Corporate Update

Modification of Net Worth Standard for Determining Accredited Investor Status

On July 21, 2010 the President signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). Effective immediately upon enactment of the Dodd-Frank Act, the net worth standard used for determining whether a natural person qualifies as an “accredited investor” was modified to exclude the value of one’s principal residence in determining whether such person has a net worth of at least $1 million. Prior to enactment of the Dodd-Frank Act, the value of a person’s principal residence was permitted to be included in the calculation of net worth for purposes of determining whether a person was an accredited investor.

Rule 501(a) of Regulation D defines the term “accredited investor” to include any natural person either (i) whose individual net worth, or joint net worth with the person’s spouse, exceeds $1 million at the time of the purchase, or (ii) whose individual income exceeds $200,000 (or joint income with the person’s spouse exceeds $300,000) in each of the two most recent years and who has a reasonable expectation of reaching the same income level in the year of the investment. The changes that went into effect on July 21, 2010 affect only the net worth standard. The annual income standards remain unchanged.

The Dodd-Frank Act specifies that the value of a person’s primary residence must be excluded from the calculation of such person’s net worth, but it does not address the treatment of a mortgage secured by a principal residence for purposes of determining an individual investor’s net worth. In a Compliance and Disclosure Interpretation issued on July 23, 2010, the Securities and Exchange Commission staff clarified that the amount of any mortgage secured by a person’s principal residence may also be excluded from the calculation of such person’s net worth in an amount not to exceed the fair market value of the principal residence. Therefore, negative equity in a principal residence needs to be included in the calculation of an individual investor’s net worth.

Who is affected by these changes?

Issuers that rely on the Regulation D safe harbor criteria for the private offering exemption under Section 4(2) of the Securities Act must be mindful of the new accredited investor standards imposed by the Dodd-Frank Act. To that end, issuers need to incorporate the modified net worth standard into their placement memoranda and the representations contained in their subscription documents for individual investors.

Private investment funds that rely on the exclusion from regulation as an investment company under Section 3(c)(1) (i.e., issuers having securities held by not more than 100 beneficial owners) (“3(c)(1) Funds”) typically limit their offerings to accredited investors. The new rules will limit the pool of potential investors for 3(c)(1) Funds.

Private investment funds that rely on the exclusion from regulation as an investment company under Section 3(c)(7) of the Investment Company Act (“3(c)(7) Funds”) generally should not be affected by the changes to the accredited investor standard because any individual investor who invests in a 3(c)(7) Fund is required to be a “qualified purchaser.” A “qualified purchaser” is defined in Section 2(a)(51) of the Investment Company Act to include a natural person who at the time of purchase owns not less than $5,000,000 in “investments” a term that excludes real estate used for personal purposes such as a principal residence. As such, any natural person who is a “qualified purchaser” is very likely to be an “accredited investor” under the new net worth standard.

Looking Ahead

The net worth standard enacted by the Dodd-Frank Act is fixed by statute for four years—until July 21, 2014. The SEC is authorized at any time to amend or modify the other aspects of the definition of “accredited investor,” such as the income thresholds applicable to natural persons, by notice and comment rulemaking. However, we would expect the Commission not to implement further changes to the definition of “accredited investor” until the General Accountability Office (the “GAO”) issues a report on its study of 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 GAO is required by the Dodd-Frank Act to issue this report not later than July 21, 2013.

At some point after July 21, 2014 and prior to July 21, 2018, and at least once every four years thereafter, the Commission is required to undertake a comprehensive review of the definition of “accredited investor” as it applies to natural persons and determine if modifications are appropriate.