By David Mainzer
Section 413(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), which was passed in July, 2010, required the Securities and Exchange Commission (the “SEC”) to change the definition of who is an “accredited investor” for the purposes of Regulation D (“Reg. D”) under the Securities Act of 1933 (the “Securities Act”). Within the investment management industry, the primary effect of this provision was to require hedge funds, private equity funds and venture capital funds (collectively, “Private Funds”) to change their fund offering process to ensure that new investors satisfy the changed definition.
Prior to the passage of the Dodd-Frank Act, the accredited investor definition included as accredited investors “any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his purchase exceeds $1,000,000.” Section 413(a) of the Dodd-Frank Act effectively changed this definition to exclude the value of a person’s primary residence from their net worth in making the determination of whether their net worth exceeds $1 million. Shortly thereafter, the SEC issued guidance to allow investors to disregard any mortgage debt secured by their primary residence, unless the amount of the mortgage debt exceeds the fair market value of the primary residence. If the amount of the mortgage debt exceeds the fair market value of the primary residence, then the prospective investor is required to deduct the amount of such excess from their net worth in determining whether they are an accredited investor.
Effective on February 27, 2012, the SEC has made a further refinement to this set of rules. The change creates a second level of inquiry regarding mortgage debt secured by a potential investor’s primary residence. The effect of this is that any increase in primary residence mortgage debt incurred within 60 days prior to the determination of whether someone is an accredited investor (e.g. within 60 days prior to their completion of the subscription documents for a private fund) will also now be deducted from a person’s net worth for the purposes of the accredited investor definition, unless the increase was in connection with the acquisition of the primary residence. This is the case regardless of whether the then increased amount of debt exceeds the value of the residence.
One interesting effect of these provisions is that a person may be able to invest in a private fund one day, but then not able to invest in a private fund the next day simply because they bought a new house or refinanced their mortgage. In the adopting release, SEC notes the concern that, without this new rule, investors “…may be incentivized (or urged by unscrupulous sales people) to take on debt secured by their homes for the purpose of qualifying as accredited investors and participating in investments without the protection to which they are entitled.” Implicit in this line of regulation seems to be the assumption that people who have equity in their home are less able look after their own interests than people of equal means who pay rent.
The SEC has also adopted a grandfathering provision for certain investors that had existing rights to purchase securities on July 20, 2010.
Private Funds relying on Reg. D will generally need to ensure that investors that are natural persons meet the accredited investor definition as it has been changed. This will typically require updating the investor questionnaire portion of the fund’s subscription documents and the permitted investors section of the fund’s private placement memorandum.
As the accredited investor definition is only relevant at the time an investor invests in a fund, Private Funds will generally not need to determine if their existing investors remain accredited investors after the change. However, as it is possible that an existing investor will no longer be an accredited investor, Private Funds should ensure that existing investors complete a new investor questionnaire before accepting additional investments in the fund. Private Funds that rely on Securities Act exemptions other than Reg. D (for example, offshore funds relying on Regulation S under the Securities Act) should not be affected by this change.
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