What is the impact of the SEC’s new rule if an investor seeks to qualify as an accredited investor solely based upon net worth?

If an investor seeks to qualify as an accredited investor solely on net worth, the new formula for determining net worth requires that:

• the primary residence is not included as an asset
• debt secured by the primary residence is not generally included as a liability
• any increased debt secured by refinancing debt secured the primary residence within 60 days before the accredited investor determination will be counted as a liability reducing net worth
• any debt secured by the primary residence that exceeds the fair market value of the primary residence will be counted as a liability reducing net worth
• debt secured in connection with the acquisition of the primary residence will not be counted as a liability

When does the new rule go into effect?

The new rule will take effect 60 days after publication in the federal register which is viewable here and will occur on Friday, December 29, 2011.

How was the personal residence treated for calculation of net worth before Release No. 33-9287?

Before Release No. 33-9287, the value of an investors primary residence would be included in the net worth calculation with certain qualifications.

Are there any transition rules if an investor already invested an entity?

The new rule provides that the former accredited investor test will apply if (i) the rights were held on July 20, 2010, (ii) the person qualified as an accredited investor at the time the rights were acquired, or (iii) the person held securities of the issuer, excluding new rights, on July 20, 2010. The general impact of the transition rule will be to permit investors to exercise rights they were entitled to old definition.

It is important to review the facts and circumstances of an an investor’s status under the old rule and the new release for all future offerings and the exercise of any rights of investors.

Image used under the creative commons license from Images_of_money.

“(a)… The Commission shall adjust any net worth standard for an accredited investor, as set forth in the rules of the Commission under the Securities Act of 1933, so that the individual net worth of any natural person, or joint net worth with the spouse of that person, at the time of purchase, is more than $1,000,000 (as such amount is adjusted periodically by rule of the Commission), excluding the value of the primary residence of such natural person, except that during the 4-year period that begins on the date of enactment of this Act, any net worth standard shall be $1,000,000, excluding the value of the primary residence of such natural person.” [Emphasis added]

Now an accredited investor must have a net worth of $1,000,000.00 excluding his primary residence. The SEC is taking the position that this requirement is effective upon enactment. In addition, the SEC is also taking the position that the amount of any mortgage indebtedness secured by the personal needs to be reviewed in considering the investors net worth. If the indebtedness is less than the value of the property then the indebtedness does not need to reduce the investors net worth. If the indebtedness is more than the value of the personal residence, the indebtedness may need to be factored into the investors net worth.

What does this mean for start up business?

This will likely reduce the number of angel and other investors that are able to invest in start-up and small businesses. The pool of accredited investors will now be smaller.

What steps do I need to take if I am raising capital?

Companies seeking capital will need to review their suitability questionnaires in light of the new requirements.The investors will now need to give a representation regarding their net worth excluding their personal residence and may also need to to give a representation that any mortgage indebtedness does not exceed the value of their personal residence.

Thank you to Alan M. Parness (www.cadwalader.com) for writing about the SEC’s interpretation.

The image is used under the creative commons license from pbarnhart