Change in Capital-Raising Rules in Private Placements

By: Stephen E. Goodman and Terence P. Kennedy

Raising money privately from wealthy investors? One of the rules recently changed as a result of the adoption of the Dodd-Frank Wall Street Reform and Consumer Protection Act. A keynote of private capital raises is the concept of “accredited investor”, an SEC defined term which includes, among other definitions, an investor who has a net worth in excess of $1 million. Before Dodd-Frank (and for the past 26 years), the value of the primary residence was included in determining an investor’s net worth. Under Dodd-Frank, the $1 million is to be calculated without including the value of the investor’s principal residence. On July 23, 2010, the SEC issued a Compliance and Disclosure Memorandum clarifying how such value should be calculated pending amendment to the rules by the SEC (the “Disclosure Memorandum”). Under the Disclosure Memorandum, the amount of mortgage debt secured by the investor’s primary residence up to its fair market value need not be counted as a liability in determining the investor’s net worth. However, any indebtedness secured by the primary residence in excess of its fair market value (the “underwater” portion) needs to be counted as a liability and deducted from the investor’s net worth. 

In many cases, the inclusion of an investor’s personal residence was necessary to reach the $1 million dollar mark – now that is no longer an option. Under some State securities or “Blue Sky” laws (Illinois for example), the value of an investor’s personal residence was not included, but in many, if not most, private placements, the more lenient definition controlled. 

Does this change make sense? Like so many other legislative actions, there was probably more action than thought involved. Take two investors who want to each invest $100,000. Each has a $1,000,000 house. One has no mortgage and the other has a $950,000 mortgage. The investor with the debt free house has $900,000 in other assets (for a total net worth of $1,900,000) and the other has $1,000,000 in other assets (for a total net worth of $1,050,000). Who do you think is better able to take care of himself or bear the risk of loss? If the investor with the debt-free house draws $100,000 on his home equity line and deposits the cash in his checking account, does that make him better able to risk the investment or fend for himself? 

Unfortunately, what we might think has nothing to do with it. Ignoring the change could result in increased risk and loss to the promoter and others involved in the capital raising process or the business. In the event an issuer is raising funds in reliance on the accredited investor definition that involves investors who are natural persons, the issuer should revise its disclosure documents and subscription agreements to reflect the new test. 

Not earlier than 4 years after the enactment of the Dodd-Frank Act, and not less frequently than every 4 years thereafter, the SEC is required to review the definition, in its entirety of the term “accredited investor” as it applies to natural persons, to determine whether the requirements of the definition should be adjusted or modified for the protection of investors, in the public interest, and in light of the economy. 

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