Financial Advisors Should Note More Restrictive Accredited Investor Definition

The Securities and Exchange Commission (SEC) has adopted a new rule that redefines the standard for “accredited” investors. Required by the Dodd-Frank legislation enacted in 2010, the accredited investor standard is intended to protect less sophisticated investors in less regulated investments. The rule change, which eliminates an investor’s principal residence from consideration in determining accredited status, may dramatically affect whether some potential investors remain eligible for Regulation D offerings.

Most of the accredited investor qualification criteria remain the same, but the net worth criteria has changed. In order to qualify as an accredited investor, the qualifying net worth amount remains $1,000,000; however, the value of the investor’s principal residence must now be excluded from the calculation of the investor’s assets. In addition, subject to some exceptions, the amount of the mortgage debt on the principal residence is also excluded from the investor’s liability calculation. The overall purpose of the changes is to insure that accredited investor status is determined without regard to the value of any equity in the principal residence.

There are some exceptions to the portion of the change excluding a home’s mortgage from the liability determination:

  • Any increase in mortgage indebtedness incurred within 60 days of the date of investment. For example, if an investor has $700,000 in non-residential assets and a $500,000 home owned free and clear, the investor cannot merely become accredited by improving his cash position with proceeds from a $300,000 mortgage within 60 days of an investment. (This exception does not apply in the case of an initial purchase of a new residence with new mortgage indebtedness.)
  • Also, despite the exclusion, mortgage debt over and above a home’s value is still included in the investor’s liability determination. Therefore, an investor whose principal residence is “under water” will see his potential accredited status negatively affected. “Positive equity” in a principal residence no longer increases applicable net worth, but “negative equity” still reduces it.

These changes mean that if an investor has a $5,000,000 house with no mortgage or other liabilities, and $800,000 in other assets, he would not be accredited unless he meets one of the other existing standards, such as income level. However, if an investor has a $500,000 house with a $400,000 mortgage, but has $1,100,000 in other assets with no other liabilities, he would meet the accredited investor definition.

The new rule also contains transitional provisions. Essentially, any investment after February 27, 2012, is covered by the new net worth standards.

Parker MacIntyre provides legal and compliance services to investment advisers, broker-dealers, registered representatives, hedge funds and issuers of securities, among others. Our regulatory practice group assists financial service providers with the complex issues that arise in the course of their businesses, including compliance with federal and state laws and rules.