Yesterday the Securities and Exchange Commission adopted final rules and amendments conforming the net worth standard under the definition of accredited investor to the requirements of Section 413(a) of the Dodd-Frank Act. The Commission’s rules and amendments are effective as of February 27, 2012, but the amended net worth standard has been in effect since the Dodd Frank Act was enacted on July 21, 2010.
The General Rule
To qualify as an accredited investor under the amended net worth standard, an individual investor must have a net worth, alone or jointly with their spouse, in excess of $1,000,000 excluding the estimated fair market value of their primary residence.
Subject to certain exceptions, any indebtedness secured by an investor’s primary residence, up to its estimated fair market value at the time of the sale of the securities, should be excluded from the liability side of the net worth equation. Meaning that you only need to exclude the positive equity in an investor’s primary residence when calculating their net worth.
The Commission illustrates this general rule with the example of an investor that has:
- a net worth of $2,000,000 (calculated by using the commonly accepted definition of net worth, i.e., the difference between the value of the investor’s total assets, including their primary residence, and the value of their total liabilities, including any indebtedness secured by their primary residence);
- a primary residence with an estimated fair market value of $1,200,000 at the time of the sale of the securities; and
- indebtedness secured by the primary residence (a mortgage) in the amount of $800,000.
How do you calculate the investor’s net worth under the amended standard? First you have to calculate the positive equity in their primary residence:
Then you can determine their net worth under the amended standard:
The 60-Day Look-Back — The Refinancing Scenario
The liability side of the net worth equation should generally include any incremental increase in the amount of indebtedness secured by an investor’s primary residence (e.g., a refinancing, second mortgage or home equity loan, etc.) that is incurred during the 60-day period prior to the sale of the securities, even if the estimated fair market value of the investor’s primary residence exceeds the total amount of the indebtedness incurred.
The one exception to this requirement is for indebtedness incurred during the 60-day look-back period as part of an investor’s acquisition of a new primary residence.
Negative Equity — The Underwater Mortgage Scenario
The liability side of the net worth equation should also include any excess of indebtedness secured by an investor’s primary residence over its fair market value (e.g., an underwater mortgage). Meaning that you need to reduce an investor’s net worth by the amount of any negative equity in their primary residence.
Limited Grandfathering of Certain Formerly Accredited Investors
The final rule provides for limited grandfathering under which the former accredited investor net worth standard will apply to certain purchases of securities by an investor that would not otherwise qualify under the new accredited investor net worth standard, provided that:
- the right to purchase those securities was held on or before July 20, 2010 (the day before enactment of the Dodd-Frank Act);
- at the time the investor acquired the right they qualified as an accredited investor under the former net worth standard; and
- the investor held securities of the same issuer, other than the right, on July 20, 2010.
The grandfathering provision applies to the exercise of:
- statutory rights, such as pre-emptive rights arising under state law;
- rights derived from an issuer’s constituent documents, such as its certificate of incorporation; and
- contractual rights, such as rights to acquire securities upon exercise of an option or warrant or conversion of a convertible instrument, rights of first offer or refusal and contractual pre-emptive rights.
Some interesting statistics from the final rule’s adopting release:
For the Commission’s fiscal year ended September 30, 2010:
- 22,941 issuers filed a Notice of Exempt Offering of Securities on Form D;
- 17,593 of those were initial Form D filings (filings for new offerings);
- only 66, or 0.4%, of the initial Form D filings relied on an exemption from registration afforded by Section 4(5) (formerly Section 4(6)) of the Securities Act;
- it’s interesting how the Commission presents this and the next data point, it might not make sense at first (the numbers don’t immediately add up), but if you think it through, it works: 16,856, or 96%, of the initial Form D filings relied on an exemption from registration afforded by one of the rules promulgated under Regulation D;
- 834 of the initial Form D filings relied on an exemption from registration afforded by both Section 4(5) and one of the rules promulgated under Regulation D; and
- finally, the median size of an offering relying on an exemption from registration afforded by one of the rules promulgated under Regulation D was approximately $1,000,000.