Signing of the Dodd-Frank Act into law
The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), effective July 21, 2010, immediately impacts private placements of securities under Regulation D. Dodd-Frank makes important changes to key aspects of Regulation D, including the definition of "accredited investor" and restrictions on private securities sales by "bad boys."
In our last post, we discussed the basics of Regulation D private placement offerings. In this post, we highlight the critical changes and discuss how they will affect private securities offerings.
Dodd-Frank Changes the Definition of "Accredited Investor"
Section 413 of Dodd-Frank revises the accredited investor definition for natural persons. Specifically, the new definition of accredited investor excludes the value of a person’s primary residence from the $1 million net worth test. All other parts of the accredited investor definition remain the same, including the net income test for natural persons.
The Securities and Exchange Commission ("SEC") recently clarified a common situation: What if the mortgage debt exceeds the value of the primary residence? Regarding the $1 million net worth test, the SEC will allow an investor to exclude a mortgage or other debt secured by the investor’s primary residence that does not exceed the fair market value of the residence. But if the amount of such debt is greater than the fair market value of the residence and the lender can go after the investor personally for any deficiency, the investor must deduct the excess liability from the net worth calculation.
One unresolved question is how to calculate the value of the primary residence. Dodd-Frank does not specify how to make this calculation.
This change in the accredited investor definition takes immediate effect upon the enactment of Dodd-Frank. Public and private companies should update their subscription and disclosure documents immediately.
The new definition also affects companies who are currently conducting an offering pursuant to Regulation D or Section 4(6) of the Securities Act. Such companies should obtain new accredited investor representations from investors. If some of the investors who qualified under the old standard do not meet the new standard, the company risks losing its registration exemption unless the newly unqualified investors are barred from participating in the offering.
In addition to these immediate changes, more changes may come in the future. Beginning in 2014, the Act requires the SEC to review the definition of accredited investor for natural persons at least once every four years. Upon such review, the SEC may revise the net worth requirement for natural persons. However, the SEC may not change the net worth requirement prior to 2014.
Dodd-Frank Places Restrictions on "Bad Boy" Participation
Section 926 Dodd-Frank directs the SEC to issue rules by July 21, 2011 that disqualify "bad boys" from relying on the Rule 506 exemption under Regulation D (Rule 506 covers the largest private placements). The definition of "bad boys" includes:
- Persons convicted of a felony or misdemeanor in connection with the purchase or sale of any security or involving the making of any false filing with the SEC, and
- Persons subject to a final order of a regulatory body that bars the person from engaging in the business of securities, insurance, or banking or constitutes a final order based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct within the prior 10-year period.
The scope of the disqualifications will not be known until the SEC promulgates the rules. When the changes are implemented, issuers will need to conduct due diligence of their executives, control persons, and others associated with a private offering before relying on the Rule 506 exemption.
Implications of Dodd-Frank For Regulation D Private Placements
Why do these changes matter? First, the revised standard raises the bar for individuals to qualify as an accredited investor. As a result, fewer individuals will qualify as angel investors who can purchase securities offered through a Regulation D private placement. Although both public and private companies will be affected, startups may be the hardest hit. With fewer available accredited investors, startups may not be able to raise as much money as they could pre-Dodd-Frank.
However, it is unclear how many who met the prior accredited investor standard will not meet the revised standard. It will be interesting to see how Dodd-Frank impacts the number of accredited investors.
Second, the changes to Regulation D are intended to help protect investors. The more stringent net worth requirement is supposed to raise the level of sophistication and investment experience of accredited investors, thereby reducing the potential for investors to be defrauded. On the other side of the investment equation, the "bad boy" disqualifications are designed to keep unsavory individuals from participating in unregistered securities offerings.
Failure to comply with these changes in Regulation D puts you at risk of losing your registration exemption. To ensure compliance, consult legal counsel.
Twitter: @DougYPark
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