July 21, 2010

New "Accredited Investor" Standard in Effect

Arnold & Porter Advisory

The Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Act"), which President Obama signed into law on July 21, 2010, includes an immediate change to the definition of "accredited investor."1 This Client Alert focuses on the practical implications to hedge funds and other pooled investment vehicles ("private funds") of the Act's revised definition of accredited investor. As noted below, this revised definition is effective immediately. This Client Alert does not address the other changes in the Act that affect private fund managers (many of which will phase in over the next 12 months).

Q:  How has the accredited investor standard changed?

  There are two standards to determine whether an individual investor (that is, an investor who is a natural person, as opposed to a legal entity) is an accredited investor: the "income test" and the "net worth test." Under the net worth test, an individual qualifies as an accredited investor if he or she has an individual net worth, or joint net worth with his or her spouse, that exceeds $1 million. Previously, an investor could include the value of his or her primary residence in determining whether the investor's net worth met the $1 million minimum. As a result of the Act's passage and effective immediately, the value of an investor's primary residence is excluded in determining whether the investor's net worth meets $1 million minimum. Thus, for an individual investor to qualify as an accredited investor, he or she now must either:

  1. Have an individual net worth, or joint net worth with his or her spouse, that exceeds $1 million, excluding the value of the investor's primary residence; or

  2. Have had individual income in excess of $200,000 in each of the two most recent years or joint income with his or her spouse in excess of $300,000 in each of those years and a reasonable expectation of reaching the same income level in the current year.

Q:  I manage a private fund. How does this change affect me?

A:  You will need to revise your subscription documents to reflect the change to the accredited investor standard. In addition, each time you accept an additional investment from (or sell new shares to) an existing individual investor, you should obtain a representation from the investor that he or she is accredited under the revised standards.2

Q:  An individual investor in my fund is already required to be a "qualified purchaser" or a "qualified client." Does the change to the definition of "accredited investor" still affect me?

A:  Yes. An investor in your fund must meet the "accredited investor" standards independently of any standards required of "qualified purchasers" or "qualified clients."3 All these standards are distinct. For example, it is possible — albeit unlikely — that an individual investor who satisfies the standards for being a "qualified purchaser" by owning not less than $5 million in investments (net of investment related indebtedness) could still fail to have a net worth in excess of $1 million under the revised accredited investor standards (which also take non-investment related debt into account), and thus potentially fail to be an accredited investor. Similar considerations apply to "qualified clients" (who, at least currently, are generally able to include the value of their primary residences in calculating their net worth for the purpose of meeting the applicable standards).

Q:  What should I do now?

A:  Please call or email your usual Howard Rice contact for assistance. We will provide you with an addendum to your current Subscription Application reflecting the revised accredited investor standard for immediate use. At your request, we will also send you: (i) a revised version of your Subscription Application and (ii) a Supplemental Subscription Application to provide to existing investors who make a new capital contribution.

1 Under the Securities Act of 1933 (the "Securities Act"), a private fund that offers or sells its securities, such as limited partner interests or shares, must register the securities with the Securities and Exchange Commission (the "SEC") or find an exemption from the registration requirements. Most private funds rely on the non-exclusive "safe harbor" from registration provided by Rule 506 of Regulation D. Among other requirements (including, importantly, prohibitions on "general solicitation"), Rule 506 requires that a private fund limit sales of its securities to (i) accredited investors and (ii) no more than 35 "non-accredited" investors. A private fund that sells securities to any non-accredited investors must meet special disclosure requirements. Thus, most private funds offer and sell securities only to investors that are accredited.

2 Under the Rule 506 safe harbor, an issuer must reasonably believe that a each investor is accredited "at the time of purchase." An additional capital investment by an existing investor is considered a new purchase; however capital contributions made in respect of mandatory capital calls (for example, by private equity or venture capital funds) generally do not require "bring down" representations by investors as to their status as an accredited investors, insofar as capital contributions in those circumstances are non-volitional and do not involve new investment decisions by the investors.

3 The definition of "qualified purchaser" is found in the Investment Company Act of 1940 (the "Investment Company Act"), a separate regulatory regime from the Securities Act. A fund that admits only qualified purchasers is eligible for the "3(c)(7)" exclusion from registration as an investment company. Similarly, the definition of "qualified client" appears in Rule 205-3 under the Investment Advisers Act of 1940 (which is a separate regulatory regime from both the Securities Act and the Investment Company Act). Rule 205-3 permits SEC-registered investment advisers to enter into investment advisory contracts that provide for performance-based fees, so long as the "client" (as defined in the Rule) entering into the contract is a qualified client.

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