On Tuesday, January 25, 2011, the Securities and Exchange Commission (the “SEC”) issued a release announcing the proposed new language of the net worth standard for “accredited investors” under the Securities Act of 1933 (the “1933 Act”). The proposed amendments will align the standards for determining whether an investor is an “accredited investor” under the 1933 Act Rules 215 and 501 with the changes made by Section 413(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), which was passed in July 2010. Under Section 413(a) and as indicated by the SEC in an interpretation shortly after enactment of the Dodd-Frank Act, in addition to excluding the value of a person’s primary residence, the related amount of indebtedness secured by the primary residence up to its fair market value may also be excluded.
Thus, if an individual’s net worth (as has been historically calculated as assets minus liabilities) is $2 million, and the primary residence is worth $1 million subject to a $800,000 mortgage, that individual’s net worth, for purposes of the 1933 Act, is reduced by $200,000. In this example, for the purposes of determining whether this individual is an “accredited investor,” their net worth is $1.8 million. Note, in calculating the individual’s assets minus liabilities, the fair market value of the primary residence was included as an asset, and the $800,000 mortgage was included as a liability.
The release outlines the new language to Rules 215 and 501, which mirrors and provides additional clarification to the Dodd-Frank Act changes. In order to fully implement and provide clarification to the Dodd-Frank Act changes to the current SEC Rules, the SEC is requesting comments, before March 11, 2011, on a variety of issues impacting the “accredited investor” standard.
How should the Dodd-Frank Act impact investors who were previously determined to be “accredited investors,” but as a result of Section 413(a), no longer meet the definition of an “accredited investor”? This issue is at the forefront of the SEC’s release addressing the inconsistencies between Regulation D and the rules prescribed therein and Section 413(a) of the Dodd-Frank Act. The SEC is proposing transition rules which would provide guidance to companies on this issue. One option is to allow for “follow-on” investments by investors who purchased securities prior to the Dodd-Frank Act solely for the purposes of maintaining their proportionate interest in a company or fund, or in connection with exercising a right that arose because of the initial investment. Nevertheless, such a policy may be qualified to limit the amount of such “follow-on” investment, such as up to the amount necessary to avoid dilution of the individual’s investment.
The SEC’s final solution to “follow-on” investors could impact companies and their ability and manner in which they raise capital going forward. Smaller companies may be unfairly limited in future offerings if they cannot access capital that has been accessible under the old “accredited investor” standards. While it is evident that guidance during this transition period is imperative for the capital markets, this comment period could prove valuable in shaping the SEC’s rulemaking process.
Additionally, the SEC is seeking comments on the following offering issues:
1. Value of primary residence – Should the rules net out the debt secured by the primary residence, or exclude the entire fair market value of the primary residence? Similarly, should the term “equity” be used in the place of “value” with regard to the primary residence in the “accredited investor” net worth standards?
2. In calculating a person’s net worth, should the SEC exclude both the fair market value of the primary residence and all indebtedness secured by the primary residence, regardless of whether such indebtedness exceeds the fair market value of the property?
3. Definition of “primary residence” – This term is not defined, but the SEC proposes the IRS’s use of “the home where a person lives most of the time” to be the standard. Comments are welcome on whether this term should be formally defined, and if so, should it mirror the federal income tax code?
4. Should potential investors be required to include debt secured by the primary residence if proceeds of the debt are used to invest in securities? There are issues regarding tracking such proceeds, which may be unduly burdensome to companies and their potential investors.
5. Timing Provision – Should there be a “record date” for determining when the net worth calculation shall be made as of? Should there be a second net worth calculation made at the time of sale “bringing current” the prior calculations?
6. Calculating Net Worth – Historically, there has been no formal guidance on the method of calculating the net worth of an individual. Would guidance on the calculation be helpful, providing definitions or guidance on what is an asset, liability, etc.?