SEC Tightens the Noose in "Accredited Investor" Standard

In September 2011, we distributed a client alert describing regulatory changes adopted by the SEC which were expected to adversely affect capital raising by private fund advisers in New York. One of the changes discussed related to the prohibition against a registered adviser charging his or her client a performance fee except where the adviser reasonably believes that such client has a net worth of at least $2,000,000, increased from $1,500,000, or where the adviser manages at least $1,000,000 of such client’s assets, increased from $750,000, each effective September 19, 2011.

The SEC has again focused its regulatory efforts on clarifying who it deems to be a ‚sophisticated? investor eligible to participate in a private placement of securities. On December 21, 2011, the SEC adopted a final rule amending the definition of accredited investor under Rule 501(a)(5) of the Securities Act of 1933.

The Dodd-Frank Act amended the accredited investor definition, effective July 21, 2010 by requiring a natural person to have, individually or jointly with a spouse, a net worth of at least $1,000,000 not counting the value of his or her primary residence and including, as a liability, any indebtedness in excess of the fair market value of such person’s primary residence.

Pursuant to the new SEC final rule, effective February 21, 2012, the $1,000,000 net worth calculation for a natural person will also include as a liability any debt which exceeds amounts outstanding on a person’s primary residence 60 days prior to the sale of securities issued in connection with a private placement. The foregoing look-back rule does not apply to debt incurred in connection with the purchase of a primary residence within the 60 day period. This change effectively closes the door on investors who may seek to otherwise include in their net worth calculation the positive equity in their primary residence by borrowing against such positive equity and using amounts borrowed to purchase assets. As reasonable and logical as the foregoing may sound, this change does not consider increases in an investor’s debt secured by his or her primary residence which do not result from or are not in any way connected to a desire to subvert existing SEC rules.

For example, take an investor who owns assets net of liabilities other than his or her primary residence and its related mortgage(s) of $1,000,000, a primary residence valued at $800,000 with a primary mortgage of $600,000, and a home equity line of credit of $100,000. This investor would qualify as an accredited investor regardless of the amount outstanding in the home equity line of credit since the sum of the primary mortgage plus the home equity line of credit is less than the fair value of the primary residence. However, if this investor were to use his or her home equity line of credit for any reason any time within 60 days prior to purchasing securities in a private placement, he or she would not qualify as an accredited investor since the amount borrowed would be included as a liability thereby reducing the investor’s net worth to less than $1,000,000. An investor may want to use the home equity line of credit to pay college tuition fees for his or her children, take a vacation, pay for a wedding, etc., none of which is designed to inflate such investor’s net worth in anticipation of purchasing securities in a private placement.

The above recent change would further limit the number of eligible investors making it that much tougher for issuers to raise capital in increasingly volatile capital markets. In addition, it may require investors to delay investment decisions so as not to get caught within the 60 day look-back period.

If you would like more information on how recent regulatory pronouncements may affect your investment advisory business, please contact Ira Halperin or Gisella Rivera at Meltzer, Lippe, Goldstein & Breitstone, LLP.