For companies raising capital through private or other limited offerings conducted in reliance on the safe-harbors from the registration requirements of the Securities Act of 1933, as amended (the “Securities Act”), contained in Regulation D promulgated by the Securities and Exchange Commission (the “SEC”) under the Securities Act, a provision in the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) enacted in 2010, and a rule recently adopted by the SEC to implement that provision, may have a significant impact. Pursuant to Rule 501(a) of Regulation D, individuals with a net worth, either individually or jointly with their spouse, exceeding $1,000,000 qualify as “accredited investors” for the purposes of offerings of securities that are intended to be exempt from the registration requirements imposed by the Securities Act. The distinction between accredited and non-accredited investors is an important one for issuers of securities relying on Regulation D because the participation of non-accredited investors in such offerings is limited or, in some instances, prohibited.[i] Prior to the enactment of the Dodd-Frank Act, an individual was permitted to include the value of his or her primary residence in calculating that individual’s net worth, or joint net worth with that individual’s spouse, for the purposes of determining whether that individual met the “accredited investor” standard. Section 413(a) of the Dodd-Frank Act provides that the calculation of an individual’s net worth for the purposes of qualifying as an “accredited investor” under Regulation D must exclude the value of that individual’s primary residence and requires the SEC to amend its rules to conform to the new standard.
In response, on December 21, 2011, the SEC adopted amendments to Regulation D that would both implement the primary residence exclusion contained in Section 413(a) of the Dodd-Frank Act and clarify how the value of an individual’s primary residence would be calculated for the purposes of Regulation D.[ii] Under the final rule, the new accredited investor standard, as applied to natural persons, clarifies that an individual’s net equity in a primary residence is excluded from the net worth calculation. Specifically, the final rule indicates that both (i) the value of an individual’s primary residence, and (ii) the amount of indebtedness secured by the individual’s primary residence, up to the estimated fair market value of the residence, are excluded from the net worth calculation. The amount of indebtedness secured by the primary residence that is in excess of the estimated fair market value of the residence, as in the case of underwater mortgages, is included as a liability in the net worth calculation.[iii]
There is, however, one important exception from the general rule. In instances where indebtedness secured by a primary residence is incurred in the sixty (60) days prior the purchase of securities in question, and is not the result of the acquisition of the primary residence, as in the case of a refinancing, such indebtedness is included as a liability in the net worth calculation. The SEC indicated that this 60-day “look-back” provision “will make it more difficult for individuals to manipulate their net worth . . . by borrowing against their primary residence shortly before seeking to quality as an accredited investor, to take advantage of any positive equity in the primary residence.”[iv]
The new standard also contains a “grandfathering” provision, whereby the exclusion of net equity in a principal residence does not apply to follow-on investments made in connection with a previously granted right to purchase securities, provided that (i) such right to purchase was held by the investor on July 20, 2010 (the day prior to the enactment of the Dodd-Frank Act), (ii) the person qualified as an accredited investor on the basis of net worth at the time the right was acquired, and (iii) the person held securities of the issuer, other than the right to purchase, on July 20, 2010. The SEC indicated that this limited grandfathering provision is intended to strike a balance between investors’ ability to exercise previously bargained-for rights and the need to maintain the investor protections that Section 413(a) of the Dodd-Frank Act seeks to achieve.[v]
The obvious impact of the revised net worth calculation is a decrease in the number of individual accredited investors available to issuers seeking to rely on the safe-harbor provisions contained in Regulation D. Using data compiled in 2007 (the most recent year available), the SEC estimates that approximately 9% of U.S. households would have qualified for the accredited investor status on the basis of the prior net worth standard, compared with approximately 6.5% under the revised standard.[vi]
The new net worth standard for accredited investors became effective on February 27, 2012.[vii] Accordingly, issuers conducing private placements and other limited offerings under Regulation D should ensure that all offering and subscription documents reflect this change. In addition, because investors must satisfy the accredited investor standard in effect at the time of each sale of securities under Regulation D, prior investors that met the accredited investor standard under the previous net worth calculation may become non-accredited if the primary residence exclusion brings them below the $1,000,000 threshold. As a result, Regulation D issuers should ensure that prior, non-grandfathered investors participating in new offerings remain accredited under the new standard in order to avoid running afoul of the limitations on non-accredited investor participation. It is also worth noting that, beginning in 2014 and every four years thereafter, the Dodd-Frank Act requires the SEC to review the “accredited investor” definition in its entirety and to engage in further rulemaking to the extent it deems appropriate.
[i] Although Rule 504 offerings under Regulation D in which an issuer chooses to engage in a general solicitation or general advertising as permitted by the rule are limited exclusively to accredited investors, both Rule 505 and Rule 506 offerings permit up to 35 non-accredited investors to participate. See 17 CFR 230.504(b)(1)(iii), 230.505(b)(2)(ii), 230.506(b)(2)(i).
[ii] Net Worth Standard for Accredited Investors, Final Rule, Release No. 33-9287, File No. S7-0411 (December 21, 2011).
[iii] An alternative approach, arguably consistent with the letter of Section 413(a), would have been to exclude the entire fair market value of the primary residence, but not indebtedness secured by the residence, resulting in far greater reductions in net worth under Regulation D and a corresponding reduction in the number of accredited investors. Importantly, because the amount of secured indebtedness excluded from the net worth calculation is limited by the estimated fair market value of the property under the new standard, those investors whose debt secured by the residence exceeds the value of the property must include this excess amount of indebtedness in the net worth calculation, thus avoiding the anomalous result of an increased net worth for such investors under Regulation D as compared to a traditional net worth calculation.
[iv] Release No. 33-9287, at 16.
[v] Release No. 33-9287, at 20.
[vi] Net Worth Standard for Accredited Investors, Proposed Rule, Release No. 33-9177, File No. S7-0411, at 9 n. 31 (January 25, 2011).
[vii] The exclusion of the value of an individual’s primary residence from the net worth calculation under Regulation D became effective immediately upon enactment of the Dodd-Frank Act on July 21, 2010.