Did Tuesday's SEC "Net Worth" Release Reverse the Prior Guidance?

Answer: At first I thought it did, but now I think it just muddied it.

In July, promptly after passage of Dodd-Frank and its immediately-effective change to the net worth test of the accredited investor definition, the SEC issued guidance, pending rule-making, on how to interpret the new law:

"Under Section 413(a) of the Dodd-Frank Act, the net worth standard for an accredited investor, as set forth in Securities Act Rules 215 and 501(a)(5), is adjusted to delete from the calculation of net worth the 'value of the primary residence' of the investor. . . .

"Pending implementation of the changes to the Commission’s rules required by the Act, the related amount of indebtedness secured by the primary residence up to its fair market value may also be excluded. Indebtedness secured by the residence in excess of the value of the home should be considered a liability and deducted from the investor’s net worth."

(Emphasis added.)

Last Tuesday, the SEC proposed an actual rule to conform the net worth standard under regulations to the Dodd-Frank change:

“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, excluding the value of the primary residence of such natural person, calculated by subtracting from the estimated fair market value of the property the amount of debt secured by the property, up to the estimated fair market value of the property.”

(Emphasis added.)

On first reading, I thought the proposed rule meant that the "downside" of the exclusion of the primary residence was to be capped by "the estimated fair market value of the property.” That was exciting for two reasons: (1) fewer angels would be knocked out of startup investing simply by the happenstance of an underwater mortgage, and (2) the new rule would, unlike the preliminary guidance, be easy to administer - one would simply take the primary residence off the table, and assign it no weight, positive or negative.

But on second reading, after working through additional examples in the release, it's clearer that the SEC intends to "ding" you for an underwater mortgage, which is consistent with the prior guidance.

Joe Wallin and I are preparing a slide deck to give a presentation to an angel group on the new net worth standard. In connection with that, Joe came up with the following, plain language version of the new proposed rule:

"You calculate net worth in the ordinary way. So an upside down house dings you. If your house is not upside down then you only reduce your net worth by the value in excess of debt."

Joe also points out on his blog that the preliminary guidance is still posted on the SEC's website, implying that it is still in effect.

Now, there may be "wiggle room" between the prior guidance and the proposed rule, if you ignore the examples in the release: in a nonrecourse state, one could reasonably conclude that an underwater mortgage was not, to the extent of the deficiency, an actual liability, since it could not be collected. That is, in certain jurisdictions, under the "ordinary way" of calculating net worth, you would not go negative even if the value of your property plummeted below the balance on your mortgage. The language of the prior guidance didn't permit this nuance, but simply deemed that "indebtedness secured by the residence in excess of the value of the home should be considered a liability." The proposed rule, I think, may leave it up to you to determine whether a deficiency in an underwater mortgage is in fact legitimately "debt secured by the property." You might determine that your deficiency is not secured or that it is not a liability at all?

Let's go back to what Dodd-Frank itself says, emphasis added:

"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."

In retrospect, the phrase "the value of" should have been excluded, to avoid the mischief we are dealing with now in implementing it. IMHO, if we simply took the principal residence off the table, the net worth standard would be easier for all to understand and for the startup community to self-police.