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News January 31, 2011 Issue

Accredited Investor Rules Set For Tune-up

The Dodd-Frank Act revised the definition of accredited investor for the purposes of Regulation D and private securities offerings when it became effective back in July. Now, and through July 2014 at a minimum, "accredited" investors must have a net worth of $1,000,000 or more excluding the value of their primary residence.

Last week, the SEC proposed amendments that would bring the existing definition of accredited investor under its rules into line with the Dodd-Frank law.

How to value the house.

After the Dodd-Frank Act became effective and ahead of the SEC’s anticipated rulemaking, questions arose regarding how to determine the value of the primary residence for purposes of excluding that value from the net worth calculation. Many mortgaged properties are "under water," and the property’s value is less than the mortgage. What "value" does the home have then? Fair market value? Mortgage value? Something else?

The Division of Corporation Finance offered guidance for issuers seeking to comply with the new law. It said that indebtedness over the fair market value of the primary residence "should be considered a liability and deducted from the investor’s net worth."

The proposed amendment is consistent with this guidance. The proposed new definition of accredited investor would be:

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 purpose of adding the phrase introduced by the words ‘calculated by’ is to clarify that net worth is calculated by excluding only the investor’s net equity in the primary residence," said the proposal.

What is a "primary" residence?

Another potential point of confusion is determining an investor’s "primary residence." The staff has not proposed a definition, but is asking for comments on whether it should. The staff’s current position is that, consistent with past practices and to avoid unnecessary complexity, issuers and investors should be able to use the commonly understood meaning of primary residence – the home where a person lives most of the time. This is consistent with the Internal Revenue Service’s interpretation of the term.

What if an investor is no longer "accredited" under the new law?

The staff didn’t have any answers on this one, though it clarified that

Under the current rules, a company or fund is not permitted to treat an investor as accredited if the investor subsequently loses that status, even if the investor has previously invested in the company or fund at a time when it satisfied the accredited investor standard. Investors must satisfy the applicable accredited investor income or net worth standard in effect at the time of every exempt sale of securities to the investor that is made in reliance upon the investor’s status as such. The proposed amendments would not change this situation.

The staff is seeking comment on whether some transition rules might be appropriate. Newly disqualified investors may want to retain proportionate interest in a company, said the staff, or exercise rights the investor owned prior to the change.

Other issues the staff raised for comment:

  • Would it be more appropriate to substitute the word "equity" for "value" when referring to the primary residence in the proposed definition?
  • Should home debt (such as a home equity line of credit) that is used to invest in securities, even where the fair value of the home exceeds the debt, be subtracted from net worth? How would you track that?
  • How can the rule prevent an investor from inflating their net worth to qualify as accredited by using borrowings against their home’s value?

Comments on the proposed rule amendments are due March 11.