Issuers conducting private offerings of securities often rely on Regulation D as the exemption from the registration requirements of the federal Securities Act of 1933. When raising money, most hedge funds, private equity funds, and private real estate investment vehicles, as well as those arranging angel financing, generally restrict themselves to “accredited investors”. By complying with the relatively simple requirements of Rule 506, an issuer may sell securities to up to 35 non-accredited investors and an unlimited number of accredited investors.
Under Regulation D, a natural person unrelated to the issuer becomes an accredited investor by (i) having a net worth of at least $1 million, or (ii) having annual income in each of the last two years, and reasonably expecting annual income in the current year, of at least $200,000 individually or at least $300,000 with one’s spouse. Other requirements exist for financial institutions, registered investment companies, trusts, and certain other entities.
The Dodd-Frank Wall Street Reform and Consumer Protection Act modified the requirements for accredited investors as follows, effective immediately:
- Required the calculation of $1 million net worth to exclude the value of one’s primary residence
- Required no further change to the net worth standard for four years; and
- After four years, and every four years thereafter, required the SEC to review the definition of an accredited investor and to adjust the definition if needed “for the protection of investors, in the public interest, and in light of the economy”.
The income test is not changed. The change in the definition of “accredited investor” may also affect compliance with state securities laws in states that use the federal definition in state law or regulations.
The SEC issued a Compliance and Disclosure Interpretation (“CDI”) relating to the new definition of accredited investor involving the treatment of primary residences that are encumbered by a mortgage, as follows:
“Section 179. Rule 215 – Accredited Investor
Question 179.01Question: 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.”
The current numbers for income and net worth were adopted in 1982. Adjusting those numbers for inflation could have changed the income amounts to approximately $460,000 for singles and $690,000 for married investors, with the net worth requirement rising to $2.3 million. Since earlier proposals called for much more sweeping changes in the definition of an accredited investor, the end result, particularly as modified by the SEC’s interpretation, is relatively modest. This is particularly true since the existing limits will now be in place for four years.