Clipping the Wings of Angels? New Accredited Investor standards contained in Dodd-Frank Wall Street Reform Act

It is expected that within a few days President Obama will sign the Dodd-Frank Wall Street Reform Act (link to very long PDF).  [**Update: President Obama signed the law on July 21, 2010.**] Among the many goodies in the bill is Section 413 which excludes the value of an investor’s primary residence for purposes of calculating net worth for an “accredited investor.”  This is a change from past practice, where the value of residence was included, thereby increasing the pool of available accredited investors (especially in states with high home values).  The old rule can be found here. Read more to find out how this affects startups.

Gerry Laporte, Chief of the Office of Small Business Policy of the SEC’s Division of Corporation Finance, has confirmed that, in the view of the SEC Staff, the exclusion of a primary residence from an investor’s net worth for purposes of the accredited investor test in Rule 501(a)(5) of SEC Regulation D (as well as for purposes of the identical test in Rule 215(e) under the 1933 Act) will be effective upon enactment of the law.  Based on this stated view of the SEC Staff and the fact that there is no transition period or grandfathering permitted by Section 413, it would be prudent for companies relying on the definition of “accredited investor” in Regulation D or in Rule 215 to revise their disclosure and subscription documents in anticipation that the Act will be signed into law within the next several days.

If asked, the SEC Staff is expressing the informal view that the amount of any mortgage or other indebtedness secured by an investor’s primary residence should be netted against the value of the residence; thus, so long as the amount of the indebtedness is less than the fair market value of the residence, it need not be considered as a liability deducted from an investor’s net worth. If, however, the amount of the debt exceeds the fair market value of the residence and the mortgagee or other lender has recourse to the investor personally for any deficiency, that excess liability will have to be deducted from the investor’s net worth.  The SEC views this latter interpretation as a “common sense” reading of Section 413, which is otherwise silent with respect to the treatment of such mortgage indebtedness.

So what does this mean for startups?  When raising money, for a variety of reasons, it is generally recommended to only target accredited investors.  Therefore, the pool of likely available investors will by definition shrink, although it’s hard to know currently what impact this will have in practice.  If you are currently raising money, your counsel should provide a revised accredited investor questionnaire.

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For your information, the relevant text of Section 413 reads as follows:

SEC. 413. ADJUSTING THE ACCREDITED INVESTOR STANDARD.

(a) IN GENERAL.—The Commission shall adjust any net worth standard for an accredited investor, as set forth in the rules of the Commission under the Securities Act of 1933, so that the individual net worth of any natural person, or joint net worth with the spouse of that person, at the time of purchase, is more than $1,000,000 (as such amount is adjusted periodically by rule of the Commission), excluding the value of the primary residence of such natural person, except that during the 4-year period that begins on the date of enactment of this Act, any net worth standard shall be $1,000,000, excluding the value of the primary residence of such natural person.