Wednesday, December 21, 2011

SEC Implements Dodd-Frank Changes to Accredited Investor Definition

The SEC adopted amendments to the accredited investor standards in the Securities Act regulations to implement the requirements of Section 413(a) of the Dodd-Frank Act, which requires the definition 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. Under the previous standard, individuals qualified as accredited investors if they had a net worth of more than $1 million, including the value of their primary residence. The definition of accredited investor was adjusted in Rule 501(a)(5) of Regulation D and Securities Act Rule 215(e).

Under the new regulations, the value of an individual’s primary residence will not count as an asset when calculating net worth to determine accredited investor status. Thus, an individuals’ net worth will be calculated excluding any positive equity that they may have in their primary residence.

Thus, for example, if an investor with a net worth of $2 million (calculated in the conventional manner before the enactment of Section 413(a), that is, by subtracting from the investor’s total assets, including primary residence, the investor’s total liabilities, including indebtedness secured by the residence, has a primary residence with an estimated fair market value of $1.2 million and a mortgage loan of $800,000, the investor’s net worth for purposes of the new accredited investor standard is $1.6 million. Before enactment of Section 413(a), the primary residence would have contributed a net amount of $400,000 to the investor’s net worth for purposes of the accredited investor net worth standard, the value of the primary residence ($1.2 million) less the mortgage loan ($800,000). Under the changes, exclusion of the value of the primary residence would reduce the investor’s net worth by the same $400,000 amount.

Also, under the amended net worth calculation, indebtedness secured by the person’s primary residence, up to the estimated fair market value of the primary residence, is not treated as a liability, unless the borrowing occurs in the 60 days preceding the purchase of securities in the exempt offering and is not in connection with the acquisition of the primary residence. In such cases, the debt secured by the primary residence must be treated as a liability in the net worth calculation. This is intended to prevent manipulation of the net worth standard, by eliminating the ability of individuals to artificially inflate net worth under the new definition by borrowing against home equity shortly before participating in an exempt securities offering.

In addition, any indebtedness secured by a person’s primary residence in excess of the property’s estimated fair market value is treated as a liability under the new definition. Thus, the fair market value of the residence and the amount of the mortgage up to that fair market value are excluded from the calculation, and the excess of the amount of the mortgage over the fair market value of the primary residence is included as a liability. In both cases, the overall impact on net worth is a reduction equal to the underwater amount (i.e., the excess of the amount of the mortgage over the fair market value of the esidence). For example, if you have an investor whose primary residence has an estimated fair market value of $1.2 million, with a mortgage of $1.4 million, the excess of mortgage loan over the fair market value of the primary residence (in this case, $200,000) would be taken into account as a liability and serve to reduce net worth both under a conventional net worth calculation and under the accredited investor definition adopted by the SEC. If, on the other hand, all debt secured by the primary residence were excluded, including debt in excess of the estimated fair market value of the residence, the investor’s net worth would be $200,000 higher than under a conventional calculation because the mortgage debt in excess of the value of the primary residence would not be treated as a liability.

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