Dec. 21, 2011, the Securities and Exchange Commission (the "SEC") adopted a final rule amending the definition and calculation for individuals eligible to participate in certain unregistered securities offerings as an "accredited investor" as per Rules 215 and Rule 501 of Regulation D under the Securities Act of 1933, as amended (the "Securities Act").
The final rule also addresses certain interpretive issues and becomes effective 60 days after it is published in the Federal Register, on February 27, 2012, and implements the requirements set forth in Section 413(a) of the Dodd-Frank Act that an individual exclude the value of his or her primary residence when calculating whether his or her net worth exceeds the $1 million minimum requirement for qualification as an accredited investor. This Rule primarily affects companies and funds that rely on one of the "private placement" exemptions, found in Regulation D (e.g. Rules 504, 505 and 506) under the Securities Act, from the registration requirements of the Securities Act when raising private capital from individual investors. The Rule impacts all companies, both public and private, raising capital through private placements with accredited investors under Regulation D. The amendments change the methodology for calculating the $1 million net worth threshold when calculating an individual’s net worth. Pursuant to the final amended Rule, an individual’s net worth should:
- exclude as an asset the person’s primary residence;
- exclude as a liability the indebtedness secured by a person’s primary residence, up to the estimated fair market value of the property at the time of the sale of securities, unless the person incurred the debt within 60 days prior to the purchase of securities in the exempt offering for the purpose of buying the securities and not for buying the primary residence; and
- Include as a liability any indebtedness secured by the person’s primary residence that exceeds the estimated fair market value of the property.
The SEC noted that this provision is intended to reduce incentives for an individual investor to increase the debt secured against his or her residence only for the purpose of making investments and/or qualifying as an accredited investor. Moreover, the SEC interprets "net worth’ as something commonly understood to mean the difference between the value of an individual’s assets and the value of his or her liabilities and "primary residence", which the SEC notes is commonly understood to mean the home where a person lives most of the time..
Grandfathering provisions are also included in the final Rule for investment decisions taken prior to the enactment of the Dodd-Frank Act. Specifically, the revised net worth calculation will not apply to a purchase of securities in accordance with a right to purchase such securities, provided that: (i) the right was held by the individual on or before July 20, 2010; (ii) the individual already qualified as an accredited investor on the basis of net worth at the time the individual acquired such right; and (iii) the individual held securities of the same issuer, on July 20, 2010.
The grandfathering provision also applies to the exercise of statutory rights in connection with an investor’s pre-existing rights to acquire securities (such as pre-emptive rights arising under state law), rights arising under an entity’s constituent documents and contractual rights (such as rights to acquire securities upon exercise of an option or warrant or upon conversion of a convertible instrument, rights of first offer or first refusal‚ and contractual pre-emptive rights).
Beware: Funds and companies should immediately correct their offering documents, subscription documents and investor questionnaires and:
- update their subscription and other investment agreements to incorporate the new definition of accredited investor;
- review the terms of any outstanding rights to acquire securities, such as warrants, stock options and convertible securities, that permit exercise by accredited investors, to determine whether any amendments are required; and
- make sure when necessary that the bring down representations comply with, the new definition.
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