Issues Surrounding Verification of Accredited Investor Status Under Proposed Rule 506(c)
A company seeking to raise capital through the sale of securities must either register its securities offering with the SEC or conduct the offering in reliance on one of the SEC's exemptions from registration. Most of the SEC’s exemptions from registration prohibit companies from engaging in a general solicitation or using general advertising in connection radio, television and newspaper advertisements or other media broadcasts; mass e-mail campaigns; public seminars or meetings, etc. Pursuant to Section 201(a) of the Jumpstart Our Business Startups Act ("JOBS Act") that was signed into law in 2012, the SEC was mandated to eliminate the restrictions against general solicitation or general advertising in certain exempt offerings made to "accredited investors" in reliance upon Rule 506. To fulfill this requirement, the SEC has proposed Rule 506(c), which permits the use of general solicitation in connection with an offering of securities, provided that: (1) all purchasers of securities in such offering are “accredited investors,” as defined in Rule 501(a) of Regulation D; (2) the issuer in such offering takes reasonable steps to verify that all purchasers of the securities are accredited investors; and (3) all terms and conditions of Rule 501 and Rules 502(a) and 502(d) are satisfied.
The proposed requirement that the issuer take reasonable steps to verify that all purchasers of the securities in a Rule 506(c) offering are accredited investors would heighten the obligations of the issuer as compared to the obligations under other regulation D exemptions. Rule 501(a) defines "accredited investor" as any person who (i) comes within any one of the eight categories of investors listed in Rule 501(a), including corporations having assets in excess of $5 million and individuals meeting specified net worth or income tests, or (ii) the issuer reasonably believes comes within any of said enumerated categories, at the time of the sale of the securities to that person. Accordingly, an issuer relying upon proposed Rule 506(c) would have to go beyond having the reasonable belief that is required under Rule 501(a) as to an investor's accredited status.
In its release accompanying the proposed rule, the SEC did not offer any uniform verification method or a non-comprehensive list of verification methods for satisfying the proposed “reasonable” verification requirement. Instead, the determination of whether the verification steps taken in a given transaction are “reasonable” would be based on an objective analysis by the issuer of the particular facts and circumstances surrounding each transaction. Under this proposed approach, the issuer would need to consider a number of factors when determining the reasonableness of the steps to verify that a purchaser is an accredited investor. Some examples of these factors include:
- the nature of the purchaser and the type of accredited investor that the purchaser claims to be;
In its proposing release, the SEC recognizes that the accredited investor verification steps will likely vary depending on the claimed category of accredited investor. In this regard, what would be considered reasonable steps to verify that a broker-dealer registered with the SEC and FINRA is an accredited investor will differ from what would be reasonable steps to verify the accredited investor status of a natural person under the applicable Rule 501(a) net worth and/or annual income categories. The SEC is also cognizant that taking reasonable steps to verify the accredited investor status of natural persons poses greater practical difficulties as compared to other categories of accredited investors, and these practical difficulties would likely be exacerbated by natural persons’ privacy concerns about the disclosure of personal financial information. Further, as between the net worth test and the income test for natural persons, it will likely be more difficult for an issuer to obtain information about a person’s assets and liabilities than it would be to obtain information about a person’s annual income, although there could be privacy concerns with respect to either test.
- the amount and type of information that the issuer has about the purchaser;
The SEC comments under this factor that the more information that an issuer has indicating that a prospective purchaser is an accredited investor, the fewer steps the issuer would have to take to verify the investor’s eligibility, and vice versa. The SEC's proposing release offers examples of the types of information an issuer could review or rely upon any of which might, depending on the circumstances, in and of themselves constitute reasonable steps to verify a purchaser’s accredited investor status. For example:
- publicly available information filed with a federal, state or local regulatory body (e.g., the purchaser is a named executive officer of reporting company and the purchaser's compensation is disclosed in that reporting company’s proxy statement that indicates that the investor falls within one of the enumerated categories of accredited investor);
- third-party information that provides reasonably reliable evidence that the investor falls within one of the enumerated categories of accredited investor (e.g., without limitation: the investor is a natural person and provides copies of Forms W-2; or the investor works in a field where industry or trade publications disclose average annual compensation for certain levels of employees or partners, and specific information about the average compensation earned at the investor’s workplace by persons at the level of the investor’s seniority is publicly available); or
- verification of the investor’s status by a third-party (e.g., a broker-dealer, attorney or accountant), provided that the issuer has a reasonable basis to rely on such third-party verification.
- the nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount.
In this regard, the means through which the issuer publicly solicits purchasers may be relevant in determining the reasonableness of steps taken to verify a particular purchaser’s accredited investor status. For example, an issuer that solicits new investors through a website accessible to the general public, or through a widely-disseminated e-mail or social media solicitation, would likely be required to take more stringent verification measures than an issuer that solicits investors included in a database of pre-screened accredited investors maintained by a “reasonably reliable” third-party such as a registered broker-dealer. In the case of the former, an issuer most likely would not have taken reasonable steps to verify accredited investor status if it required only that a person check a box in a questionnaire or sign a form, absent other information about the purchaser indicating accredited investor status. In the case of the latter, an issuer most likely would be entitled to rely on a third party that has verified a person’s status as an accredited investor, provided that the issuer has a reasonable basis to rely on such third-party verification.
Also, depending on the facts, the terms of an offering may be relevant. For example, setting a minimum investment amount requirement per investor (with a direct cash investment that is not financed by the issuer or any other third party) that is sufficiently high such that only accredited investors could reasonably be expected to meet it, could be taken into consideration in verifying accredited investor status.
The SEC stated in its proposing release that these factors are interconnected, and the information gained by looking at these factors would help an issuer assess the reasonable likelihood that a potential investor is accredited, which would, in turn, affect the types of steps that would be reasonable to take to verify an investor’s accredited status
Whatever the steps taken in a specific offering to verify that an investor qualifies as an “accredited investor” the “reasonableness” of these steps most likely will be challenged after the fact (e.g., in the context of a lawsuit or SEC investigation). For that reason, the SEC cautions that it is important for issuers to retain adequate records to document the steps that were taken by the issuer to verify an investor's accredited status. The SEC also points out that the issuer ultimately will bear the burden of establishing the availability of an exemption from the registration provisions of the Securities Act. Accordingly, an issuer seeking to rely on proposed Rule 506(c) would face significant consequences for failing to meet this burden of proof, since an issuer that relies on the new Rule 506(c) exemption and fails to meet the "reasonable steps" requirement will not have qualified for the Rule 506(c) exemption. At the same time, the issuer would be precluded from relying on the statutory private placement exemption provided by Section 4(2) of the Securities Act because the issuer would have conducted the offering using public solicitation and/or public advertising, which is not allowed in a Section 4(2) private placement. In such a case, the issuer would be left without any available exemption from the registration requirement and not having registered the offering with the SEC would have violated Section 5 of the Securities Act of 1933, as amended.
It is possible that in finalizing the proposed rule, the SEC will clarify some of these concerns. Should this rule take effect, we would welcome your inquiries as to how to best structure your offering to take advantage of this capital raising tool. Please feel free to contact Susan Burke (312 261 2120) or David Diamond (312 261 2174) with questions or comments.
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