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SEC Adopts Net Worth Standard for Accredited Investors Under Dodd-Frank Act On December 21, 2011, the U.S. Securities and Exchange Commission (SEC) amended its rules to exclude the value of a person’s home from net worth calculations used to determine whether an individual may invest in private hedge funds. The changes were made to conform the SEC’s definition of an “accredited investor” to the requirements of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. SEC rules permit certain private and limited offerings to be made without registration in the United States and without requiring specified disclosures, if sales are made only to "accredited investors." Beginning in 2014, and every four years thereafter, the Dodd-Frank Act requires the SEC to review the “accredited investor” definition in its entirety and to engage in further rule making to the extent it deems appropriate.
U.S. Accredited Investors Explained A U.S. "accredited investor" is defined in the Securities Act of 1933 as any person who comes within any of the categories described below. Generally, accredited investors include individuals with a minimum annual income (Income Test) or $1 million in net worth (Net Worth) and most institutions and entities with $5 million in assets. In addition to the Income and Net Worth Tests, there are other accredited investor categories. In all cases, a proposed investor must have knowledge and experience in financial and business matters so as to be capable of evaluating the relative merits and risks of an investment in your hedge fund. A U.S. hedge fund that does not advertise may have up to 35 non-accredited investors. Learn More About U.S. Hedge Fund Advertising
Subscription Agreement Description of U.S. Accredited Investor
The language below is taken from a standard Subscription Agreement used in hedge fund offering documents.
1. Any bank as defined in section 3(a)(2) of the [Securities] Act, or any savings and loan association or other institution as defined in section 3(a)(5)(A) of the Act whether acting in its individual or fiduciary capacity; any broker or dealer registered pursuant to section 15 of the Securities Exchange Act of 1934; any insurance company as defined in section 2(a)(13) of the Act; any investment company registered under the Investment Company Act of 1940 or a business development company as defined in section 2(a)(48) of that Act; any Small Business Investment Company licensed by the U.S. Small Business Administration under section 301(c) or (d) of the Small Business Investment Act of 1958; any plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5,000,000; any employee benefit plan within the meaning of the Employee Retirement Income Security Act of 1974 if the investment decision is made by a plan fiduciary, as defined in section 3(21) of such act, which is either a bank, savings and loan association, insurance company, or registered investment adviser, or if the employee benefit plan has total assets in excess of $5,000,000 or, if a self-directed plan, with investment decisions made solely by persons that are accredited investors;
2. Any private business development company as defined in section 202(a)(22) of the Investment Advisers Act of 1940;
3. Any organization described in section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;
4. Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer;
5. Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his purchase exceeds $1,000,000;
6. Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;
7. Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person as described in Rule 506(b)(2)(ii) and
8. Any entity in which all of the equity owners are accredited investors.
Comments on the U.S. Accredited Investor Income Test The Income Test states that any natural person who had an individual income in excess of $200,000 in each of the 2 most recent years or joint income with that person's spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year and future years is an accredited investor. Though joint spousal income can be used to establish accredited investor status, proposed investors cannot use separate income for one year and joint income for the next year and future years to meet the test. Future income is relevant. You are required to inquire into the proposed investor's income for the year in question to determine whether an individual can satisfy the Income Test. You cannot accept a proposed investor's representations as to income. If the prospective investor has a consistent pattern of income that exceeds $200,000, or $300,000 joint income, the investor's representation is acceptable if you are operating a Rule 506(b) hedge fund (i.e., an unadvertised U.S. hedge fund).
U.S. Accredited Investor Rule 506(c) Verification Procedures If you are operating under Rule 506(c) of Regulation D (i.e., applicable to advertised U.S. hedge funds) you must request that the proposed investor provide you with a CPA confirmed, licensed attorney confirmed, or SEC registered broker-dealer confirmed income statement. A third party confirmation of an investor's status is a good practice to observe for Rule 506(b) hedge funds in any event. Learn More About Hedge Fund Marketing Of course, contact the actual party documenting the confirmation directly to verify that the third party in fact authored the net worth statement (i.e., to avoid fabricated statements).
Comments on the U.S. Net Worth Test Any natural person whose individual net worth or joint net worth with that person's spouse, at the time of purchase exceeds $1,000,000 is an accredited investor. Neither the Securities Act of 1933 nor the various rules and interpretations associated with the law in this area define exactly what makes up net worth. To determine net worth, both spouse's assets can be counted even if only one spouse is the purchaser. The Dodd-Frank Act requires that the value of a person’s primary residence be excluded from the net worth calculation used to determine the person’s accredited investor status. When in doubt of a proposed investor's net worth, the best bet is to request third party confirmation of prospective investor's financial statement of net worth.
U.S. Accredited Investor Rule 506(c) Verification Procedures If you are operating under Rule 506(c) of Regulation D (i.e., applicable to advertised U.S. hedge funds) you must request that the proposed investor provide you with a CPA confirmed, licensed attorney confirmed, or SEC registered broker-dealer confirmed net worth statement. A third party confirmation of an investor's status is a good practice to observe for Rule 506(b) hedge funds in any event. Learn More About Hedge Fund Marketing Of course, contact the actual party documenting the confirmation directly to verify that the third party in fact authored the net worth statement (i.e., to avoid fabricated statements).
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