Hedge Funds and
Venture Funds
SEC Publishes Final Rule Amending the
Definition of “Accredited Investor” to
Implement Exclusion of the Value of a
Person’s Primary Residence
Broker-Dealer
By Diane E. Ambler and András P. Teleki
January 23, 2012
Practice Groups:
Investment
Management
On December 29, 2011, the Securities and Exchange Commission (“Commission”) published a final
rule release (“Final Rule”) amending the Commission’s rules so as to exclude the value of a person’s
primary residence and certain related secured debt from net worth calculations used to determine
whether a person qualifies as an “accredited investor” eligible to purchase unregistered securities
pursuant to private and other limited offering exemptions under the Securities Act of 1933 (“Securities
Act”).1
The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) requires that
the accredited investor net worth standard that applies to natural persons individually, or jointly with
their spouse, be “more than $1,000,000…excluding the value of the primary residence.”2 The
standard in effect prior to enactment of the Dodd-Frank Act also required a minimum net worth of
more than $1,000,000 but allowed the primary residence to be included in the calculation of net worth.
The Final Rule revises the Commission’s rules so as to conform to the new standard, which became
effective upon enactment of the Dodd-Frank Act on July 21, 2010.
The Final Rule is, for the most part, consistent with the proposing release published by the
Commission on January 31, 2011 (“Proposed Rule”).3 As in the Proposed Rule, the Commission
declined to define the term “primary residence” in the Final Rule. According to the Commission, it
omitted a definition in order to avoid unnecessary complexity in applying the rule. Although the rule
itself provides no definition, the Commission stated that it believes the term “has a commonly
understood meaning as the home where a person lives most of the time.”4
Treatment of Secured Debt
As in the Proposed Rule, indebtedness that is secured by the person’s primary residence, up to the
estimated fair market value of the primary residence at the time of the sale of securities, is not to be
included as a liability for the purpose of calculating net worth. However, the Commission expressed
concerns that investors could use this provision “to artificially inflat[e] their net worth by incurring
incremental indebtedness secured by their primary residence, thereby effectively converting their
home equity … into cash or other assets that would be included in the net worth calculation.” Thus, it
1
See Net Worth Standard for Accredited Investors, 76 Fed. Reg. 81793 (Dec. 29, 2011), available here (“Final Rule”).
2
124 Stat. 1376, 1577, Section 413(a) (July 21, 2010).
3
See Net Worth Standard for Accredited Investors, 76 Fed. Reg. 5307 (Jan. 31, 2011), available here. See our previous
client alert on this subject by clicking here.
4
Final Rule at 81799.
qualified this provision by including, in the calculation as a liability, “any increase in the amount of
debt secured by a primary residence in the 60 days before the time of sale of securities to an
individual.”
Grandfathering Provision
In addition, the Commission included in the Final Rule a grandfathering provision that is designed to
preserve investors’ ability to exercise certain previously held rights to purchase securities that may
have otherwise been impaired by the change in accredited investor definition. The grandfathering
provision applies the pre-Dodd-Frank accredited investor net worth test to purchases of securities
made “in accordance with a right to purchase such securities, provided that: (i) such right was held by
the person on July 20, 2010; (ii) the person qualified as an accredited investor on the basis of net
worth at the time the person acquired such right; and (iii) the person held securities of the same issuer,
other than such right, on July 20, 2010.” The Commission stated that this provision is intended to
apply to “the exercise of statutory rights, 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.”5
Just as with the former rule, any investor relying on the accredited investor net worth standard must
satisfy the requisite conditions at the time each exempt sale of securities is made.
Periodic Review of the Standard
The Dodd-Frank Act requires the Commission to review the definition of “accredited investor” in its
entirety at least once every four years, beginning after July 21, 2014. The Commission is authorized
to issue rule amendments consistent with these reviews, which could result in the net worth formula
being adjusted at some point after July 2014. A separate section of the Dodd-Frank Act also requires
the Government Accountability Office to conduct a study regarding the appropriate criteria for
qualification as an accredited investor, and the Commission stated that any future rulemaking it may
engage in would likely be influenced by this study, which is due by July 2013.
Authors:
Diane E. Ambler
diane.ambler@klgates.com
+1.202.778.9886
András P. Teleki
andras.teleki@klgates.com
+1.202.778.9477
5
Final Rule at 81799, n. 58.
2
3