• Raising the Net Worth of Accredited Investors and Disqualifying Bad Actors
  • October 12, 2010 | Author: Julie Jarvis
  • Law Firm: Miller Nash LLP - Portland Office
  • The Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Act") was signed into law by President Obama on July 21, 2010. The 2,300-page Act makes significant changes to financial-sector regulations including adjusting the accredited investor standard for regulations under the Securities Act of 1933 (the "1933 Act") and disqualifying certain offenders from Regulation D offerings.

    Change to the Net Worth Definition of "Accredited Investor"

    Effective July 21, 2010, the net worth standard for an accredited investor located in Rule 501(a)(5) of Regulation D under the 1933 Act, and in Rule 215(e), no longer includes the value of a person's primary residence.

    Before the enactment of the Act, any natural person whose individual net worth, or joint net worth with his or her spouse, exceeded $1 million (including the equity value of the person's primary residence) qualified as an accredited investor. The Act now requires that a person's net worth exceed $1 million without including the value of his or her primary residence. In effect, the Act increased the amount of the net worth test.

    For example, if, before the Act, John had a total net worth of $2.2 million counting the value of a home with a fair market value of $1.3 million, owned free and clear of any mortgage obligation, John is now considered to have a net worth of $900,000 and is not an accredited investor.

    On July 23, 2010, in response to the question of how a primary residence should be valued, the Securities and Exchange Commission (the "SEC") explained that fair market value is the appropriate value and that any indebtedness secured by the residence can be excluded from calculating the person's net worth, unless the indebtedness exceeds the fair value of the residence. In other words, a person's home cannot be included in equating his or her net worth, but a mortgage on the home does not lower net worth unless the mortgage is greater than the fair market value of the home.

    For example, if the fair market value of John's home is $1.3 million secured by a mortgage of $900,000, and John owns $1.2 million in stocks, John is accredited. John cannot include the $400,000 equity value of the home, but also need not deduct the $900,000 mortgage when calculating his accredited investor status.

    But if the indebtedness on the residence exceeds the fair market value of the residence, this will affect the net worth equation. For example, if the fair market value of John's home is $1.3 million secured by a mortgage of $1.4 million, John has a $100,000 debt that must be included in determining whether he is an accredited investor. If the value of John's other assets equals $1 million, John's net worth for accredited investor purposes is $900,000 and John is not an accredited investor.

    The net worth test is one of eight ways to qualify as an accredited investor and one of two ways for a natural person to qualify, the other being net income. The Act does not require the SEC to adjust the other accredited investor definitions.

    The above-described adjusted net worth standard must remain in place for the next four years. After four years the Act requires the SEC to review and if necessary amend the entire definition of accredited investor in Rule 215 of the 1933 Act as it applies to natural persons. The Act is ambiguous as to how an amendment to Rule 215 will affect the definition of accredited investor located in Rule 501.

    The adjusted net worth standard has an immediate impact on issuers conducting private offerings in reliance on Regulation D or Section 4(6). These issuers should reevaluate the accredited investor status of investors to make sure that they comply with the revised definition.

    Additionally, issuers relying on state blue sky law exemptions may be affected by the Act's accredited investor changes. In Oregon, the Act affects transactions exempt from registration under Oregon's accredited investor exemption because ORS 59.035(5) references Section 2(15) of the 1933 Act in defining accredited investor. Issuers relying on ORS 59.035(5) to avoid registering security transactions in Oregon should reassess the accredited investor status of their investors.

    Disqualifying "Bad Actors" From Regulation D Offerings

    In addition to increasing the net worth accredited investor standard under Regulation D, the Act requires the SEC to make Rule 262 and other "bad actor" disqualifications applicable to Rule 506 by July 21, 2011. Rule 262 additions will prevent an issuer from relying on Rule 506 if the issuer, its officers, directors, promoters, underwriters, or shareholders with a 10 percent or greater interest are subject to certain pending proceedings, are subject to a judgment or decree permanently restraining their engagement in the purchase or sale of securities, are subject to a United States Postal Service false-representation order, or have been convicted of a felony or misdemeanor in connection with the purchase or sale of securities or a false filing with the SEC within five years.

    Along with adding rules parallel to Rule 262 to Rule 506, the SEC is required to adopt rules disqualifying an offer or sale under Rule 506 by persons subject to certain final orders of a state securities commission (or state agency performing similar functions) within ten years, or who have ever been convicted of a felony or misdemeanor in connection with the purchase or sale of securities or a false filing with the SEC, indefinitely extending Rule 262's five-year look-back for felonies. Bad actors will now disqualify an issuer from making a Regulation D offering.