As a result of the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) on July 21, 2010, it is now more difficult for individuals to qualify as “accredited investors” under Rule 501(a)(5) of Regulation D under the Securities Act of 1933.
The “Accredited Investor” Standard
Start-up companies and investment funds frequently depend on the exemptions available in Regulation D to avoid registering their private securities offerings under the federal securities laws. Although it is possible to offer and sell securities to a limited number of non-accredited investors in a private offering, doing so typically requires the issuer of the securities to comply with heightened financial and business disclosure requirements. The Securities and Exchange Commission (the “SEC”) views non-accredited investors as needing more protections under the securities laws than accredited investors who are deemed to have the financial wherewithal and/or sophistication to understand or bear the risks of their investments. As such, most issuers do not offer securities to individuals who do not qualify as “accredited investors” to avoid the stricter disclosure requirements, among other reasons.
For an individual to be considered an “accredited investor,” he or she typically must meet either (1) the “net worth test,” which requires that the investor have a net worth of at least $1,000,000, or (2) the “income test,” which requires that the investor have an annual income of $200,000 (or $300,000 jointly with his or her spouse) in the last two years and have the expectation of the same level of income in the current year.
Modification of “Net Worth Test”
Section 413(a) of the Dodd-Frank Act modifies the net worth test for determining “accredited investor” status. Prior to the modification of this test, an investor was able to include the “value” of his or her primary residence, net of encumbrances on the property (i.e., the equity in the residence), in determining if he or she had net worth of at least $1,000,000. Under the modified test, an investor must exclude the net value of his or her primary residence in calculating net worth.
In addition, according to guidance provided by the SEC, “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.”
The Dodd-Frank Act does not define the term “value” for these purposes. The SEC has announced that it will issue amendments to its rules, as required by the Dodd-Frank Act, to conform them to the modification of the net worth test made by the Dodd-Frank Act. These are important considerations, given the depressed state of the real estate markets throughout the country.
Effects of the Change
The modified net worth test became effective upon the enactment of the Dodd-Frank Act on July 21, 2010, with no transition period or grandfathering for pending transactions. For offerings under Regulation D, accreditation is determined “at the time of the sale of the securities” under Rule 501(a)(5). As such, there is no reprieve for pending transactions that have not “closed” before July 21st.
If an investor gave his or her funds to the issuer and the issuer closed on the funds prior to July 21st, then the issuer does not have to revisit the issue of the investor’s accreditation under the modified net worth test.
The concern, however, is whether the issuer in fact closed on those funds. In a typical case, the investor submits his or her signed/completed subscription documents, along with the funds, and then the issuer must take the extra step of accepting the subscription. Also, there may be an escrow or certain conditions to closing that must be met (for example, selling a minimum amount of the securities offered). If the issuer has not accepted the subscription, or if the escrow has not closed or the conditions to closing have not been met, then the investor’s accredited investor status should be re-evaluated under the modified test. An issuer would be able to do this by asking the investor to sign an updated Investor Questionnaire that contains the modified test.
If an investor who qualified as an accredited investor solely under the old net worth test no longer qualifies under the modified test, the issuer may need to provide the more detailed disclosures required to be given to non-accredited investors. Otherwise, the issuer may have to return the funds to the investor to avoid violating Regulation D. A tainted transaction under Regulation D could have severe consequences, including potentially exposing the issuer to penalties and/or requiring the issuer to conduct a “rescission offer” in which the issuer offers to buy back its own securities.
Impact on Future Transactions
The modified net worth test also will impact any future mergers, exchange offers and other corporate transactions in which part of the consideration offered to shareholders consists of securities. For issuers that have shareholders who qualified as accredited investors solely under the previous net worth test, it may be more difficult to conduct these types of major corporate transactions, since one or more of their shareholders may no longer meet the accreditation standards under Rule 501(a)(5), requiring the issuer to comply with the heightened disclosure requirements.
Review and Adjustment of “Accredited Investor” Definition by the SEC
The Dodd-Frank Act requires the SEC to periodically review and adjust the definition of “accredited investor” under Rule 501(a)(5). Within four years of the enactment of the Dodd-Frank Act, the SEC is charged with conducting an initial review of the definition of “accredited investor” as it pertains to natural persons and making adjustments to the definition, except that it cannot make any further changes to the net worth test in the first four years after enactment of this law. Once the first four-year period has passed, the SEC is charged with reviewing the definition of “accredited investor” as it pertains to natural persons at least once every four years and making adjustments to the definition, including both to the net worth test and the income test.
The Dodd-Frank Act has many far-reaching implications on the financial markets. One of them is that it may be more difficult for issuers to raise private equity, and to conduct major corporate transactions of the types discussed above, since fewer individuals will qualify as “accredited investors.”
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