredited investor” to include any natural person whose individual net worth, or joint net worth with his or her spouse, exceeds $1 million. Prior to Dodd-Frank, investors were permitted to include the value of his or her primary residence in calculating such net worth. Shortly after Dodd-Frank became law, the Securities and Exchange Commission Division of Corporate Finance (Division) withdrew its prior public interpretation that permitted natural persons to include in their net worth calculation the value of their primary residence and issued a new interpretation requiring investors to exclude the value of their primary residence in such calculation.

Proposed Rule

The SEC is proposing to formally amend the net worth standard set forth in SEC Rules 215 and 501 to comply with Section 413(a) of Dodd-Frank 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.

The revised rule has the effect of deducting from an investor’s net worth the net equity in his or her primary residence. In calculating net worth, investors would total all assets (including the value of his or her primary residence), deduct all liabilities (including all debt secured by such primary residence) and then adjust the result by excluding the value of the primary residence and the amount of debt secured by such residence but only up to the value of such residence. Indebtedness secured by the residence in excess of the value of such residence is considered a liability and would continue to be deducted from the investor’s net worth. The SEC explained that to exclude all debt secured by a primary residence irrespective of the value of such residence would result in an increase in the net worth of investors whose mortgages exceed the value of their primary residence. The SEC is seeking comment on a number of technical points, including whether to exclude the value of the primary residence but not any indebtness secured by the residence. Comments are due March 11, 2011, and a final rule is expected to be issued shortly thereafter.

What It Means

The proposal simply codifies the Division’s interpretation of Section 413(a) of Dodd-Frank, in effect since July 21, 2010. If adopted as proposed, there will be no change in the existing law. In the release, the SEC cited data from the 2007 Federal Reserve Board Survey of Consumer Finances that estimated that 9.04% of U.S. households qualified for accredited investor status on the basis of the net worth standard prior to Dodd-Frank. As a result of excluding home equity, it is estimated that approximately 5.91% of households would continue to qualify. By reducing the pool of accredited investors, the increased threshold could make it more difficult to raise capital on a private placement basis. Issuers raising capital on a private placement basis should review, and if necessary revise, any private offering memoranda and securities purchase or similar agreements to ensure investors who purchase their securities meet the new accredited investor standard.