The New Accredited Investor Standard

After thinking about it for almost year, the Securities and Exchange Commission has finalized the new definition of “accredited investor.” On January 25, 2011, the SEC proposed amendments to the accredited investor standards in the rules under the Securities Act of 1933 to implement the requirements of Section 413(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Section 413(a) of the Dodd-Frank Act required the SEC to adjust the accredited investor net worth standard that applies to natural persons individually, or jointly with their spouse, to “more than $1,000,000 . . . excluding the value of the primary residence.” Previously, this standard required a minimum net worth of more than $1,000,000, but permitted the primary residence to be included in calculating net worth. Under Section 413(a), the change to remove the value of the primary residence from the net worth calculation became effective upon enactment of the Dodd-Frank Act. This rule merely clarifies a few points.

Section 415 of Dodd-Frank requires the Comptroller General of the United States to conduct a “Study and Report on Accredited Investors” examining “the appropriate criteria for determining the financial thresholds or other criteria needed to qualify for accredited investor status and eligibility to invest in private funds.” The SEC lets us know that they may take a more thorough revision of the accredited investor standard after that report comes out in July 2013.

Under the rule, owning a home can only decrease your net worth. To the extent your mortgage debt is less than the fair market value of your house, you can’t include that equity in calculating net worth. To the extent your mortgage is in excess of the value of your house, the amount underwater is counted against net worth.

Just to really screw up things, the SEC requires certain mortgage refinancings to be counted against net worth. If the borrowing occurs in the 60 days preceding the purchase of securities in the exempt offering and is not in connection with the acquisition of the primary residence, the new increase in debt secured by the primary residence must be treated as a liability in the net worth calculation. This is intended to prevent manipulation of the net worth standard, by eliminating the ability of individuals to artificially inflate net worth under the new definition by borrowing against home equity shortly before participating in an exempt securities offering.

This new 60 day rule will be a pain in the neck. On the other hand, I saw some shady operators touting the ability to leverage up your home to get you over the threshold into accredited investor land. That scheme would seem to be targeted right at the vulnerable class of “house-poor”. Apparently state securities regulators were also concerned about advising investors to use equity in their home to purchase securities.

One of the other comments was that mortgage debt in excess of the home value should not count when the loan is non-recourse or the lender is prohibited by state law from collecting a shortfall after foreclosure. The SEC dismissed that idea as being too complicated and requiring a detailed legal analysis. They also counter with some data from a 2007 Federal Reserve Board Survey that suggests that the number of households nationwide that qualify as accredited investors is not affected by whether the net worth calculation includes or excludes the underwater portion of debt secured by the primary residence.

The rule ends up amending:

  • Rule 144(a)(3)(viii),
  • Rule 155(a),
  • Rule 215, and
  • Rule 501(a)(5) and 501(e)(1)(i) of Regulation D
  • Rule 500(a)(1)
  • Form D under the Securities Act;
  • Rule 17j-1(a)(8) under the Investment Company Act of 1940and
  • Rule 204A-1(e)(7) under the Investment Advisers Act of 1940

The rule is adopted with only a limited grandfather provision. The old accredited investor net worth test will apply to purchases of securities in accordance with a right to purchase such securities, only if

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

Otherwise, the new rule goes into effect 60 days after it’s published in the Federal Register. That will the rule will be effective by the end of February 2012.