SEC Adopts New Net Worth Standard for Accredited Investors

On December 21, 2011, the Securities and Exchange Commission (the "Commission") adopted a final rule (the "Rule") to exclude the value of a person’s home for purposes of determining whether his or her net worth, individually or together with their spouse, exceeds $1 million, and would therefore qualify as an "accredited investor."

Private placements of securities that are limited to "accredited investors" are subject to fewer regulatory requirements under the Securities Act of 1933 (the "Securities Act") than private placements that include non-accredited investors. Among other things, an unlimited number of accredited investors may participate in the offering (assuming the other private placement rules are followed) compared to only 35 non-accredited investors, and the Commission’s requirements that specific detailed information be provided do not apply to accredited investors.

The Commission’s definition of "accredited investor" appears in Securities Act Rules 215 and 501. The changes were made to conform the Commission’s definition of an "accredited investor" to Section 413(a) of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"). In each case, the term "accredited investor" includes persons who fall within one of eight listed categories (or whom the issuer reasonably believes fall within one of the categories).

One of those accredited investor categories is a person with a net worth of at least $1 million. The Rule incorporates new language in Rules 215 and 501 to provide that, in calculating net worth:

• a person’s primary residence will not be counted as an asset;
• any indebtedness secured by that person’s primary residence, up to the estimated fair market value of the primary residence, will not be counted as a liability, unless the borrowing occurs in the 60 days preceding the purchase of securities in the exempt offering and is not in connection with the acquisition of the primary residence; and
• any indebtedness secured by that person’s primary residence in excess of the property’s estimated fair market value will be counted as a liability.

The treatment of indebtedness in the calculation described above is intended to discourage investors from manipulating their net worth by borrowing against home equity shortly before participating in an exempt securities offering, and to treat underwater mortgages the same as they had been prior to the enactment of the Dodd-Frank Act and the adoption of the Rule.

The accredited investor provisions allow issuers to avoid having to make subjective judgments about the suitability of an investment for any particular purchaser.  Accredited investors are presumed to be investors who can bear the economic risk of holding unregistered and illiquid securities for an indefinite period and can afford a complete loss of the investment.  (See Commission Release No. 33-9287 at 4, 7)  In view of the recent instability in values of residential real estate, it no longer made sense as a policy to presume that the value of an investor’s home contributed to their ability to bear these risks inherent in unregistered securities.

In addition, the Rule provides transition relief in limited cases by permitting certain persons who no longer qualify as accredited investors on the basis of net worth due to the exclusion of the value of their primary residence to “grandfather” the exercise of certain pre-existing rights (including statutory rights, contractual rights and rights existing under an entity’s organizational documents) to purchase securities. Under the “grandfathering” provision, in connection with the exercise of any such pre-existing right, a person’s net worth will be calculated under the standard which was in place prior to the enactment of the Dodd-Frank Act (which permitted a person to include their primary residence in the calculation of net worth), so long as he or she:

• held the right to purchase securities on July 20, 2010 (the day before the enactment of the Dodd-Frank Act);
• qualified as an accredited investor on the basis of net worth at the time that right was acquired; and
• held securities of the same issuer (other than the right) on July 20, 2010. 

The Rule was published in the Federal Register on December 29, 2011 and will be effective on February 27, 2012. Accordingly, we recommend that issuers review their offering materials and subscription documents and make appropriate revisions to incorporate the new standards set forth in the Rule.Elaine Tippitt

By Blake Hornick, Matthew Hafter, Elaine Tippitt and Greg Sale

Blake Hornick is a partner in the firm’s New York office, Matthew Hafter is a partner in the firm’s Chicago office, Elaine Tippitt is a partner in the firm’s Houston office and Greg Sale is an associate in the firm’s Houston office. If you would like further information, please contact your Seyfarth Shaw LLP attorney, Blake Hornick at bhornick@seyfarth.com, Matthew Hafter at mhafter@seyfarth.com, Elaine Tippitt at etippitt@seyfarth.com, or Greg Sale at gsale@seyfarth.com.