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SEC Amends Net Worth Standard for Accredited Investors and Provides Limited Transition Relief

White and Williams Securities Alert | December 29, 2011
by: Neil P. Casey

On December 21, 2011, the Securities and Exchange Commission (the SEC) amended its rules to exclude the value of a person’s primary residence in determining whether he or she has sufficient net worth to qualify as an “accredited investor” eligible to invest in certain private or other limited unregistered offerings of securities.  The amendments implement Section 413(a) of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), clarify how mortgage debt is to be counted in the calculation of net worth and provide limited transition relief for the exercise of pre-existing rights to acquire securities by persons who no longer qualify as accredited investors due to the exclusion of residence value.   

The final amended rules will take effect on February 27, 2012 and contain important changes from the proposed amendments released by the SEC in January 2011.  Accordingly, issuers will need to revise offering materials and subscription documents to incorporate the standards set forth in the final rules, even if those documents had been updated following release of the proposed amendments.

The definition of “accredited investor” in Rules 215 and 501 under the Securities Act of 1933, as amended, includes eight categories of persons (and persons whom the issuer reasonably believes fall within one of those categories) who are presumed to be able to bear the economic risk of an investment in unregistered securities.  One category is any natural person who individually, or jointly with his or her spouse, has a net worth of more than $1 million at the time of sale of the relevant securities.  Prior to enactment of the Dodd-Frank Act, the value of a person’s primary residence could be included in calculating net worth, while any mortgage debt would be treated as a liability.  Following enactment of the Dodd-Frank Act, primary residence value must be excluded from the calculation of net worth.

The SEC’s final rule amendments incorporate identical language in Rules 215 and 501 to implement the Dodd-Frank Act.  The language provides that, in calculating net worth, a person’s primary residence will not be included as an asset and any indebtedness that is secured by the residence will not be counted as a liability, with two exceptions.  In other words, an individual’s net worth will now be calculated excluding any positive equity that individual has in the residence.  The exceptions are that (i) any mortgage debt in excess of the estimated value of the residence and (ii) any mortgage debt incurred within 60 days prior to the sale of the securities (other than as a result of the acquisition of the residence) will be counted as a liability.  These exceptions are intended to treat “underwater” mortgages the same as they had been before the rules were amended and to discourage investors from artificially inflating their net worth by borrowing against home equity to participate in an unregistered securities offering.

In response to comments received by the SEC on its proposed amendments, the final amended rules “grandfather” the exercise of certain pre-existing rights to acquire securities by persons who no longer qualify as accredited investors on the basis of net worth due to the exclusion of primary residence value.  The grandfather provision applies to the exercise of statutory rights (e.g., pre-emptive rights under state law), rights under an entity’s organizational documents, and contractual rights (e.g., the right to acquire securities upon conversion of a convertible instrument or the exercise of an option or warrant, rights of first offer or first refusal and contractual pre-emptive rights).  So long as the person (i) held the applicable right to purchase securities as of July 20, 2010 (the day before enactment of the Dodd-Frank Act), (ii) qualified as an accredited investor on the basis of net worth at the time that right was acquired; and (iii) held securities of the same issuer (other than the right) on July 20, 2010, then in connection with any exercise of that right, the person’s net worth will be calculated as it had been before enactment of the Dodd-Frank Act.  For example, if on July 20, 2010, an investor owned stock of an issuer and a pre-emptive right for any subsequent offerings of stock of that same issuer, and the investor qualified as an accredited investor on the basis of his or her net worth at the time the pre-emptive right was acquired, then in connection with any subsequent exercise of that pre-emptive right, the investor’s net worth would be calculated in the same manner as it had been prior to enactment of the Dodd-Frank Act.

It is important to note that the grandfather provision is of limited application.  It does not apply to investments where there is no pre-existing right to acquire the securities or the securities to be acquired are issued by a different issuer, such as a stock for stock merger.  The SEC observed that special treatment for situations involving new investment decisions (such as an investment in a different issuer) could raise significant investor protection concerns and accordingly declined to extend relief under those circumstances. As a result, investors may not be able to participate in these offerings unless they qualify as accredited investors under the new net worth standard.

For more information regarding this alert, please contact Neil Casey (212.631.4414; or Lori Smith (212.714.3075; in our New York office; or Merritt Cole (215.864.7018; in our Philadelphia office.

This correspondence should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult a lawyer concerning your own situation and legal questions.
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