One year later than required by the JOBS Act, the SEC enacted a rule on July 10, 2013 to lift the ban on general solicitation and advertising in Rule 506 offerings to accredited investors. The SEC added a new subsection (c) to existing Rule 506 that permits general solicitation and advertising in connection with an offering of securities if the issuer takes reasonable steps to verify that all the purchasers of the securities are accredited investors. The old rule is now denoted subsection (b) and requires that the issuer forms a reasonable belief as to the status of the accredited investors, and, in any case, still permits up to 35 non-accredited investors. (Of course your lawyer still won’t let any non-accredited investors into the deal because of onerous disclosure requirements under Rule 502.)
According to the SEC: “whether the steps taken [to verify accreditation] are ‘reasonable’ would be an objective determination by the issuer (or those acting on its behalf), in the context of the particular facts and circumstances of each purchaser and transaction.” This is the same standard that the SEC put forth in the proposing release. However, in the rule, the SEC also included a list of specific and detailed non-exclusive, non-mandatory methods for verifying accredited investor status of purchasers who are natural persons.
Satisfying the Income Requirement. The issuer might review tax forms, including W-2s, 1099s, K-1s, and 1040s, that report the purchaser’s income for the two most recent years. The SEC also asks for a written representation from the purchaser (and the purchaser’s spouse) that the purchaser has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year.
Satisfying the Net Worth Requirement. The issuer might review bank, brokerage and other statements of securities holdings, certificates of deposit, tax assessments and appraisal reports. To ascertain liabilities, the issuer might look to reports from credit agencies. The reports would need to be dated within the prior three months. Further, the issuer would need to obtain a written representation from the purchaser that all liabilities necessary to make a determination of net worth have been disclosed.
Third Party Confirmation. The issuer might (instead) ask for a written confirmation from certain third parties, including broker-dealers, SEC-registered investment advisers, attorneys and certified public accountants, that such third party has taken reasonable steps within the prior three months to verify that the purchaser is an accredited investor based on either the income requirement or the net worth requirement.
Grandfathering of Existing Investors. In follow-on rounds, the investors who purchased securities in a Rule 506 offering as an accredited investor prior to the effective date of the new rule, could simply certify that they remain qualified as accredited investors.
High Minimum Investment Requirements. According to the SEC: “if the terms of the offering require a high minimum investment amount and a purchaser is able to meet those terms, then the likelihood of that purchaser satisfying the definition of accredited investor may be sufficiently high such that, absent any facts that indicate that the purchaser is not an accredited investor, it may be reasonable for the issuer to take fewer steps to verify or, in certain cases, no additional steps to verify accredited investor status other than to confirm that the purchaser’s cash investment is not being financed by a third party.”
If none of this is required, should you care? Well, think of what might happen if you (as a founder of a start-up company) end up having some non-accredited investors in a 506(c) transaction. Now add to this that you could have spotted and excluded them by using heightened (or, for that matter, any) verification procedures. Imagine, also, that things are a bit slow at your office and some of these non-accredited investors become disgruntled and call your state regulator to find out what remedies they might have. In the past, the state regulator would have told them that the state was pre-empted from taking action by the 506 filing. Or if the issuer had been careless enough to miss the required filing date of the Form D, the state might have told the issuer to find another private placement exemption. But now state securities enforcement would have a real live non-accredited investor, and could ask pointed questions. Also, what other private placement exemption would the offering fit under, now that you have gone public? So the state might bring an enforcement action. Then SEC enforcement might pile on and ask you to withdraw the offering or file a registration statement, which of course you could never afford to do. Then there is the possibility of a civil claim by the disgruntled investors against you personally, seeking rescission and an 8% return on their investment (See: RCW 21.20.430). Seen from a legal perspective, the SEC’s non-exclusive, non-mandatory verification procedures are not merely suggestions.
Most accredited investors traditionally qualify by claiming to have net worth in excess of $1 million. Well it is relatively easy to verify assets, but how does one account for liabilities? How would a credit agency know about personal guarantees on a business line of credit or on an office lease? And how exactly does one spot the potential investor who is a bit short but draws on his home equity credit line to get some cash to beef up his assets? (If he does so within 60 days of investing, that cash is not supposed to be included in net worth, according the SEC.)
Investors are understandably reluctant to share their personal finances with a start-up in which they are investing, so third-party verification is, in theory, a good idea. But who is going to pay for that? And, while I can’t speak for CPAs and investment bankers, as a lawyer I am not too keen on getting into this business. What can I say about liabilities that my client has not told me about?
So the effect of these suggested verification procedures might well be to move investors toward income verification. And this might work nicely for investors with salaries. But a significant portion of investors in private placements live off of capital gains or accumulated savings. These folks might have a lot of income one year, but very low income the next.
We are rapidly leaving behind a private placement market in which investors were considered accredited based on their own word. This market worked well for over 30 years. Why did we need to add the complications associated with verification?
John A. Myer is a corporate and securities lawyer with Myer Law PLLC in Seattle, Washington. This posting does not constitute legal advice.