SEC Changes to Accredited Investor Miss the Point

As required by Dodd-Frank, the SEC today voted to proposed rules that would bring the definition of "accredited investor" into compliance with the Dodd-Frank Wall Street Reform and Consumer Protection Act.  As explained in the proposed rule (pdf here) Dodd-Frank section 413(a) required that the definitions of “accredited investor” in the SEC's rules "to exclude the value of a person’s primary residence for purposes of determining whether the person qualifies as an 'accredited investor' on the basis of having a net worth in excess of $1 million."  

The rule now provides:

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. 

Thus, in excluding the value of the primary residence, the calculation will net out any mortgage.  The SEC explains that under the old rules, an investor with a conventional calculation of net worth of $2 million with a $1.2 million primary residence (FMV) and a mortgage loan of $800,000, the investor’s net worth under the new accredited investor standard would be $1.6 million.  Before Section 413(a), the net worth would have been the $2 million.  The SEC thus reasons that, under the old rule, the "primary residence would have contributed a net amount of $400,000 to the investor’s net worth for purposes of the accredited investor net worth standard—the value of the primary residence ($1.2 million) less the mortgage loan ($800,000).  Under the proposed rule, exclusion of the value of the primary residence would reduce the investor’s net worth by the same amount of $400,000.   

Okay, but this has a potentially perverse effect. Here's my math:

Old Rule:

$1,600,000 Other Assets

$1,200,000 House

($800,000) home mortgage

$2,000,000 net worth

Proposed Rule:

$1,600,000 Other Assets

$1,200,000 House

($800,000) home mortgage

($400,000) value added by home

$1,600,000 net worth

This seems fine, but it also sends a message that I think conflicts with the intent of Section 413(a):  take on more debt to raise your net worth.  How?  

Under the proposed rule, the same investor can raise his or her net worth for accredited investor purposes by taking out a larger loan on the home.  

Proposed Rule, Bigger Loan:

$2,000,000 Other Assets ($1.6 million + the $400,000 cash from taking an additional mortgage)

$1,200,000 House

($1,200,000) home mortgage

$2,000,000 net worth

Okay, perhaps someone can't get a 100% loan today (certainly it's not as easy), but you can see the point. In my view, Dodd-Frank was intended to take the primary home out of the equation.  Under this rule, you do that to a point,  but if someone owns their home outright, they can take a loan on it, add that cash to their assets and raise their net worth. Perhaps better stated, the investor is encouraged to maintain debt for purposes of investment, even if it isn't quite this easy.  

For example, suppose someone has a $800K in non-primary-home assets, and a $1.2 million home with no mortgage.  This person has a conventional net worth of $2 million, but cannot meet the $1 million net worth calculation under the proposed rule.  If the same person takes out $400K in a mortgage, that money can be added to their non-home assets.  The new net worth is $1.2 million because the $800K goes to non-home assets and the SEC nets out the rest.  In fact, the SEC notes in the proposed rule that "The North American Securities Administrators Association (“NASAA”) has recommended that we not permit the exclusion of debt secured by a primary residence from the calculation of net worth if proceeds of the debt are used to invest in securities."  At a minimum, I think NASAA is right. 

The change in Dodd-Frank may be wrong but that's not the issue.  The SEC's proposed rule does not satisfy what I think was the point of the legislation. Thus, it may be the better rule, but it's not the right rule.  

--JPF