Dodd-Frank Change to Definition of Accredited Investor Under Regulation D by Paul B. Benham, III, Robert T. Smith, Bryan W. Duke and John F. Griffee The SECs Regulation D is the one of the most commonly relied upon registration exemptions for private securities offerings. To satisfy the Regulation D safe harbor, an issuer (i.e., the bank or company raising capital) often seeks to qualify investors as accredited investors. One important category of accredited investors are natural persons who, individually or jointly with their spouse, have a net worth of more than $1,000,000. Prior to the Dodd-Frank Act (the Act), investors were permitted to include the equity in their primary residence in calculating net worth. The Act, however, amended the definition of net worth in Rule 501 of Regulation D to exclude the value of the primary residence from an investors net worth. On December 21, 2011, the SEC released its final rule (Final Rule) amending Rule 501 to exclude the value of the primary residence from an investors net worth. In Final Rule Release 33-9287, the SEC promulgated a net worth calculation that addresses (i) treatment of positive equity and mortgage debt, (ii) incremental debt secured by the primary residence that is incurred in the 60 days before the sale of securities, and (iii) grandfathering the pre-Act net worth calculation. Treatment of Positive Equity and Mortgage Debt The Act required the SEC to establish a rule to exclude the value of the primary residence from an accredited investors net worth. Both the SECs Proposing Release, issued January 25, 2011 (Proposing Release), and its Final Rule interpret the language in the Act to require the exclusion of any positive equity in the primary residence and inclusion of underwater mortgage debt. The method of calculating net worth in the Final Rule, however, is different than the method suggested in the Proposing Release. Although the calculation method in the Final Rule is different than the Proposing Release, the result is the same both calculations (i) reduced net worth by underwater mortgage debt and (ii) exclude positive equity in the primary residence from net worth.1 Specifically, the net worth calculation under the Proposing Release reduced net worth by underwater mortgage debt in the initial netting of assets and liabilities by including the primary residence as an asset and total mortgage debt as a liability in the initial netting of assets and liabilities. The Final Rule also reduces net worth by underwater mortgage debt, but it does so by a specific reduction of the amount of underwater debt following an initial netting of assets and liabilities. With respect to excluding positive equity, the Proposing Release excluded positive equity by a specific reduction to net worth after the initial netting of assets and liabilities. The Final Rule also reduces net worth by positive equity, but does so by excluding the primary residence as an asset and mortgage debt as a liability in the initial netting of assets and liabilities. In other words, while the result is the same, the calculation differs as follows: (i) the Proposing Release takes out positive equity post-netting, while the Final Rule takes out positive equity through the initial netting, and (ii) the Proposing Release reduces net worth by underwater mortgage debt through the initial netting, while the Final Rule reduces net worth by underwater mortgage debt postnetting. 60-Day Look Back Provision The SEC also included specific language to prevent investors from artificially inflating their net worth by incurring incremental indebtedness secured by their primary residence, thereby effectively converting their home equity which is excluded from the net worth calculation under the Final Rule into cash or other assets that would be included in the net worth calculation. Specifically, any increase in the amount of debt secured by a primary residence in the 60 days before the time of sale of securities to an individual generally will be included as a liability, even if the estimated value of the primary residence exceeds the aggregate amount of debt secured by such primary residence. As a result, if any such incremental debt is incurred, net worth will be reduced by the amount of the incremental debt. In other words, the only additional calculation required by the 60-day look-back provision is to identify any increase in mortgage debt over the 60-day period preceding the purchase of securities. Grandfathering Pre-Dodd-Frank Accredited Investor Definition In the Final Rule, the SEC adopted a provision to permit investors who ceased to qualify as accredited investors as a result of the changes to the net worth definition to be treated as accredited for purposes of certain subsequent or follow-on investments (e.g., preemptive rights to acquire additional stock). The Final Rule, therefore, contains a provision under which the former accredited investor net worth test will apply to purchases of securities in accordance with a right to purchase such securities, so long as (i) the right was held by a person on July 20, 2010, the day before the enactment of the 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. The grandfathering provision applies to the exercise of statutory rights, such as pre-emptive rights arising under state law; rights arising under an entitys certificate of incorporation and/or bylaws; and contractual rights, such as rights to acquire securities upon exercise of an option or warrant or upon conversion of a convertible instrument, rights of first offer or first refusal and contractual pre-emptive rights.
Preemptive Rights Provisions
Background Although common in the charters of many corporations, particularly community banks and their holding companies, a preemptive right provision may create securities law problems when a company seeks to raise additional capital. As a general matter, when a corporation issues shares of stock, it must either (1) register the offering with the SEC (and any applicable state), or (2) rely on an exemption from these registration requirements. Registering an offering is usually cost-prohibitive for a non-public company (that does not intend to make additional offerings and/or list its shares on a national exchange). The exemptions relied on generally limit the overall number of investors and impose certain criteria on who may invest - e.g., requiring that each investor have some level of "sophistication" in finance and business matters. Arkansas law provides an exemption for sales of securities by both banks and bank holding companies. Federal law, however, provides an exemption only for offers and sales by banks (state and federal), but not by registered holding companies. Problems Arising From Preemptive Rights Preemptive rights provisions generally require that the issuer offer the newly issued securities to all shareholders. The problem that this creates is that the issuer would be required to offer and (potentially) sell shares to all of its current shareholders, which may exceed the applicable limit on the number of non-accredited investors who may participate in an exempt offering. Many of these investors may not have the required level of financial experience necessary for the exemption to apply. If the issuer made a non-exempt and unregistered offering, it could later be required to return an investor's investment upon demand. These provisions can make it very difficult to raise capital given the potential inability to qualify for a private placement exemption. If this provision is deleted from the charter, the bank or holding company would then have the freedom to make an offering to all of its current shareholders (and other non-shareholders) but condition acceptance of any investor's subscription upon satisfaction of the financial sophistication and experience requirements mentioned above. We generally recommend that a clients Board consider removing the preemptive right provision. To do so, the board would be required to call a special meeting of shareholders and obtain shareholder consent to the action. With respect to holding companies chartered under Arkansas law, shareholders would have the right to dissent from the action and be paid the fair value of their shares. Rather than removing the preemptive rights provision altogether, an alternative that we have used for some clients is to revise the provision to both (i) exclude certain types of securities from the requirement, and (ii) give the Board of Directors flexibility to impose criteria on who may participate in an offering. If not already included, a preemptive rights provision should generally not apply to (i) securities issued to directors, officers, agents or employees as compensation for services rendered; (ii) securities issued to an ESOP or other qualified plan; (iii) securities issued to satisfy conversion or option rights issued in accordance with the preemptive rights provision; or (iv) securities issued to effect a merger, consolidation or plan of exchange requiring approval of the shareholders. We also recommend modifying the provision to allow the Board, in its discretion, to make an offering of securities conditional on each proposed investor (including current shareholders) satisfying financial sophistication and experience conditions mentioned above along with any other exemption requirements. For example, a Board could decide to issue additional shares of common stock but limit participation in the offering only to accredited investors (as discussed above) and up to thirty-five (35) non-accredited investors each of which has the necessary financial sophistication required to qualify for the exemption. In this case, the Board could limit participation by non-accredited investors on a first-come-first-served basis in order to comply with an available exemption from registration. We regularly assist both financial and non-financial clients in capital raising activities. Please contact one of the attorneys listed above if you have any questions or would like to discuss any of the topics discussed in this publication. This Friday, Eldredge & Clark, LLP publication should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own attorney on any specific legal questions you may have.
1. 1 Take, for example, an investor whose primary residence has an estimated fair market value of $1.2 million, with a mortgage of $1.4 million. The underwater mortgage debt (in this case, $200,000) would be taken into account as a liability and serve to reduce net worth both under the Proposing Release net worth calculation in the initial netting of assets and liabilities and under the Final Rule calculation in a post-netting reduction. Likewise, take an investor whose primary residence has an estimated fair market value of $1.2 million, with a mortgage of $1 million. The positive equity (in this case, $200,000) would not increase net worth both under the Proposing Release and Final Rule calculation. In the Proposing Release positive equity is specifically excluded post-netting, and under the Final Rule, the $200,000 does not increase net worth because it is not included in the initial netting. download the article here