Regulation D under the Securities Act of 1933 provides a “safe harbor” for private placements from the requirement that any sale of securities must first be registered with the Securities and Exchange Commission.  To qualify for this safe harbor, certain requirements must be met.  One of the requirements is a limitation on the number of purchasers if the total amount of the securities sold in the private placement exceeds $1,000,000.   This limit is 35 purchasers, excluding Accredited Investors, with the further requirement that in the case of any sale of securities exceeding $5,000,000 in the aggregate, each purchaser who is not an Accredited Investor, either alone or with his purchaser representative, must have such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment, or the issuer must reasonably believe immediately prior to making any sale that such purchaser comes within this description.


Rule 501 of defines the term “accredited investor”.   In respect of natural persons, the definition is:

• a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person;  (The language in italics was added by the SEC on December 21, 2011)
• a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year;

The definition of Accredited Investor is important for another reason apart from the limitation on the number of purchasers.  In any private placement over $1,000,000 the issuer must provide certain information, specified in Rule 502, to each purchaser that is not an accredited investor.  In contrast, there is no specific information that need be provided if all the purchasers are accredited investors (subject, of course, to the general Rule 10b-5 requirement that if any information is given, it cannot contain material misstatements or omissions).   Thus, in an private placement over $1,000,000, if (i) there is a purchaser who is not an accredited investor, regardless of the purchaser’s level of financial sophistication, and (ii) the issuer has not provided all the information required by Rule 502, the SEC or a court may take the position that requirements of Regulation D were not met and therefore the securities were offered in violation of the registration requirements of Section 5 of the Securities Act.  This would give the purchaser a right of rescission or a right to recover losses if it had already sold the security.

On December 21, 2011, the SEC adopted amendments to the accredited investor standards in its rules under the Securities Act of 1933 to implement the requirements of Section 413(a) of the Dodd-Frank Act.  Section 413(a) requires that the value of a person’s primary residence be excluded when determining whether the person qualifies as an “accredited investor” on the basis of having a net worth in excess of $1 million.

The SEC has issued the following guidance relating to the Section 413(a) amendment:

The individual must have a net worth greater than $1 million, either individually or jointly with the individual’s spouse. Except for the special provisions described below, individuals should include all of their assets and all of their liabilities in calculating net worth. 


• The primary residence is not counted as an asset in the net worth calculation. The term “primary residence” is not defined in SEC rules but is commonly understood to mean the home where a person lives the most of the time. 
 
• In general, debt secured by the primary residence (such as a mortgage or home equity line of credit) is not counted as a liability in the net worth calculation if the estimated fair market value of the residence is greater than the amount of debt secured by it. There is no requirement to obtain a third party estimate of the fair market value of the residence. 
 
• However, if the amount of debt secured by the residence has increased in the 60 days preceding the sale of securities to the investor (other than in connection with the acquisition of the primary residence), then the amount of that increase is included as a liability in the net worth calculation, even if the estimated value of the residence is greater than the amount of debt secured by it. The purpose of this provision is to deter individuals from incurring debt secured by their primary residence for the purpose of inflating their net worth to qualify as accredited investors in purchasing securities. 
 
• If the amount of debt secured by the primary residence is greater than the estimated fair market value of the residence, then the excess is included as a liability in the net worth calculation. Where the amount of secured debt is greater than the value of the primary residence, such as when a mortgage is “underwater,” the excess is counted as a liability when calculating net worth. This is true even if the borrower may not be personally liable for the excess amount by reason of the contractual terms of the debt or the operation of state anti-deficiency statutes or similar laws.
• The primary residence can be included in the net worth calculation for certain follow-on investments   The former accredited investor net worth test, under which the primary residence and indebtedness secured by it are included in the net worth calculation, applies to purchases of securities in accordance with a right to purchase such securities, if:  (i) the right was held by a person on July 20, 2010, the day before the enactment of the Dodd-Frank Act; 
(ii) the person qualified as an accredited investor on the basis of net worth at the time the right was acquired; and (iii) the person held securities of the same issuer, other than the right, on July 20, 2010.

This guidance is surprising in two respects.  First, it requires that if the amount of mortgage debt on a primary residence exceeds the market value, the excess must be treated as a liability in the net worth calculation.  (Note that no third party appraisal is required.  How then is the excess amount determined?)   Second, mortgage debt acquired within 60 days of the purchase of the securities must be included in liabilities for purposes of the net worth test.  This could be problematic because the issuer might not know if the purchaser has acquired new mortgage debt within 60 days of the sale.  The Investor’s Questionnaire that is typically used to verify Accredited Investor status is often completed weeks, even months, before the closing of the private placement.  Presumably, this will lead to a covenant that investors must make to the effect that they will acquire no new mortgage debt without revising their Investor’s Questionnaire.

Corporate Law Advisers LLP

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