SEC Final Rule: Net Worth Standard for Accredited Investors

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Gavel.png FINAL RULE: The SEC issued the final rules on December 29, 2011.
Dodd-Frank Timeline,
Net Worth Standard for Accredited Investors, SEC
Proposal Date Final Rule Issue Effective Date
January 31, 2011 December 29, 2011 February 27, 2012

On December 21, 2011, the SEC passed final rules setting a net worth standard for accredited investors. These rules were proposed on January 25, 2011, and conform the definition of "accredited investor" to the requirements of the Dodd-Frank Act. The rules clarify the criteria by which household net worth is measured. Under Securities Act rules, individuals and entities that qualify as "accredited investors" are eligible to participate in certain private and limited offerings that are exempt from Securities Act registration requirements. One of the bases on which individuals may qualify as accredited is having a net worth of at least $1 million, either alone or together with their spouse.

Rules go into effect 60 days after publication to the Federal Register. In 2014, and every four years thereafter, the SEC will reexamine accredited investor definitions and rules.[1]

Final Rules

The Dec. 21 SEC release:

"SEC rules permit certain private and limited offerings to be made without registration, and without requiring specified disclosures, if sales are made only to 'accredited investors.' One way individuals may qualify as 'accredited investors' is by having a net worth, alone or together with their spouse, of at least $1 million. The Dodd-Frank Act requires that the value of a person’s primary residence be excluded from the net worth calculation used to determine the person’s 'accredited investor' status.

Under the amended net worth calculation, indebtedness secured by the person’s primary residence, up to the estimated fair market value of the primary residence, is not treated as a liability, unless 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. In such cases, the 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. In addition, any indebtedness secured by a person’s primary residence in excess of the property’s estimated fair market value is treated as a liability under the new definition."


Background

Under the Securities Act of 1933, a company that offers or sells its securities must register the securities with the SEC or find an exemption from the registration requirements. The Act provides companies with a number of exemptions. For some of the exemptions, such as rules 505 and 506 of Regulation D, a company may sell its securities to what are known as "accredited investors." Regulation D defines an accredited investor as:

  1. a bank, insurance company, registered investment company, business development company, or small business investment company;
  2. an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;
  3. a charitable organization, corporation, or partnership with assets exceeding $5 million;
  4. a director, executive officer, or general partner of the company selling the securities;
  5. a business in which all the equity owners are accredited investors;
  6. a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase;
  7. a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or
  8. a trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes.[2]

Prior to enactment of the Dodd-Frank Act, the value of one's primary residence was allowed to be included in the calculation of net worth. Traditionally, this was defined by the amount of equity in the home (fair market value less any secured indebtedness). Section 413(a) of Dodd-Frank required the SEC to adjust the net worth standards for an accredited investor in our Securities Act rules that apply to any natural person individually, or jointly with the spouse of that person, to “more than $1,000,000 . . . excluding the value of the primary residence of such natural person.”

This proposal would amend the Dodd-Frank rules to clarify the term "value of primary residence," by adding the phrase "...“calculated by subtracting from the estimated fair market value of the property the amount of debt secured by the property, up to the estimated fair market value of the property.” As a result, under the proposed rule:

  • An investor's net worth would be reduced by the amount of "value" that the primary residence would have contributed to net worth if the residence were not required to be excluded.
  • Limiting the amount of indebtedness subtracted from a property's value circumvents the adverse effect of allowing the holder of an "underwater mortgage" (a property whose fair market value is less than the debt secured against it) being allowed to add the underwater amount to one's net worth calculation for accreditation purposes.

References

  1. SEC Adopts Net Worth Standard for Accredited Investors Under Dodd-Frank Act. SEC. Retrieved on December 21, 2011.
  2. Accredited Investor. U.S. Securities and Exchange Commission. Retrieved on January 27, 2011.

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