Changes to "Accredited Investor" and "Qualified Client" Standards Under Dodd-Frank Act
August 27, 2010
By Greg Powell
On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"), which brings into place a broad range of financial regulatory reforms. Title IV of the Dodd-Frank Act, titled Private Fund Investment Advisers Registration Act of 2010 (the "Registration Act") significantly modifies the registration and reporting requirements under the Investment Advisers Act of 1940 ("Advisers Act"). This is the first of several Tips that Tonkon Torp will prepare about the Registration Act.
The value of an "Accredited Investor's" primary residence is now excluded from the "net worth" calculation
The term "accredited investor" is used for purposes of determining whether an offering of securities is eligible for an exemption from registration under Regulation D of the Securities Act of 1933. The Registration Act revised the definition of "accredited investor." Generally, individual investors have been able to qualify as an accredited investor under either an annual income test or a net worth test. Prior to the Registration Act, an individual was able to satisfy the net worth test if, at the time of purchasing the securities, the net worth of the individual (or joint net worth with a spouse) exceeded $1,000,000.
Effective July 21, 2010, the Registration Act requires an individual to exclude the value of the individual's primary residence from his or her net worth calculation in order to satisfy the net worth test. The SEC has issued guidance clarifying that mortgage and other indebtedness secured by a primary residence should be excluded from the liability side of an individual's net worth calculation up to the fair market value of the residence, but such indebtedness secured by the primary residence in excess of the residence's fair market value must be included as a liability and deducted from an individual investor's net worth.
The revised "accredited investor" standard does not apply to existing investors unless those investors are making additional contributions. Therefore, funds, advisers, broker-dealers and other issuers must ensure that this new accredited investor standard is satisfied for new investors and for investors making additional investments.
Recommended action steps
- We recommend that you review your offering documents (PPMs, subscription agreements, etc.) to ensure that the definition of accredited investor accurately reflects the revised standard.
Advisers with distribution or solicitation agreements should review your agreements to determine whether any specific investor standards that are described will need to be revised.
Be prepared for increased regulatory scrutiny. In light of the stated policy of increased enforcement by the SEC, we anticipate further regulatory scrutiny with respect to how funds and other issuers incorporate this "net worth" calculation change into their sales and compliance process.
The definition of "accredited investor" will continue to be reviewed by the SEC
While the above change to the net worth test is effective immediately, the SEC is directed to conduct subsequent reviews of the entire definition of "accredited investor" (as that term applies to natural persons) at least every four years to determine if further adjustments or modifications should be made. In addition, the Registration Act requires the Comptroller General of the United States to conduct a study on the appropriate criteria for determining the financial thresholds and other criteria needed to qualify for accredited investor status and eligibility to invest in private investment funds. The results of that study must be reported within three years after enactment of the Registration Act.
Potential Changes to "Qualified Client" Standard
In general, the Advisers Act provides that a registered investment adviser may only charge a performance-based fee to clients who meet the "qualified client" standard. Generally, for natural persons the Advisers Act defines a "qualified client" as a person who has at least $750,000 under the management of the investment adviser and who has a net worth (together with assets held jointly with a spouse) of more than $1,500,000 at the time the management contract is entered into.
The Registration Act will change the above dollar thresholds used in determining a qualified client. The Registration Act requires the SEC, no later than July 21, 2011 (and every five years thereafter), to adjust the thresholds to give effect to inflation (rounding to the nearest multiple of $100,000 as necessary).
For further questions concerning the Dodd-Frank Act and its impact on the financial advisory and broker-dealer industries, please contact our Financial Services practice group.