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Capital Markets Alert: SEC Issues Small Entity Compliance Guide for Accredited Investors


The staff of the Securities and Exchange Commission ("SEC") recently issued a Small Entity Compliance Guide (the "Guide") to explain the amendments to the SEC's "accredited investor" standards under the Securities Act of 1933 (the "Securities Act") that were adopted in December 2011 to implement the requirements of Section 413(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank"). As a result of those amendments and the adoption of related SEC rules, the value of a potential investor's primary personal residence may no longer be included in the determination of whether the investor has a net worth that meets the test for classification as an "accredited investor". This could make it more difficult for smaller companies to raise capital through offerings that have the advantage of being exempt from the SEC's registration and certain of its disclosure requirements.

The Securities Act permits companies to raise capital through offerings of securities that are exempt pursuant, for example, to Regulation D ("Reg D") from costly and complex registration with and scrutiny by the SEC if certain conditions are met. In effect, Reg D permits sales under those offerings to an unlimited number of "accredited investors." It also permits sales under those offerings to a limited number of "non-accredited investors" if, in effect, additional financial statement and non-financial statement information is provided to such investors.

Generally, it has been acknowledged that smaller, emerging businesses are the primary agent in the creation and expansion of jobs in the U.S. Such businesses require access to capital for their growth. Subsequent to 1999, fewer and fewer smaller businesses have been able to obtain capital through initial public offerings that require registration with and significant scrutiny by the SEC due to the increasing cost and complexity of such offerings. Instead, many of those businesses have been able to raise capital privately through less costly debt and equity offerings that are exempt from registration pursuant to Reg D. As a result, the overall pool of available "accredited investors" is significant to smaller businesses seeking capital through exempt offerings.

The Guide states: "The accredited investor concept identifies investors who are eligible to participate in those offerings of unregistered and illiquid securities. In order to rely on investor status as an "accredited investor," issuers must know or have a reasonable basis to believe that the investor falls within one of eight categories. The individual net worth standard is one such category." Some of the other "accredited investor" categories are banks, insurance companies and registered investment companies; certain employee benefit plans; certain charitable organizations; and directors and executive officers of the company selling the securities.

The Guide explains that the individual net worth category, as amended by Dodd-Frank, is comprised of "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 term "primary residence" is not defined in SEC rules but is commonly understood to mean the home where a person lives most of the time. Prior to the enactment of Dodd-Frank, the value of the primary residence was not excluded and, accordingly, the pool of available "accredited investors" has been reduced.

The Guide also states that:

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.

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.

In addition, the Guide includes examples of "accredited investor" net worth calculations:

Example: Basic Net Worth Calculation for an Investor with Positive Home Equity

Estimated fair market value of primary residence                                               $1,200,000

Value of debt secured by primary residence                                                       $800,000

Other assets                                                                                                   $850,000

Other liabilities                                                                                                $20,000

Net worth (comprised of other assets less other liabilities and would exclude the net value of the primary residence of $400,000) $830,000

In the above example, the investor would fall below the $1,000,000 threshold required for qualification as an "accredited investor."

Example: Net Worth Calculation for an Investor with Negative Home Equity

Primary residence with an estimated fair market value that declined to:                $600,000

Value of debt secured by primary residence                                                        $800,000

Other assets                                                                                                    $850,000

Other liabilities                                                                                                 $20,000

Net worth (comprised of other assets less other liabilities and the $200,000 excess of the fair value of the debt secured by the primary residence over the fair value of the primary residence)                                                                         $630,000

Again, the investor would fall below the $1,000,000 threshold required for qualification as an "accredited investor."

Our View of the News

The financial crisis of 2008 in part prompted these changes to enhance the protection for investors. There is a double-edge to this sword, however, because this protection has the tendency to reduce the number of potential investors. We believe that another bill (H.R. 3606, Reopening American Capital Markets to Emerging Growth Companies Act of 2011), which is still subject to final Congressional passage and enactment, reflects a more prevalent trend toward Congressional recognition that small companies need capital in order to innovate and create jobs that will bolster the economy. For some time, J.H. Cohn has believed that the U.S. needs to "jump start" the corporate engines by restoring access to public capital. Capital, in all its forms, is the underpinning of job creation. Further, we need to create a more efficient delivery system for small enterprises to access the capital markets. This includes removing the friction that small companies experience when raising capital. The passage of this bill is a sign toward that very direction.

For more information on this issue or to discuss going public, please contact Richard Salute, CPA, J.H. Cohn partner and Capital Markets and SEC Practice director, at rsalute@jhcohn.com or 516-336-5501, or your J.H. Cohn engagement partner at 877-704-3500.

Download the full PDF.

This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and J.H. Cohn LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

Published date: 3/13/2012

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