CHANGE IN INDIVIDUAL NET-WORTH TEST FOR DETERMINING ACCREDITED INVESTORS

With the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”) on July 21, 2010 comes an important change to the definition of “accredited investor” with implications for the way companies raise money from private sources. 

Nature of the Change

There are two tests by which an individual who is not a director, executive officer, or general partner of a company can qualify as an “accredited investor” for federal securities law purposes.  The first relies on the individual’s net worth.  An individual whose net worth or joint net worth with his or her spouse exceeds $1,000,000 is considered an “accredited investor.”  Pursuant to the Act, individuals must now exclude the value of their primary residence in calculating their net worth.  Guidance from the staff at the Securities and Exchange Commission also reveals that indebtedness secured by the primary residence up to its fair market value may also be excluded from the calculation while 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 second test—the "income test"—was not changed by the Act.  Thus, an individual with income in excess of $200,000 (or, with his or her spouse, in excess of $300,000), who reasonably expects the same for the current year, is still considered an “accredited investor.”

Why it Matters

“Accredited investor” is an important concept for private securities offerings that will not be registered under securities laws.  Any offer or sale of securities must be registered under the federal (and state) securities laws or qualify for an exemption from registration.  Private companies raising money commonly rely on the exemptions from federal registration found in Regulation D of the Securities Act of 1933.  In a Regulation D offering to accredited and non-accredited investors, companies may be obligated to provide significantly more detailed disclosures than they would be required to provide in an offering limited solely to accredited investors.  Furthermore, offerings made pursuant to Rule 506 of Regulation D are often limited to accredited investors to avoid the more ambiguous requirement that each investor be sophisticated enough to be able to evaluate the risks of the prospective investment.

Excluding an individual’s primary residence from the calculation of their net worth has the potential to eliminate a significant number of people from the definition of “accredited investor.”

What You Should Do Now

Companies in the midst of raising private funds should revisit their offering materials immediately as there is no transition period or grandfathering under the Act.  Subscription agreements and other documents containing investor representations and warranties should be updated to reflect the new net worth test.  These companies should also reevaluate whether the planned exemptions from federal and state securities registration requirements will remain available.

Companies in the planning stages of a private capital raise should consider the impact that the new net worth test will have on prospective investors—including any existing individual investors who may have previously qualified under the net worth test. 

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