Under the current law, Rule 506 does not impose any disqualification requirements for bad actors under federal law and since the securities are “covered securities” the state level bad actor disqualification rules do not apply. The SEC has proposed to include a broad range of actors including:

• the issuer and any predecessor of the issuer or affiliate of the issuer
• any director, officer, general partner or managing member of the issuer
• any beneficial owner of 10% or more of any class of issuer’s equity securities
• any promoter connected with the issuer at the time of the sale
• any person that has been or will be paid remuneration for the solicitation of purchasers in connection with the sale of securities
• any director, officer, general partner, or managing member of any such compensated solicitor

This provision now includes not only the controlling group raising the capital but also investors owning 10% or more of any class of securities. Syndicators may need to include additional representations and warranties from investors that they will not cause a disqualification event and may need to conduct background checks these people.

In addition, the proposed disqualification has 5 and 10 year look back periods and the SEC is considering whether a longer, or permanent, look back period would be appropriate for issuers or other covered persons. I expect many comments will be submitted on this issue.

Question 179.01

Question: Under Section 413(a) of the Dodd-Frank Act, the net worth standard for an accredited investor, as set forth in Securities Act Rules 215 and 501(a)(5), is adjusted to delete from the calculation of net worth the “value of the primary residence” of the investor. How should the “value of the primary residence” be determined for purposes of calculating an investor’s net worth?

Answer: Section 413(a) of the Dodd-Frank Act does not define the term “value,” nor does it address the treatment of mortgage and other indebtedness secured by the residence for purposes of the net worth calculation. As required by Section 413(a) of the Dodd-Frank Act, the Commission will issue amendments to its rules to conform them to the adjustment to the accredited investor net worth standard made by the Act. However, Section 413(a) provides that the adjustment is effective upon enactment of the Act. When determining net worth for purposes of Securities Act Rules 215 and 501(a)(5), the value of the person’s primary residence must be excluded. Pending implementation of the changes to the Commission’s rules required by the Act, the related amount of indebtedness secured by the primary residence up to its fair market value may also be excluded. Indebtedness secured by the residence in excess of the value of the home should be considered a liability and deducted from the investor’s net worth. [July 23, 2010] [Emphasis Added]

What does this mean if you are looking to raise capital?

Any mortgage indebtedness that exceed the value of an investors primary residence is a liability and should be deduced from the investor’s net worth calculation. It also means that value of the investor’s primary residence is also excluded.

This is not a big surprise and confirmed the SEC’s initial position on the matter.

Thanks to  Broc Romanek for posting about this here.

“(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

Broker-Dealers should review this release if they are involved in recommending Regulation D offerings.

Notice 10-22 also serves as a good due diligence checklist for anyone involved in reviewing Reg D offering memorandum or private placement documents.