Tag: Accredited Investor

Proposed “New” Standard for Accredited Investor

If you are involved in the private placement of securities, then you have been waiting to hear how the SEC was going to change the definition of “accredited investor.”

Section 413(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act requires the definitions of “accredited investor” to exclude the value of a person’s primary residence for purposes of determining whether the person qualifies as an “accredited investor” on the basis of having a net worth in excess of $1 million. Previously, the standards required a minimum net worth of more than $1,000,000, but permitted the primary residence to be included in the calculation.

Other than changing the calculation of net worth change mandated by Dodd-Frank, the SEC has declined to change the definition.

The other test for determining qualification was an individual income in excess of $200,000 in each of the two most recent years (or joint income with a spouse in excess of $300,000). I expected those number to nearly double to keep pace with inflation.

Section 415 of the Dodd-Frank Act requires the Comptroller General of the United States to conduct a “Study and Report on Accredited Investors” examining “the appropriate criteria for determining the financial thresholds or other criteria needed to qualify for accredited investor status and eligibility to invest in private funds.” That study is not due for three years. The SEC indicated that they will likely use the results of that study when they once again address the accredited investor standard in 4 years, as allowed under Dodd-Frank.

It seems to me that the SEC found an opportunity to reduce its rulemaking agenda, by not significantly changing a rule. Maybe this is the first sign of the SEC creaking under the weight of the Dodd-Frank mandates.

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The First Attack on the Accredited Investor Standard

Many of the provisions in the merely provide for future regulatory framework. That it is in part true for the changing definition of “accredited investor” under the Securities Act. The other part is that the definition changed once President Obama signed the bill into law ten days ago.

The definition of accredited investor now excludes the value of the primary residence from the calculation of net worth. Angel investors who poured too much of their wealth into a new swimming pool and cabana may get excluded from future private placements.

The SEC has also shown that it intends to be aggressive in setting the new accredited investor definition through the rule-making called for in Section 413 of Dodd-Frank. Last week, as part of their regular Compliance and Disclosure Interpretations the SEC gave an opinion on valuing the primary residence.

Question 179.01

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]

So you get no benefit to your net worth calculation for your home. Even worse, if you are underwater on your home then that excess debt is eating into your net worth calculation.

I think it’s easy to argue with this interpretation. By excluding “value” you can argue that it should exclude positive value as well as negative value. You could also argue that in some states (and some loan documents) the mortgage is non-recourse so the excess of debt over the value of the home should be excluded.

You can make those arguments when the SEC begins its rule-making to create a new definition for “accredited investor.” For now, you need to live by this interpretation while you are privately raising capital.

I expect the SEC is going to continue to be aggressive in establishing the new standards. As I said early this month:

Looking into my crystal ball, I expect the SEC to adjust the income standards based on inflation. That would put them at around $459,000 if single and $688,000 if married. I would also expect the standard to include some sort investment expertise and knowledge standard. Having a big pile of cash or a big paycheck will likely no longer be the only standard.  At least that’s my guess.

Now you will need a bigger pile of cash if your home mortgage is underwater.

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The Changing Standard for an Accredited Investor

As financial reform has made its way through Congress there have been several proposed changes to the standard of what it takes to be an accredited investor.

In 1982, the SEC prescribed the standard in Rule 501 of Regulation D:

5. Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his purchase exceeds $1,000,000;

6. Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;

The Senate version of the bill would have increased both amounts. If you use the CPI index, the amounts would more than double.

Although the bill has not passed yet, but it looks like the accredited investor standard is going to change. Section 413 of the bill is Adjusting the Accredited Investor Standard.

The net worth standard will stay at $1 million for at least the next four years, but the value of the primary residence will be excluded from net worth. Otherwise the SEC will be tasked with a review of the definition of “accredited investor” and has a clean slate to develop its own definition. The SEC can revisit the definition every four years. The only standard is that the definition be “appropriate for the protection of investors, in the public interest, and in light of the economy.”

Looking into my crystal ball, I expect the SEC to adjust the income standards based on inflation. That would put them at around $459,000 if single and $688,000 if married. I would also expect the standard to include some sort investment expertise and knowledge standard. Having a big pile of cash or a big paycheck will likely no longer be the only standard.  At least that’s my guess.

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Updated pdf file with text of the Private Fund Investment Advisers Registration Act of 2010

Image: three horsemen of the apocalypse, greenspan, et al by daveeza

Dodd Bill, Private Placements and Accredited Investors

I previously wrote about how the Restoring American Financial Stability Act being tossed around in the Senate could affect private investment funds by changing the definition of accredited investor and altering the process for a Regulation D private placement.

It looks like much of that is going to be wiped out of the bill. Senate Amendment 4056, proposed by Senator Bond, was passed by a voice vote.

The amendment directs the SEC to adjust the net worth needed to attain accredited investor status to $1,000,000, excluding the value of the primary residence. Within the period of four years after enactment, however, the net worth standard must be $1,000,000, excluding the value of the primary residence. The proposal would give the SEC the power to adjust the the definition of “accredited investor” every four years.

Senate Amendment 4056 also removed the 120 review period for private placements.

I have found Senate process for dealing with financial reform bill to be incredibly opaque and fast moving. There have been almost 400 amendments proposed since the bill was submitted last month, with the text of most of the amendments not being available until after vote has taken place.

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Accredited Investors under the Restoring American Financial Stability Act

Senator Dodd

One of the surprises in the Restoring American Financial Stability Act of 2010 is that it proposes to raise the standard for being an accredited investor. Section 412 of the bill would require the SEC to increase the dollar thresholds to be qualified as an accredited investor. Section 413 would require the GAO to study the appropriate criteria.

The current standards come from Section 2(a)15 of the Securities Act of 1933

ii. any person who, on the basis of such factors as financial sophistication, net worth, knowledge, and experience in financial matters, or amount of assets under management qualifies as an accredited investor under rules and regulations which the Commission shall prescribe.

In 1982, the SEC prescribed the standard in Rule 501 of Regulation D:

5. Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his purchase exceeds $1,000,000;

6. Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;

If you adjust for inflation from 1982, those levels could increase to $459,000 if single and $688,000 if married, with the net worth requirement becoming $2.29 million. The bill is not clear on what to use as an inflation index. I used the Consumer Price Index for All Urban Consumers (CPI-U) comparing March 1981 (94.5) to February 2010 (216.741).

The Private Fund Investment Advisers Registration Act passed by the House in the Wall Street Reform and Consumer Protection Act of 2009 (H.R.4173) required the SEC to start increasing the asset levels. The Dodd bill (still not in the Thomas system) takes the issue on more forcefully.

The result is that there will be fewer investors for private investment funds. Under and , you are limited to 35 non-accredited investors in a private fund offering, with an unlimited number of accredited investors.

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Defining An Accredited Investor

bull investor

One of the key rules for private investment funds is that their investors generally need to be “accredited investors.” This is the gateway to an exemption from the registration requirement under the federal securities laws.

The exemption is generally targeted so that experienced investors with significant financial resources and their own advisers are in less need of the Securities and Exchange Commission’s regulatory protection. In theory, they can protect themselves better than the SEC could protect them.

Who qualifies as an accredited investor? The answer is spelled out in Rule 501 of Regulation D:

  • Any bank as defined in section 3(a)(2) of the Act, or any savings and loan association or other institution as defined in section 3(a)(5)(A) of the Act whether acting in its individual or fiduciary capacity;
  • Any broker or dealer registered pursuant to section 15 of the Securities Exchange Act of 1934; any insurance company as defined in section 2(a)(13) of the Act;
  • Any investment company registered under the Investment Company Act of 1940 or a business development company as defined in section 2(a)(48) of that Act;
  • Any Small Business Investment Company licensed by the U.S. Small Business Administration under section 301(c) or (d) of the Small Business Investment Act of 1958;
  • Any plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5,000,000;
  • Any employee benefit plan within the meaning of the Employee Retirement Income Security Act of 1974 if the investment decision is made by a plan fiduciary, as defined in section 3(21) of such act, which is either a bank, savings and loan association, insurance company, or registered investment adviser, or if the employee benefit plan has total assets in excess of $5,000,000 or, if a self-directed plan, with investment decisions made solely by persons that are accredited investors
  • Any private business development company as defined in section 202(a)(22) of the Investment Advisers Act of 1940
  • Any charitable organization, corporation, or partnership with assets exceeding $5 million (not formed for the specific purpose of acquiring the securities offered);
  • Any director, executive officer, or general partner of the company selling the securities;
  • Any natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase;
  • Any natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year;
  • Any trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes
  • Any entity in which all of the equity owners are accredited investors.

In addition to the definition of accredited investor, you also need to understand how accredited investor status relates to the common exemptions from the registration requirements of the federal securities law.

Rule 504 permits allows a business to sell up to $1 million in securities during a 12 month period to an unlimited number of non-accredited investors. Additionally, Rule 504 does not require the issuer to provide any specific disclosure to the investors, regardless of whether they are accredited.

Rule 505 allows a business to sell up to $5 million in securities during a 12 month period to an unlimited number of accredited investors, and up to 35 non-accredited investors. The disclosure requirements when selling to non-accredited investors are significantly more difficult to meet and are very similar to the disclosures required in a public offering.

Rule 506 allows a business to raise an unlimited amount of capital via the sale of securities to an unlimited number of accredited investors and up to 35 non-accredited investors. In addition to the disclosure requirements for Rule 505, any non-accredited investors must also meet a “sophistication” standard, either themselves or through a qualified  representative. The status of an investor as “sophisticated” is a high standard. Investors who are merely knowledgeable about the particular industry are not necessarily sophisticated. They must have such knowledge and experience in financial and business matters that they are capable of evaluating the merits and risks of the prospective investment.

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