Sign-up for our Free Newsletter, Whitepaper and SEC and FINRA Updates as they occur.

by Laura Anthony, Esq.

SEC Extends Valuable Guidance to Determine and Verify Accredited Investors

We thank each and every one of our Securities-Law-Blog.com readers for your devotion and positive interaction. Without you, writing these blogs just wouldn’t be exciting. Nominate Securities Law Blog for this year’s ABA Journal Blawg 100 and keep the dynamic energy flowing. Our readers are our greatest strength. Click Here to nominate.

On July 3, 2014, the SEC updated its Division of Corporation Finance Compliance and Disclosure Interpretations ) to provide guidance as to the determination and verification of accredited investor status for purposes of Rule 506 offering.  The SEC published six new C&DI’s on the topic.

Background

Effective September 23, 2013, the SEC adopted final rules eliminating the prohibition against general solicitation and advertising in Rules 506 and 144A offerings as required by Title II of the JOBS Act.  For a complete discussion of the final rules, please see my blog Here.

Title II of the JOBS Act required the SEC to amend Rule 506 of Regulation D to permit general solicitation and advertising in offerings under Rule 506, provided that all purchasers of the securities are accredited investors.  The JOBS Act required that the rules necessitate that the issuer take reasonable steps to verify that purchasers of the securities are accredited investors using such methods as determined by the SEC.  Rule 506 is a safe harbor promulgated under Section 4(a)(2) (formerly Section 4(2)) of the Securities Act of 1933, exempting transaction by an issuer not involving a public offering.  In a Rule 506 offering, an issuer can sell an unlimited amount of securities to accredited investors and up to 35 unaccredited sophisticated investors.  The standard to determine whether an investor is accredited has historically been the reasonable belief of the issuer.

New Rule 506(c) which permits the use of general solicitation and advertising to offer and sell securities under Rule 506 provided that the following conditions are met:

  1. the issuer takes reasonable steps to verify that the purchasers are accredited;
  2. all purchasers of securities must be accredited investors, either because they come within one of the categories in the definition of accredited investor, or the issuer reasonably believes that they do, at the time of the sale; and
  3. all terms and conditions of Rule 501 and Rules 502(a) and (d) must be satisfied.

Rule 506(c) includes a non-exclusive list of methods that issuers may use to verify that investors are accredited. An issuer that does not wish to engage in general solicitation and advertising can rely on the old Rule 506 and offer and sell to up to 35 unaccredited sophisticated investors.  An issuer opting to rely on the old Rule 506 does not have to take any additional steps to verify that a purchaser is accredited.

Reasonable Steps to Verify Accredited Investor Status

The SEC final rule requires that an issuer take reasonable steps to verify that purchasers are accredited.  Moreover, the SEC included a non-exclusive list of methods that issuers may use to satisfy the verification requirement.  Note that the verification requirement is separate from the requirement that all investors in fact be accredited.

According to the SEC, “whether the steps taken are ‘reasonable’ would be an objective determination, based on the particular facts and circumstances of each transaction.”  Among the factors that issuers should consider under the fact and circumstance analysis are:

a.The nature of the purchaser and type of accredited investor they claim to be.  For instance, if the purchaser is claiming that they are accredited because they are a broker-dealer registered with the SEC, verification could be a simple check on the FINRA website.  Of course, the hardest status to verify will be natural persons claiming they meet the net worth ($1 million) or income ($200,000 a year) requirements.  Accordingly, as set forth below, the SEC final rule sets forth non-exclusive methods that issuers may use to satisfy the verification requirement.

b.The amount and type of information that the issuer has about the purchaser.  Clearly, the more information, the better.  The SEC lists the obvious (W-2; tax returns; letters from a bank or broker-dealer).  Moreover, although not required, it is assumed that an issuer should at least conduct a check of publicly available information.

c.Nature and terms of the offering, such as type of solicitation and minimum investment requirements.  The example proffered by the SEC is an offering conducted by soliciting preapproved accredited investor lists from a reasonably reliable third party, vs. open-air solicitation via social media or television or radio advertising—the latter, of course, requiring greater verification than the former.  The SEC highlights the obvious, such as that the greater the minimum investment required, the fewer steps an issuer would need to take to verify accreditation.

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. Moreover, where accreditation has been verified by a trusted third party, it would be reasonable for an issuer to rely on that verification.

The more information an issuer has evidencing that a prospective purchaser is accredited, the fewer additional steps it will have to take to verify the status, and vice versa.  Examples of the type of information that issuers can review and rely upon include:

(i)Publicly available information in filings with federal, state and local regulatory bodies (for example:                                          Exchange Act reports; public property records; public recorded documents such as deeds and mortgages)

(ii)Third-party evidentiary information including, but not limited to, pay stubs, tax returns, and W-2 forms

(iii) Third-party accredited investor verification service providers

Regardless of the methods an issuer uses to verify accredited status, they should keep adequate and complete records.  If the exemption is challenged, the burden is on the issuer to prove that under the facts and circumstances of their particular offering, they took reasonable steps to verify and they reasonably believed that an investor was accredited at the time of the sale.  However, although the rules do not address the issue, the SEC is cognizant of the privacy concerns raised by having issuers obtain and maintain personal financial records from investors.

 Non-Exclusive Methods that Issuers May Use to Satisfy the Verification Requirement

In its final rule publication, the SEC included four specific non-exclusive methods of verifying accredited investor status for natural persons which, if used, will be deemed to satisfy the verification requirements as long as the issuer does not have actual knowledge that the purchaser is not accredited.  Issuers are not required to use these methods of verification and can rely on their own reasonableness standard directed to the specific facts and circumstances. The non-exclusive methods of verification include:

 a. Review of copies of any Internal Revenue Service form that reports income including, but not limited to, a Form W-2, Form 1099, Schedule K-1 and a copy of a filed Form 1040 for the two most recent years along with a written representation that the person reasonably expects to reach the level necessary to qualify as an accredited investor during the current year.  If such forms and information are joint with a spouse, the written representation must be from both spouses.

  b.Review of one or more of the following, dated within three months, together with a written representation that all liabilities necessary to determine net worth have been disclosed.  For assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments and appraiser reports issued by third parties and for liabilities, credit reports from a nationwide agency.

 c.Obtaining a written confirmation from a registered broker-dealer, an SEC registered investment advisor, a licensed attorney, or a CPA that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months.

 d. A written certification verifying accredited investor status from existing accredited investors of the issuer that have previously invested in a 506 offering with the same issuer.

New SEC Guidance

On July 3, 2014, the SEC updated its C&DI to add six new C&DI’s to provide guidance as to the determination and verification of accredited investor status for purposes of Rule 506 offering.

In the first two updates, the SEC provided some basic guidance in calculating income and assets.  As relates to calculating income from foreign investors with income in a foreign currency denomination, the SEC states that an issuer may use either the exchange rate that is in effect on the last day of the year for which income is being determined or the average exchange rate for that year in determining whether such income meets the income test for qualifying as an accredited investor.  Related to jointly held property, the SEC states that assets in an account or property held jointly with a person who is not the purchaser’s spouse may be included in the calculation for the accredited investor net worth test, but only to the extent of his or her percentage ownership of the account or property.

The SEC also provided guidance specific to the verification criteria published in the rule.  Verification can be accomplished by reviewing the purchaser’s last two years of tax returns.  The SEC provided guidance regarding relying on tax returns by noting that in a case where the most recent tax return is not available but the two years prior are, an issuer may rely on the available returns together with a written representation from the purchaser that (i) an Internal Revenue Service form that reports the purchaser’s income for the recently completed year is not available, (ii) specifies the amount of income the purchaser received for the recently completed year and that such amount reached the level needed to qualify as an accredited investor, and (iii) the purchaser has a reasonable expectation of reaching the requisite income level for the current year.  An issuer can only rely on this expanded interpretation if the evidence presents supports that the investor is accredited and the issuer reasonably believes so.  If the evidence is at all questionable, further inquiry should be made.

Although the review of tax returns filed in a foreign country does not qualify under the verification safe harbors in the rule, the SEC noted that an issuer could rely on foreign tax returns if the laws of that jurisdiction provide penalties similar to the laws of the IRS for making a false statement. Again, if the evidence is at all questionable, further inquiry should be made.

Verification can be accomplished by reviewing certain documents dated within three months, including tax assessments.  In its guidance, the SEC recognizes that tax assessments are generally issued yearly and accordingly a tax assessment, even if the most recent issued, would not qualify if dated more than three months prior.  However, if the most recent tax assessment shows a value that, after deducting the purchaser’s liabilities, results in a net worth substantially in excess of $1 million, it may be sufficient verification that the purchaser has met the net worth test.  Again, if the evidence is at all questionable, further inquiry should be made.

The rules provide that an issuer can review a consumer report from one of the “nationwide consumer reporting agencies” to determine the purchaser’s liabilities.  Although an issuer cannot rely on a report from a foreign consumer reporting agency under the rule, it can rely on the report together with taking other steps necessary to determine the purchaser’s liabilities (such as a written representation from the purchaser that all liabilities have been disclosed).

Reasonable Belief that all Purchasers are Accredited Investors

In addition to requiring that an issuer take reasonable steps to verify that accredited investor status, Rule 506(c) requires that an issuer have a reasonable belief that all purchasers are accredited investors.   In particular, the reasonable belief standard ensures that the exemption will not be lost if an issuer takes reasonable steps to verify accredited status and reasonably believes that an investor is accredited, but later learns that such investor was not, in fact, accredited.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.

Download our mobile app at iTunes.

Legal & Compliance, LLC makes this general information available for educational purposes only. The information is general in nature and does not constitute legal advice. Furthermore, the use of this information, and the sending or receipt of this information, does not create or constitute an attorney-client relationship between us. Therefore, your communication with us via this information in any form will not be considered as privileged or confidential.

This information is not intended to be advertising, and Legal & Compliance, LLC does not desire to represent anyone desiring representation based upon viewing this information in a jurisdiction where this information fails to comply with all laws and ethical rules of that jurisdiction. This information may only be reproduced in its entirety (without modification) for the individual reader’s personal and/or educational use and must include this notice.

© Legal & Compliance, LLC 2016

Copy of Logo