Source: JIM VERDONIK, Ward and Smith, P.A.
Let’s analyze the SEC’s recent Rule 506 (c) changes through the eyes of dogs. The SEC threw business trying to raise capital a bone by letting them advertise in Rule 506 (c) private placements, but you have to learn new tricks about how you verify that a purchaser is an “accredited investor” if you want to chew on this bone.
Are the benefits of advertising worth it?
Will it cure your capital woes?
Or are the accredited investor verification a poison pill that will kill your business?
Scope of this Article
This is one of a series of articles about the July 2013 changes to SEC Rule 506 that made substantial changes to how you raise capital in private placements, including the addition of new Rule 506 (c).
This article explores how you comply with the requirement to take reasonable steps to verify that someone is an “accredited investor.”
Our other articles in this series about SEC Rule 506 private placements discuss:
Beware of SEC Integration Rules: Why you should look before you leap into advertising. What integration and related pitfalls does Rule 506 (c) create for businesses that choose to advertise or engage in general solicitations? How do you sell securities to people who are not accredited investors under another SEC private placement exemption, if your advertising fails to attract enough accredited investors to finance your business?
SEC and State Antifraud Disclosure Rules: How do you decide what you want to say in advertisements and how do you say it?
Bad Actors: How do you prevent the SEC’s Bad Actor Prohibition for Rule 506 private placements from cutting off your ability to raise capital?
(See them at: http://jimverdonikintersection.blogspot.com/2013_07_01_archive.html)
Government Bouncer at Capitalist Club: Why is the Government using Rule 506 (c) to decide who is allowed to be a capitalist? Do you have what it takes to get past the Government bouncer?
Rule 506 (c) Advertising and General Solicitation
Here’s a link to the page of the SEC’s website that contains SEC Release 33-9415 about advertising and general solicitations in Rule 506 (c) private placements: http://www.sec.gov/rules/final.shtml. Most of the SEC’s release explains Rule 506 (c) and the reasons for it, but the full text of the Rule 506 (c) is at the end of the release.
You won’t find any direct statement in Rule 506 (c) that permits advertising or general solicitations. Instead, the SEC backed into allowing advertising and general solicitations by not including in the new Rule 506 (c) the same prohibition against advertising and general solicitations that Rule 506 (b) had and continues to have. This avoidance of actually directly giving permission to advertise and solicit generally might reflect the fact that the SEC has only approved Rule 506 (c), because Congress and the President required it in the JOBS Act of July 2012.
When you try to predict how the SEC will interpret and enforce Rule 506 (c), it’s useful to remember that people at the SEC didn’t just wake up one day and say: “I have a great idea. Let’s permit businesses to advertise for investors in private placements.”
That’s another way of saying that the SEC will probably strictly enforce accredited investor verification rules and anti-fraud provisions that relate to what you say in advertising and how you say it. Think of it like going to your father to let you do something your mother wouldn’t let you do. Your mom might reluctantly go along with it, but she will hold you to the letter of what you agreed with your father. Don’t expect too many breaks.
To better understand advertising and general solicitations, let’s look at Rule 502 (c) which is incorporated into Rule 506 (b) offerings, but is not incorporated into Rule 506 (c) offerings.
“Neither the issuer not any person acting on its behalf shall offer or sell securities by any form of general solicitation or general advertising. . . .”
Rule 502 (c) gives examples of prohibited practices, which includes advertisements, articles notices and other communications published in any newspaper magazine, or similar media or broadcast over television or radio and any seminar or meeting whose attendees have been invited by general solicitation or general advertising. Since Rule 502 (c) pre-dates the Internet, Rule 502 (c) does not specifically mention websites and social media, but these newer media are covered by Rule 502 (c).
Accredited Investors Only
To qualify to advertise or conduct another form of general solicitation, Rule 506 (c) states that all people and organizations that purchaser securities must be “accredited investors” Rule 506 (c) also requires you to take specific steps to verify the purchasers actually meet the criteria for being accredited investors. You can’t use Rule 506 (c) to advertise if all you do is ask an investor whether they are accredited.
Two Separate Tests
The SEC’s release makes it clear that you have to satisfy two separate tests if you want to rely on Rule 506 (c) to advertise or conduct a general solicitation. The release states that the verification requirement “is separate from and independent of the requirement that all sales be limited to accredited investors, and must be satisfied even if all purchasers happen to be “accredited investors.” The SEC believes this separate requirement “will avoid diminishing the incentive for issuers to undertake the reasonable verification steps envisioned by the JOBS Act.
The bottom line is that being lucky isn’t a defense. You actually have to do the work to verify accredited investor status if you want to advertise.
This two separate tests approach opens the door for purchasers who actually are accredited investors to sue you and your business for not taking reasonable steps to verify their status, if they lose money by investing in your business. So, if you just guess that your investors are accredited or if you just take their word for it, you are giving the investors a gun to put to your head, if the investors lose money. If they sue you, fraud and who is at fault won’t even be issues, if you advertised but you failed to satisfy Rule 506 (c)’s verification standards. Of course, if the person actually isn’t an accredited investor, their case against you is even stronger.
This may change existing law (at least for Rule 506 (c) offerings). Courts frequently dismissed law suits in which investors claimed they were not accredited investors, because the courts have ruled the investors should not benefit from misleading the seller by signing false statements, unless investors could show the seller knew the statements were false.
Accredited Investor Definition
Let’s briefly review who is an accredited investor before we deal further with the more complicated verification requirements of Rule 506 (c).
Rule 501 (a) of Regulation D lists eight (8) types of “accredited investors.” These include a variety of banks, investment funds and other financial institutions, trusts, directors, executive officers, general partners of the issuer (or of the issuer’s general partner, if the issuer is a partnership or limited partnership), and any corporation or other entity if all its equity owners are accredited investors. Natural persons who satisfy one of the following net worth or income tests are also accredited investors:
A natural person whose individual net worth, or joint net worth, with that person’s spouse, at the time of purchase exceeds $1,000,000 (not including the value of their primary residence or mortgage or other debt the home secures, unless the mortgage or other debt exceeds the value of the primary residence); or
A natural person who had an individual income in excess of $200,000 in each of the two most recent years that precedes the investment or joint income with that person’s spouse in excess of $300,000 in each of the two prior years who also has a reasonable expectation of reaching the same income level in the year the investment is made.
We note that Rule 501 (a) makes it clear that someone can be an accredited investor in one of two ways:
The investor actually meets the criteria specified in Rule 501 (a); or
The issuer has a “reasonable belief” that the investor meets the criteria specified in Rule 501 (a).
Rule 506 (c)’s verification requirements apply to all eight (8) types of accredited investors specified in Rule 501 (a). But the most vocal concerns about the verification provisions relate to procedures for verifying the income or net worth or individual investors. We discuss the reasons for these objections in one of our other articles in this series of articles about Rule 506 (c).
We note, however, that the verification requirement for other types of accredited investors also present difficulties. For example, verifying that all the equity owners of the investor are accredited investors may require substantial effort. If you have an investor that is owned by a series of corporations, limited liability companies or other entities, you would have to trace back up the chain to the ultimate equity owners at the end of the chain to determine whether the investor is an accredited investor.
The SEC acknowledges that collecting data may subject a business to other obligations under state and Federal laws. Footnote 118 of the SEC’s release indicates:
“Information and documentation collected r these verification purposes may be subject to federal and/or state privacy and data security requirements.”
Therefore, businesses that intend to advertise should consult with legal counsel other than their securities attorney to ensure that they have internal processes and infrastructure to comply with applicable privacy and data security laws. Compliance with securities laws will not be a defense for violating other laws. Demonstrating t investors that you have systems to protect their confidential financial information can help you raise capital from cautious investors.
Reasonable Steps to Verify Accredited Investor Status
Let’s discuss in detail the verification requirement for using Rule 506 (c) to raise:
“The issuer shall take reasonable steps to verify that purchasers of securities sold in any offering under paragraph (c) of this section are accredited investors.”
This requirement to take “reasonable steps to verify” accredited investor status is the meatiest part of the rule.
Footnote 116 of the SEC’s release states the standard for considering someone an “accredited investor” for purposes of Rules 505 and 506 (b) of Regulation D:
“Because an issuer must have a reasonable belief that a purchaser is an accredited investor, the issuer could not form such reasonable belief if it has knowledge that the purchaser is not an accredited investor.”
Later in the release, the SEC indicates that Rule 506 (c) builds on top of the reasonable belief foundation that is included in the accredited investor definition in Rule 501 (a):
“We believe the issuer will not lose the ability to rely on Rule 506 (c) for that offering, so long as the issuer took reasonable steps to verify that the purchaser was an accredited investor and had a reasonable belief that such purchaser was an accredited investor at the time of sale.”
Most businesses that sell securities have traditionally satisfied this reasonable belief standard by simply asking investors to sign a document that represents they are accredited investors. The document often asks investors to specify which type of accredited investor they are – usually by checking a box. Some businesses might also ask investors to sign a net worth statement that gives some specific numbers (usually by assigning values to general classes of assets like cash, securities or real estate), but prior to Rule 506 (c) very few businesses asked for proof of accredited investor status other than the investor’s own written statements. If an investment adviser, broker or investment banker is in the transaction, they often have more detailed financial information about their investor clients.
Rule 506 (c) doesn’t eliminate your ability to use Rule 506 (b) to sell securities without advertising, but you cannot advertise or conduct a general solicitation under Rule 506 (c), unless you comply with the “reasonable steps to verify” provision of Rule 506 (c).
Of course, this raises the question: What constitutes “reasonable steps to verify” that someone is an “accredited investor.”
Before the SEC finalized Rule 506 (c), the SEC received many comments from securities lawyers, investment bankers and others about how difficult it is to verify an individual’s net worth by independent means other than self-verification by the investor. The problem is that even if an investor shows you a list of $5 million of assets, you don’t know that person’s net worth, because you have to deduct all liabilities to calculate net worth. If the investor hides liabilities, they may not be an accredited investor. The SEC deals with this problem by including in Rule 506 (c) a safe harbor provision that lists the steps you have to take if you want to guaranty that you have complied with Rule 506 (c)’s verification provision.
Safe Harbor for “Reasonable Steps to Verify” Provision
Rule 506 (c) creates a non-exclusive safe harbor for how to comply with the “reasonable steps to verify” provision. Unlike some other safe harbors, the Rule 506 (c) safe harbor affords protection not only against the SEC taking action against you, but if you fully comply with this safe harbor provision, you have a guaranteed exemption from registration that will withstand attacks by investors seeking damages and attacks by state securities regulators who assert you should have complied with state securities laws, because you failed in your attempt to qualify for the Rule 506(c) exemption that pre-empts many provisions of state securities laws.
“The issuer shall be deemed to take reasonable steps to verify if the issuer uses, at its option, one of the following non-exclusive and non-mandatory methods of verifying that a natural person who purchases securities in such offering is an accredited investor; provided, however, that the issuer does not have knowledge that such person is not an accredited investor: “
Here is how you have to verify income and net worth to obtain the benefits of Rule 506 (c)’s safe harbor provision:
To verify income to qualify for the safe harbor, you must review any Internal Revenue Service form that reports the purchaser’s income for the two most recent years before the investment date (including, but not limited to, Form W-2, Form 1099, Schedule K-1 to Form 1065, and Form 1040) and you must obtain a written representation from the purchaser (and their spouse’s representation, if you use the spouse’s income to qualify the purchaser as an accredited investor) that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the year the investment occurs.
Net Worth Verification
To verify net worth to qualify for the safe harbor, you must review one or more of the following types of documents that are dated during the three months before the investment date and you must obtain a written representation from the purchaser (and their spouse’s representation, if you use the spouse’s net worth to qualify the purchaser as an accredited investor) that all their liabilities necessary to make a determination of net worth have been disclosed:
· Documentation for Assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments, and appraisal reports issued by independent third parties; and
· Documentation for Liabilities: a consumer report from at least one of the nationwide consumer reporting agencies.
Independent Expert Verification
Why are these safe harbor verification procedures controversial?
Have you ever dealt with investors? They like convenience. They often walk away from deals at the slightest hint that it will be complicated. Because investing is not their primary business, they have great freedom to walk away from deals.
Wealthy investors value their privacy. Small businesses raising capital may not have security systems in place like banks and brokers have. This exposes people to identity theft risks. It’s also inconvenient for investors who make many private investments to have to verify their income or net worth over and over again. Using services like Fully Verified, can help verify and protect your identity. For these reasons, requiring investors to deliver confidential financial documents to people investors might not know very well will probably reduce the number of people who are willing to invest.
Rule 506 (c) tries to deal with these problems by allowing businesses to qualify for the safe harbor, and investors to protect their confidential financial information, by allowing businesses that raise capital to accept a written confirmation of compliance with the safe harbor’s verification process from any of the following:
· A registered broker-dealer
· A registered investment adviser
· A licensed attorney
· A certified public accountant
One of these independent experts must confirm in writing “that such independent licensed or registered expert has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months and has determined that such purchaser is an accredited investor.”
The SEC’s release indicates that these outside experts are not an exclusive list:
“While third-party confirmation by one of these parties will be deemed to satisfy the verification requirement in Rule 506(c), depending on the circumstances, an issuer may be entitled to rely on the verification of accredited investor status by a person or entity other than one of these parties, provided that any such third party takes reasonable steps to verify that purchasers are accredited investors and has determined that such purchasers are accredited investors, and the issuer has a reasonable basis to rely on such verification.”
Angel investor groups are seeking SEC confirmation that their group could certify the accredited investor status of their members. Banks, trust companies and other financial institutions might also want to offer this type of verification services to their clients. Because these organizations are not specifically mentioned in the safe harbor, however, the business selling securities would have to determine whether it is reasonable to rely on their verification. There is no safe harbor from people challenging that decision.
Alternative Verification Procedures
The verification procedures described in Rule 506 (c) are only a safe harbor. The SEC’s release indicates that Rule 506 (c) is a “Principles-Based Method of Verification,” which means you apply general principles to particular facts and circumstances to determine what you have to do to comply with the Rule”
“Under Rule 506(c), issuers are required to take reasonable steps to verify the accredited investor status of purchasers. Consistent with the Proposing Release, whether the steps taken are “reasonable” will 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. Among the factors that issuers should consider under this facts and circumstances analysis are:
· the nature of the purchaser and the type of accredited investor that the purchaser claims to be;
· the amount and type of information that the issuer has about the purchaser; and
· 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.
The SEC’s release goes on to explain how these factors should be used to determine whether any particular verification procedures satisfy the “reasonable steps to verify” requirement of Rule 506 (c):
“These factors are interconnected and are intended to help guide an issuer in assessing the reasonable likelihood that a purchaser is an accredited investor – which would, in turn, affect the types of steps that would be reasonable to take to verify a purchaser’s accredited investor status. After consideration of the facts and circumstances of the purchaser and of the transaction, the more likely it appears that a purchaser qualifies as an accredited investor, the fewer steps the issuer would have to take to verify accredited investor status, and vice versa.
The SEC’s release then gives examples of how these factors should work:
For example, 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.”
The release contains other examples of the factors businesses can consider to determine how much checking is necessary to satisfy the “reasonable steps to verify” requirement. The examples of relevant information about the purchaser the affects the required scope of the verification process include publicly available information about an officer’s compensation in a proxy statement might be sufficient to verify the annual income requirement.
The SEC’s release indicates that the SEC remains suspicious of advertising and general solicitation when it indicates that the method the investor became aware of the investment opportunity could increase the verification requirements:
“An issuer that solicits new investors through a website available to the general public, through a widely disseminated email or social media solicitation, or through print media, such as a newspaper, will likely be obligated to take greater measures to verify accredited investor status than an issuer that solicits new investors from a database of pre-screened accredited investors created and maintained by a reliable third party.”
But the SEC’s release reminds us that a business cannot delegate its verification obligations, unless the issuer has a reasonable basis to rely on such third-party verification:
“We do not believe as issuer will have taken reasonable steps to verify accredited investor status if it, or those acting on its behalf, 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.”
Form D and Other Regulation Changes
To help the SEC monitor advertising, the SEC approved in release 33-9415 an amendment to Form D that requires issuers to check a box if they intend to rely on Rule 506 (c) to advertise or conduct a general solicitation. Issuers who continue to rely on Rule 506 (b) must check a Rule 506 (b) box. The SEC’s release indicates it would be inconsistent to check both boxes:
“We are of a view that an issuer will not be permitted to check both boxes at the same time for the same offering. We remind issuers that once a general solicitation has been made to purchasers in the offering, an issuer is precluded from making a claim of reliance on Rule 506 (b), which remains subject to the prohibition against general solicitation, for that same offering.”
In footnote 142, the SEC explains that this is to prevent purchasers who become interested in the offering from the general solicitation from being sold securities in the Rule 506 (b) offering.
We will discuss the Rule 502 (a) integration issues this raises in another article in this series about Rule 506 changes.
On July 10, 2013, the SEC issued release No. 33-9416, which proposes for comments other changes to Form D and additional rules for Regulation D to deal with advertising and general solicitation issues. These proposed changes include penalties for failing to file Form D and requiring businesses that advertise or conduct a general solicitation to:
· File their Form D at least 15 days before they begin a general solicitation or begin advertising.
· Submit advertising and general solicitation materials to the SEC.
· Provide information about methods used to verify accredited investor status.
· Have warning legends in advertising and general solicitation materials.
Transitions: Rue 506 (b) Offerings Currently Underway
If you have already sold securities to investors in a Rule 506 (b) offering before Rule 506 (c) is effective and want to continue the same offering with advertising or a general solicitation, you can begin advertising and finish the offering pursuant to Rule 506 (c), if for each new investor you comply with the “reasonable steps to verify” provisions of Rule 506 (c). The new rule will not affect your exemption for pre-Rule 506 (c) sales.
Grandfather Existing Rule 506 Accredited Investors
Rule 506 (c)’s “reasonable steps to verify” provision is much more intrusive into the investor’s financial affairs than was the case in pre-Rule 506 (c) offerings, which relied solely on self-verification by investors instead of requiring investors to produce bank, broker, tax or other records.
To enable investors to make follow-on investments without additional intrusions into their privacy, issuers can accept a self-certification of continued accredited investor status from “any person who purchased securities in an issuer’s Rule 506(b) offering as an accredited investor prior to the effective date of paragraph (c) of this section and continues to hold such securities, for the same issuer’s Rule 506(c) offering.”
The SEC’s release cautions businesses that rely on Rule 506 (c) about record keeping:
“because the issuer has the burden of demonstrating that its offering is entitled to an exemption from the registration requirements of Section 5 of the Securities Act, it will be important for issuers and their verification service providers to retain adequate records regarding the steps taken to verify that a purchaser was an accredited investor.”
How long should you retain records?
Check applicable statutes of limitation for how long any of the following can bring an action against you:
The SEC or Department of Justice for violating Federal securities laws,
Investors seeking damages
State securities regulators who assert you should have complied with state securities laws, because you failed in your attempt to qualify for the 506(c) exemption.
Why is Rule 506 Important?
Rule 506 is an important rule because more than 90% of securities offerings use Rule 506 as an exemption from registration requirements. One reason for Rule 506’s popularity is that Rule 506 preempts state securities laws other than anti-fraud laws and certain notice filing requirements.
Preempting state securities laws allows securities offerings to close quickly and reduces compliance costs. This is especially useful in multi-state private placement offerings. If you limit sales to only accredited investors, Rule 506 gives you great flexibility about what you tell investors and how you tell it to them as long as you don’t commit fraud. Now, you can also use advertising and conduct a general solicitation in Rule 506 (c) offerings.
Beware of State Securities Laws
Advertising is subject to state anti-fraud laws even if you comply with all the accredited investor verification provisions of Rule 506 (c).
If you fail to satisfy the verification provisions of Rule 506 (c), registration and other provisions of state securities laws will not be pre-empted.
Penalties for Non-Compliance
If you don’t have a Federal exemption from registration, or if you don’t comply with state securities laws, the usual remedy is rescission. That means that investors have the right to get their money back, plus interest. If the business cannot pay the money back, officers and directors, investment bankers and others might have personal liability.
Plaintiffs’ lawyers, who are unable to prove that your business committed any fraud, can win the same damages that would be available if fraud had occurred if you advertise without complying with Rule 506 (c).
Spillover Effect of New Rule
Technically, new Rule 506 (c) applies only to offerings where you choose to advertise or conduct a general solicitation. The SEC’s release specifically states: “Therefore, the amendment to Rule 506 we are adopting today does not amend or modify the requirements relating to existing Rule 506(b).”
So, from the SEC’s perspective you can still use Rule 506 (b) to sell to accredited investors without meeting the “reasonable steps to verify” accredited investor status required by Rule 506 (c), if you don’t advertise or otherwise conduct a general solicitation.
That’s the way it’s supposed to work. But we all know the law of unintended consequences.
Self-verification by investors of their accredited investor status is not contained in any SEC rule or law. Self-verification developed as a common industry practice. If industry practices change, self-verification may no longer be a sufficient basis to form a reasonable belief that someone is an accredited investor.
As more businesses implement the new accredited investor verification procedures, courts might begin to apply the verification concepts of Rule 506 (c) to Rule 506 (b) and any other provision that refers to accredited investors.
If other businesses that raise capital routinely check financial records from investors, it becomes difficult to argue that this is too burdensome. People may interpret failure to investigate beyond the investor’s self-verification statement as an indication that the business knew the statement was not correct.
If you would like to learn more about learning how to grow your business or other issues important to your success, you can reach me at JFV@WardandSmith.com or JimV@eLearnSuccess.com.
Or you can check out my eLearning course at http://www.elearnsuccess.com/start.aspx?menuid=3075
You can purchase my books at http://www.amazon.com/Jim-Verdonik/e/B0040GUBRW
Verdonik’s blog: http://jimverdonikintersection.blogspot.com
About Scale Finance
Scale Finance LLC (www.scalefinance.com) provides contract CFO services, Controller solutions, and support in raising capital, or executing M&A transactions, to entrepreneurial companies. The firm specializes in cost-effective financial reporting, budgeting & forecasting, implementing controls, complex modeling, business valuations, and other financial management, and provides strategic help for companies raising growth capital or considering M&A/recapitalization opportunities. Most of the firm’s clients are growing technology, healthcare, business services, consumer, and industrial companies at various stages of development from start-up to tens of millions in annual revenue. Scale Finance LLC has offices throughout the southeast including Charlotte, Raleigh/Durham, Greensboro, Wilmington, Washington D.C. and South Florida with a team of more than 30 professionals serving more than 100 companies throughout the region.