If, as expected, President Obama signs the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Act") into law, one provision that will go into effect immediately upon enactment and with no notice period affects all those issuing securities in private placements in the United States in reliance on Regulation D, by effectively raising the accredited investor net worth standard for natural persons.
The Act will immediately exclude the value of a natural person's primary residence in determining whether the individual net worth of that person (or joint net worth with the spouse of that person) exceeds the $1 million test for being an accredited investor under Regulation D. Previously, the value of the person's primary residence was included in the calculation of net worth to satisfy the $1 million minimum.
Issuers should immediately revise their offering documents to reflect the change to the accredited investor standard and, if in the process of an offering, ensure that investors who buy securities on or after enactment of the Act meet the new standard.
In addition, Section 413 of the Act requires the Securities and Exchange Commission to adjust the $1 million net worth test four years after the enactment of the Act. The requirement is similar to a proposal1 made by the SEC in 2007 that would have adjusted, effective in 2012, the $1 million standard set back in 1982, to reflect inflation. The SEC also remarked at the time on the huge increase in value of personal residences over their value in 1982 that in and of itself may have qualified many individuals as accredited investors.
If the SEC does no more than the minimum required of it, the impact in the case of many hedge funds and other private investment pools may be marginal. Many private placements that rely on Regulation D, including private placements for funds that are structured to not require registration under the Investment Company Act of 1940 (the "1940 Act") by reason of Section 3(c)(1) of the 1940 Act, have sufficiently high minimum subscription requirements as to make it unlikely that an investor with net assets of $1 million in today's dollars could come up with the necessary cash, even counting a primary residence. Other private investment vehicles rely on the even more stringent standard of requiring that individual investors meet the definition of a qualified purchaser by owning a minimum of $5 million in investments in order to be excluded from the requirement to register under the 1940 Act by reason of Section 3(c)(7) of the 1940 Act.
The change in the $1 million net worth test will make it harder for small businesses to raise smaller sums of money from individual investors, including "angel rounds" of venture capital, in reliance on Regulation D. In addition, if, for example, the SEC adjusts the $1 million floor for inflation since 1982, the $1 million floor would, based on 2009 calculations, grow to $2.2 million. Although issuers raising money in private placements can fall back on Section 4(2) of the Securities Act of 1933, a court could conclude, based upon the fact that Regulation D is a Section 4(2) safe harbor, that the statutory exemption has within it an element of requiring that investors be able to fend for themselves economically within the meaning of the seminal Ralston Purina Supreme Court case and that the Regulation D stated criteria are relevant to a Section 4(2) determination.
Under Section 413 of the Act, the SEC could also adjust for inflation the alternative income test for accredited investors and raise the minimum income requirement for individuals from $200,000 (or $300,000 in joint income with a spouse) in the two most recent years. In its 2007 proposal, the SEC made just this suggestion. However, the SEC could choose to time any such adjustment to synchronize with an adjustment of the $1 million net worth test.
Section 415 of the Act also requires the Comptroller General of the United States to conduct a study of the "appropriate criteria" for determining the financial thresholds or other criteria needed to qualify for accredited investor status and eligibility to invest in private Section 3(c)(1) and 3(c)(7) funds. On the face of the Section, there is no carve out for private funds, such as venture capital funds. This measure may lead the SEC on its own volition to broadly revisit the net worth/income minima for individuals investing in Section 3(c)(1) funds, as well as increasing the $5 million minimum in investments required of Section 3(c)(7) individual investors. In its 2007 proposal, the SEC suggested that the definition of accredited investor for the purposes of investing in Section 3(c)(1) funds, other than venture capital funds, also require that the investor own individually or jointly with a spouse not less than $2.5 million in investments.2 A formulation of this sort, post-Madoff, may be thought to provide a valuable additional criterion because of its focus on an individual's experience in making investment decisions of some magnitude.
Footnote
1 Release No. 33-8828; IC-27922, Fed. Reg. Vol. 72, No. 154, August 10, 2007.
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