The Confusing Analysis of Whether You Are An Accredited Investor

There are few commentators who think the current definition of “accredited investor” is a particularly good definition for individuals who should be investing in private placements of securities. Basing the standard on income and net worth does give you a perspective that the person could withstand the potential loss of investment. The definition has become even more important as the ban on general solicitation and advertising has been lifted. That’s going to leave a lot of potential investors and a lot of companies seeking capital trying to figure it out.

The income test of $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year, provides an interesting model. It’s reasonably verified with tax returns. Although I suspect few investors will want to turn over their tax returns to potential investment targets.

There is some uncertainty about the meaning of “spouse” for same-sex couples, given the Windsor decision that struck down the Defense of Marriage Act.

A humorous aspect of the income test is that the SEC Commissioners’ salaries are less than $200,000. Therefore, they each fail the accredited investor income test, unless a spouse is earning at least $150,000.

The asset test is even more difficult because assets now exclude the value of the home. Except if the mortgage balance is higher than the value of the home, then the negative value of the home is included in the asset test.

Of course the first problem is figuring out the value of your home and comparing it to the mortgage balance. I like that Zillow says my house is worth more than my mortgage, but is that an authoritative source for use in an accredited investor analysis?

Then the SEC also requires an home equity advance or mortgage increase in the prior sixty days to be a liability in calculating net worth, even if it does not put the house underwater. During the comment period, a concern was raised that an unscrupulous actor could convince grandma to mortgage her home, converting equity into cash that earns her the accredited investor standard.

The biggest problem is proving net worth to meet the accredited investor standard. You need to prove how much your house is worth, the mortgage balance, the timing of the mortgage origination, the timing of any home equity draws, all of your liabilities, and lastly your assets. merely producing a bank statement showing $1 million in cash in the bank is not enough to have take “reasonable steps” to conclude that a person is an “accredited investor.’

You can review the ridiculousness of the asset test in a new investor bulletin from the SEC: Investor Bulletin: Accredited Investors (.pdf) SEC Pub. No. 158.

John Smith fails the test because he took an additional draw on the home equity line in the past sixty days. But in two months he once again becomes an accredited investor. He did nothing but wait and his financial situation did not change. But two months later he can be an angel investor and invest in a start-up company.

James Lee fails the test because his house is $100,000 underwater and pulls him $80,000 short of the accredited investor standard. But as soon as Zillow makes a good positive update, he becomes an accredited investor. He did nothing but wait for the real estate market to recover. But then he can invest in a hedge fund.

References:

Investor Bulletin: Accredited Investors (.pdf) SEC Pub. No. 158