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A new variation on Comfort letters – Third Party Verification Letter requests from Investment Professionals

Madoffby Rickard Jorgensen, FCII, ARM, ACIArb

Comfort letters issued to lenders and mortgage companies have been a quite common practice for Tax Professionals.  Such letters are used to verify income for the purchase of a home or other asset.  The provision of comfort letters is relatively simple and merely require a review of tax return records for the most recent filed tax year. Usually comfort letters do not impose an especially onerous responsibility upon the Tax Professionals

However, a recent series of inquiries from CPA clients has added a more troubling aspect to comfort letters.

Investment Advisers and Wealth Managers are offering complex and unconventional alternative investment products. These “Alternative” may comprise REITSs, Hedge Funds, structured debt layering or option strategies.  From an Investment Professionals’ errors and omissions perspective these products are high risk and as such are heavily regulated by the SEC and often required to be accredited investors.

Accredited Investors are defined under Section 413(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (commonly referred to as the Dodd-Frank Act). Section 413(a)

The accredited investor standards are used in determining the availability of certain exemptions from Securities Act registration for nonpublic and limited offerings, including most offerings under Rule 501(a) of Regulation D of the Act. The accredited investor concept identifies investors who are eligible to participate in those offerings of unregistered and illiquid securities. In order to rely on investor status as an “accredited investor,” issuers must know or have a reasonable basis to believe that the investor falls within one of eight categories. The individual net worth standard is one such category.

The accredited investor standards are used in determining the availability of certain exemptions from Securities Act registration for nonpublic and limited offerings, including most offerings under Regulation D.

What are the requirements for an individual to qualify as an “accredited investor” based on net worth?

  • The individual must have a net worth greater than $1 million, either individually or jointly with the individual’s spouse. Except for the special provisions described below, individuals should include all of their assets and all of their liabilities in calculating net worth.
  • The primary residence is not counted as an asset in the net worth calculation. The term “primary residence” is not defined in SEC rules but is commonly understood to mean the home where a person lives the most of the time.
  • In general, debt secured by the primary residence (such as a mortgage or home equity line of credit) is not counted as a liability in the net worth calculation if the estimated fair market value of the residence is greater than the amount of debt secured by it. There is no requirement to obtain a third party estimate of the fair market value of the residence.
  • However, if the amount of debt secured by the residence has increased in the 60 days preceding the sale of securities to the investor (other than in connection with the acquisition of the primary residence), then the amount of that increase is included as a liability in the net worth calculation, even if the estimated value of the residence is greater than the amount of debt secured by it. The purpose of this provision is to deter individuals from incurring debt secured by their primary residence for the purpose of inflating their net worth to qualify as accredited investors in purchasing securities.
  • If the amount of debt secured by the primary residence is greater than the estimated fair market value of the residence, then the excess is included as a liability in the net worth calculation.Where the amount of secured debt is greater than the value of the primary residence, such as when a mortgage is “underwater,” the excess is counted as a liability when calculating net worth. This is true even if the borrower may not be personally liable for the excess amount by reason of the contractual terms of the debt or the operation of state anti-deficiency statutes or similar laws.

The comfort letters from Investment Advisers and Wealth Managers require a Tax Professional to commit to the foregoing by signing a statement as follows:

I hereby confirm that (1) I am personally familiar with the financial condition, income and/or net worth of the Investor, (2) I have taken reasonable steps to verify the Investor’s status as an “accredited investor”, as such term is defined in Rule 501(a) of Regulation D of the Act, within three months of this Written Confirmation, including review of relevant financial documents of the Investor, and (3) I have determined that the Investor is an accredited investor.

I understand and acknowledge that the Investor has requested that I provide this certification letter to assist [investment product] in its verification of Investor’s status as an accredited investor in connection with the Investor’s potential purchase of securities offered for sale by one or more companies (“Issuers”) on the [investment product]. The [investment product], and any Issuer in which the Investor invests in through the Platform, may rely on this certification letter.

I am pleased to confirm that the Investor has been verified as an “accredited investor” as defined in Rule 501 of Regulation D of the Securities Act of 1933.

This creates an onerous situation for the Tax Professional because the level of service necessary to provide such an assurance exceeds the usual and customary tax preparation work.  It might also violate professional standards if the information turns out to be materially inaccurate or incomplete and therefore misleading.

Even if the request is made on behalf of an important or long-standing client, before signing a certificate letter as outlined above, make sure you have the verifiable facts. Alternatively, decline to provide a certification letter and limit your assurance to the information provided in the last tax return (in fact, you may wish to use the standard form of comfort letter – see 10-Comfort-letter-for-lender1).

The market for Alternative Investment products is growing and this type of certification letter request will become more frequent.  It is important that the Tax Professional does not verify that an investor is accredited. This is the responsibility of the Investment Professional.

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Jorgensen & Company are not attorneys and do not offer any form of legal advice. Consult with appropriately qualified local counsel for more assistance. Rickard Jorgensen is President and Chief Underwriting Officer for the CPAGold™ program and may be contacted at (201) 345 2440 or rjorgensen@jorgensenandcompany.com