On January 25, 2011, the Securities and Exchange Commission proposed changes1 to the definition of “accredited investor” found in Rules 215 and 501 under the Securities Act of 1933. The change was required by Section 413(a) of the Dodd-Frank Act, which requires that the value of an individual’s primary residence be excluded when calculating whether his or her net worth exceeds the $1 million minimum requirement for qualifying as an accredited investor on the basis of net worth. Under Section 413(a), the change was effective upon enactment of the Dodd-Frank Act, but the SEC’s proposal addresses certain interpretive issues, as well as making conforming changes to various other rules and forms. The SEC’s comment deadline is March 11, 2011.
The change primarily affects companies that rely on one of the “private placement” exemptions from the registration requirements of the Securities Act contained in Regulation D (Rules 504, 505 and 506 of the Securities Act) in raising private capital from individual investors. Thousands of companies, both public and private, raise capital through private placements to accredited investors and others under Regulation D. One of the means by which an individual investor may qualify as an accredited investor is by having a net worth of at least $1 million. By excluding the value of an investor’s primary residence in this calculation, the change will, as a practical matter, increase the net worth requirement for many individual investors, thus likely reducing the number of qualifying individual investors and shrinking the potential pool of private capital.
The primary interpretive issue addressed by the SEC’s proposal is the treatment of mortgage debt in the calculation of the value of an individual’s primary residence. If the SEC’s rule proposal is adopted, the definition of “accredited investor” will read 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 million, 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.”
Thus, the amount by which the estimated fair market value of an individual’s primary residence exceeds the principal balance of any mortgage on the property will be excluded from the calculation of his or her net worth. An investor, in calculating the primary residence exclusion, would not need to count any amount of a mortgage that exceeds the estimated fair market value of his or her primary residence (i.e., an underwater mortgage). The full amount of any mortgage debt owed by an investor would be taken into account in determining the investor’s net worth. Thus, assigning a negative value to a primary residence with an underwater mortgage would double-count the amount of the excess mortgage debt, in determining the investor’s net worth. According to the SEC, a person’s primary residence should be determined based on the commonly understood meaning of the term — the home where the individual lives most of the time.
The SEC requests comment in particular whether the final rules should grandfather existing investors in issuers who might otherwise be excluded by this change from future rounds or rights offerings.
Because the exclusion of an individual’s primary residence from the calculation of net worth was effective upon the enactment of the Dodd-Frank Act, companies that have not already done so should revise their forms of accredited investor questionnaires and the investor representations and warranties in their forms of private placement transaction documents to ensure that the required $1 million net worth for individual accredited investors is correctly calculated.
For additional information concerning this alert, please contact your regular Bingham corporate contact or any of the following lawyers:
Thomas J. Holton firstname.lastname@example.org
This article was originally published by Bingham McCutchen LLP.