What is an Accredited Investor? Securities Lawyer 101

What Is An Accredited Investor?

The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) amended the definition of an “accredited” investor to exclude the value of an investor’s primary residence when determining whether the net worth of that person (or joint net worth with his or her spouse) exceeds the $1 million net worth test. For purposes of calculating net worth in determining status of accredited investors, the value of an investor’s primary residence may not be included.

The calculation of an accredited investor’s net worth also excludes the value of any mortgage or other debt secured by an investor’s primary residence from being deducted as a liability for an investor’s net worth provided that the debt does not exceed the fair market value of the primary residence.  If the debt exceeds the fair market value of the investor’s primary residence, the excess must be included as a liability in calculating the individual’s net worth. Accredited investor status is determined at the time of the sale of securities to the investor.

Issuers conducting offerings in reliance upon Rule 506(c) of Regulation D of the Securities Act of 1933, as amended (the “Securities Act”) may engage in general solicitation and advertising so long as sales are made only to accredited investors. Rule 506(c) is often used in connection with resale registration statements in going public transactions. Issuers who fail to follow the SEC’s verification requirements for accredited investors will be disqualified from relying upon the exemption from registration. As such, it is critical for issuers to understand what makes an investor “accredited” in the eyes of the Securities and Exchange Commission (the “SEC”)

The SEC’s Division of Corporation Finance issued a compliance and disclosure interpretation (C&DIs) addressing questions about how to calculate the net worth for a natural persons when they have jointly-held assets under Rule 501(a)(5) and how to test the annual income for a natural persons under Rule 501(a)(6) when the income is in a foreign currency.

To calculate the net worth of a prospective accredited investor using the total assets of their accounts and/or properties jointly-held with another person who is not the purchaser’s spouse, the issuer must only use the percentage of the prospective purchaser’s ownership in those accounts and properties. (Question 255.49). For example, if a prospective purchaser owns ten percent (10%) of a million dollar property, their net worth from that asset would be $100,000 dollars. If a prospective purchaser’s annual income is not reported in US dollars, then the issuer may do one of two calculations to convert the currency: (1) calculate the income based on the exchange rate in effect on the last day of the year for which the income is being reported; or (2) calculate the income based on the average exchange rate for the year reported. (Question 255.48). In this case, if the prospective purchaser’s income is in Euros, then the issuer can use either 1:1.377 on December 31, 2013 or the average of 2013 of 1:1.370, against the US Dollar, respectively.

The SEC’s Division of Corporation Finance issued compliance and disclosure interpretations (C&DIs) addressing what are safe harbors for taking “reasonable steps” to verify accredited investor status under Rule 506(c)(2)(ii).

Under Rule 506(c), an issuer offering a private placement must take reasonable steps to verify that each purchaser in its offering is an accredited investor. Rule 506(c)(2)(ii) sets out specific verification methods that serve as safe harbors for verifying the status of the prospective purchasers and once an issuer complies with one of these safe harbors, they will have satisfied the reasonable steps verification requirement. It is important to note that Rule 506(c)(2)(ii) is non-mandatory and non-exclusive because Rule 506(c) is a principles-based determination and an issuer can still satisfy the reasonable steps requirement even though it does not utilized any of the safe harbor methods specified in Rule 506(c)(2)(ii).

Under Rule 506(c)(2)(ii)(A), an issuer cannot rely on the safe harbor review of Internal Revenue Service (IRS) forms when the IRS income tax forms for the most recently completed year are not yet available because Rule 506(c)(2)(ii)(A) requires the “two most recent years.” However, the SEC believes that an issuer can still reasonably conclude that the prospective purchaser is an accredited investor and satisfy Rule 506(c)’s reasonable steps verification requirement if they (1) review the IRS forms from the two most recent completed years; (2) obtain written representations from the purchaser that states the IRS form is not available at the time, the purchaser specifies that his or her income for year that is not available (and that amount qualifies as an accredited investor); and the purchaser has a reasonable expectation that the required income level will be met for the current year. (Question 260.35). For example, an prospective purchaser does not have his 2013 IRS forms completed yet, but the issuer can use the prospective purchaser’s 2011 and 2012 IRS forms and have the prospective purchaser verify in writing that his 2013 IRS forms is not available and he reasonably expects that his 2014 income will qualify him as an accredited investor. Also, if the prospective purchaser is not a US taxpayer and therefore cannot rely on IRS form, the issuer cannot rely on comparable non-US tax forms to satisfy the requirement of Rule 506(c)(2)(ii)(A) safe harbor, but the SEC believes that the issuer could still reasonably conclude that the purchaser is an accredited investor under Rule 506(c) safe harbor requirements with these non-US tax documents.

All this considered, the safe harbor net worth test under Rule 506(c)(2)(ii)(B) requires that review of specified documents be dated “within the prior three months.” Therefore, an issuer reviewing a purchaser’s tax assessment, one of the documents specified under Rule 506(c)(2)(ii)(B), would not be able to rely on this for a safe harbor if the tax assessment is dated from more than three months ago. Also, Rule 506(c)(2)(ii)(B) safe harbor requires the review of a consumer report from a “nationwide consumer reporting agency” to determine the purchaser’s liabilities but an issuer reviewing a non-US report cannot rely on this for safe harbor purposes. Either case, the SEC believes that the issuer still could reasonably conclude that a purchaser meets the accredited investor requirements by using the reasonable steps verification requirements under Rule 506(c). (Question 260.37; Question 260.38). For example, if the issuer’s most recent assessment shows a value that, after deducting the purchaser’s liabilities, results in the prospective purchaser net worth substantially exceeding $1 million, that may be sufficient verification that the purchaser satisfies the net worth test under Rule 506(c).

It is highly important to note the SEC stresses that if the issuer has any reason to question the reliability of the prospective purchaser’s documents or the accuracy of the underlying information under Rule 506(c)(2)(ii) safe harbors, it must take additional verification measures to satisfy Rule 506(c)’s reasonable steps verification requirement.

For further information about this securities law blog post, please contact Brenda Hamilton, Securities Attorney at 101 Plaza Real S, Suite 202 N, Boca Raton, Florida, (561) 416-8956, by email at [email protected] or visit www.securitieslawyer101.com.   This securities law blog post is provided as a general informational service to clients and friends of Hamilton & Associates Law Group and should not be construed as, and does not constitute, legal and compliance advice on any specific matter, nor does this message create an attorney-client relationship. Please note that the prior results discussed herein do not guarantee similar outcomes.

Hamilton & Associates | Securities Lawyers
Brenda Hamilton, Securities Attorney
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Boca Raton, Florida 33432
Telephone: (561) 416-8956
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