The SEC has adopted final rules to amend the definition of “accredited investor” under the Securities Act rules.  Section 413(a) of the Dodd-Frank Act required the definition of “accredited investor” in the Securities Act rules to exclude the value of a person’s primary residence for purposes of determining whether the person qualifies as an “accredited investor” on the basis of having a net worth in excess of $1 million. This change to the net worth standard was effective upon enactment by operation of the Dodd-Frank Act, but Section 413(a) also required the SEC  to revise its current Securities Act rules to conform to the new standard.

New Definition

As amended, the new individual net worth standard in the accredited investor definition is any natural person whose individual net worth, or joint net worth with that person’s spouse, exceeds $1,000,000.

Except as provided below, for purposes of calculating net worth:

• The person’s primary residence shall not be included as an asset;
• Indebtedness that is secured by the person’s primary residence, up to the estimated fair market value of the primary residence at the time of the sale of securities, shall not be included as a liability (except that if the amount of such indebtedness outstanding at the time of the sale of securities exceeds the amount outstanding 60 days before such time, other than as a result of the acquisition of the primary residence, the amount of such excess shall be included as a liability); and
• Indebtedness that is secured by the person’s primary residence in excess of the estimated fair market value of the primary residence at the time of the sale of securities shall be included as a liability.

The foregoing does not apply to any calculation of a person’s net worth made in connection with a purchase of securities in accordance with a right to purchase such securities, provided that:

• such right was held by the person on July 20, 2010;
• the person qualified as an accredited investor on the basis of net worth at the time the person acquired such right; and
• the person held securities of the same issuer, other than such right, on July 20, 2010.

Mortgage Debt

Under the final rules, as in the proposed rules, individuals’ net worth will be calculated excluding any positive equity they may have in their primary residence.  Under the final rules, any excess of indebtedness secured by the primary residence over the estimated fair market value of the residence is considered a liability for purposes of determining accredited investor status on the basis of net worth, whether or not the lender can seek repayment from other assets in default.

Under the final rule, any increase in the amount of debt secured by a primary residence in the 60 days before the time of sale of securities to an individual generally will be included as a liability, even if the estimated value of the primary residence exceeds the aggregate amount of debt secured by such primary residence.  Net worth will be calculated only once, at the time of sale of securities (the same time as under current rules). The individual’s primary residence will be excluded from assets and any indebtedness secured by the primary residence, up to the estimated value of the primary residence at of that time, will be excluded from liabilities, except if there is incremental debt secured by the primary residence incurred in the 60 days before the sale of securities. If any such incremental debt is incurred, net worth will be reduced by the amount of the incremental debt. In other words, the only additional calculation required by the 60-day look-back provision is to identify any increase in mortgage debt over the 60-day period preceding the purchase of securities.

The SEC believes approach will make it more difficult for individuals to manipulate their net worth as calculated under our rules by borrowing against their primary residence shortly before seeking to qualify as an accredited investor, to take advantage of any positive equity in the primary residence. It should, therefore, significantly reduce the incentive for individuals to try to “game” the accredited investor net worth standard or for salespeople to attempt to induce individuals to take on incremental debt secured against their homes to facilitate a near-term investment in an offering.

Limited Grandfathering

In cases where securities would be purchased based on an investment decision made before enactment of the Dodd-Frank Act (for example, a capital call that is not subject to conditions under the investor’s control, under an agreement entered into before enactment of the Dodd-Frank Act), accredited investor status would have been determined at the time of the investment decision. A subsequent change in the investor’s accredited status would not be relevant, so special accommodation would not be needed.

The final rules contain a provision under which the former accredited investor net worth test will apply to purchases of securities in accordance with a right to purchase such securities.  The grandfathering provision applies to the exercise of statutory rights, such as pre-emptive rights arising under state law; rights arising under an entity’s constituent documents; and contractual rights, such as rights to so long as:

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

For example, if an investor who qualified as accredited based on net worth at the time of her original investment owned common stock of an issuer on July 20, 2010, and on that date had pre-emptive rights to acquire additional common stock of that issuer, then when the issuer makes an offering of common stock that triggers the pre-emptive rights, the investor’s net worth will be calculated as it was before enactment of the Dodd-Frank Act. Likewise, if the same investor owned Series A preferred stock of an issuer on July 20, 2010 and on that date had a right of first offer to purchase any equity securities offered by the issuer in a future sale, and the issuer proposed to sell Series B preferred stock at a future date, then the investor’s net worth will be calculated as it was before enactment of the Dodd-Frank Act for purposes of exercising the right of first offer to purchase Series B preferred stock from the issuer. The provision is limited to persons who qualified as accredited investors on the basis of net worth at the time the relevant rights were originally acquired, and who held securities of the issuer other than the rights on July 20, 2010.

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