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Financial Reform Bill Limits “Accredited Investors” Under Regulation D

07.19.10

The financial reform bill passed by the Senate on July 15 tightens the definition of “accredited investors” eligible to participate in private placements of securities.  The bill has been sent to the White House for final enactment upon the signature of President Obama.  The relevant provision of the bill changes the financial test used to define an “accredited investor” under Regulation D, a widely used exemption for private placements.

Regulation D is a safe harbor from the registration requirements under the federal Securities Act of 1933.  And since 1996, federal law has made it clear that private placements under Rule 506 of Regulation D are also exempt from regulation under state blue sky laws.  By complying with the relatively simple requirements of Rule 506, an issuer may sell securities to up to 35 non-accredited investors and an unlimited number of accredited investors.  Corporations, limited partnerships and other entities, as well as trusts and natural persons, may qualify as accredited investors.  Before the change effected by the financial reform bill, the definition of “accredited investor” applicable to a natural person required that he or she:

  • has, at the time of purchase, net worth, either alone or jointly with his or her spouse, of more than $1,000,000, or
  • had, in each of the two most recent years, income of more than $200,000 alone or more than $300,000 jointly with his or her spouse, and a reasonable expectation of reaching the same income level in the current year.

The accredited investor test is considered by the SEC as a way to determine if a person is likely to have the ability to bear the economic risk from an investment in a private investment vehicle.  The definition of a natural person “accredited investor” had been unchanged since its adoption by the Securities and Exchange Commission in 1982.  Since then, rising home values and higher salary levels caused a significant increase in the number of individuals qualifying as accredited investors.

Three provisions of the financial reform bill, set forth in section 413, have significant consequences for the accredited investor test for natural persons:

  • The SEC is directed to adjust the standard for determining the net worth of a natural person by excluding the value of the person’s primary residence.
  • The SEC may review the accredited investor definition as it applies to natural persons to determine if any adjustments are appropriate “for the protection of investors, in the public interest, and in light of the economy.”  No adjustment to the net worth test would be made, however, for four years, other than the exclusion of primary residence value. 
  • The SEC is directed to review the entire accredited investor definition, as it applies to natural persons, not earlier than four years after enactment and at least once every four years thereafter.  In these reviews, the SEC would apply the same criteria, namely, to consider whether changes are appropriate “for the protection of investors, in the public interest, and in light of the economy.”

Because section 413 directs the SEC to revise the natural person accredited investor definition, we expect that the SEC will act quickly to comply with the statute. The exclusion of the value of a primary residence from the net worth test will reduce the number of natural persons eligible to invest in private placements as accredited investors. It is unclear at this time what the SEC’s intention will be in any review of the accredited investor definition.

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In addition to the change in the accredited investor test, the financial reform bill, in section 926, requires the SEC to issue rules for the disqualification of Rule 506 offerings by companies involving individuals who are subject to “bad boy” orders barring them from certain financial or securities activities or who have been “convicted of any felony or misdemeanor in connection with the purchase or sale of any security or involving the making of any false filing with the [SEC].”  These new rules are required to be issued within one year of enactment of the bill and are to be substantially similar to the disqualification provisions under Rule 262 of Regulation A.  It is unclear what level of involvement by these “bad actors” will disqualify an offering; clarification of this question will await the final SEC rules.

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We will provide updates on significant future developments in these areas.

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