Memo on Accredited Investors

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Memo on Accredited Investors

SIGNIFICANT CHANGES TO RULES FOR PRIVATE SECURITIES OFFERINGS

The Securities and Exchange Commission (“SEC”) has adopted significant changes to its rules governing private offerings of securities.  General solicitation and general advertising will now be permitted both in certain private placements conducted under Rule 506 of Regulation D under the Securities Act of 1933 (the “Securities Act”).

USE OF GENERAL SOLICITATION AND GENERAL ADVERTISING

Rule 506 Offerings

The focal point of this change is new Rule 506(c), which removes as a condition of the Rule 506 safe harbor, compliance with Rule 502(c)’s prohibition on general solicitation and general advertising in offerings where the following two conditions are met:

  • All purchasers in the offering must be accredited investors (meaning, under Rule 501(a), that all purchasers had, or the issuer reasonably believed that they had, such status); and
  • The issuer must have taken reasonable steps to verify that all purchasers are accredited investors.

Thus, issuers making offers and sales of securities in Rule 506(c) compliant offerings will be permitted to use general solicitation and general advertising in such offerings (including, for example, by means of articles, notices and other communications in newspapers and magazines, and broadcasts over television, radio and the Internet).  Issuers may also hold seminars and meetings for such offerings where attendees have been invited by general solicitation or general advertising and may create widely accessible Internet websites from which potential purchasers can access information about the offering.

The new rules leave Rule 506 otherwise intact.  So, issuers may choose to use general solicitation and general advertising by meeting the conditions of new Rule 506(c) or proceed under existing Rule 506(b), which will continue to permit sales to up to 35 non-accredited investors while including, along with other conditions, Rule 502(c)’s prohibition on general solicitation and general advertising.  It is also worth noting that new Rule 506(c) does not affect private placements relying upon the statutory exemption for non-public offerings in Section 4(a)(2) of the Securities Act.

Reasonable Steps to Verify Accredited Investor Status

The SEC declined to mandate uniform procedures that issuers must follow to verify accredited investor status of purchasers participating in an offering under new Rule 506(c).  Instead, the SEC stated that whether the steps taken by an issuer to verify accredited investor status 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.”

As a significant addition, however, new Rule 506(c) includes a list of four verification methods, each of which will be deemed a reasonable method of verifying the accredited investor status of a natural person purchaser (so long as the issuer does not have knowledge that such person is not an accredited investor).  These verification methods, which are intended to provide greater certainty to issuers, are as follows:

  • When determining accredited investor status based on income, reviewing copies of IRS forms reporting income (e.g., Form W-2, Form 1099, Schedule K-1, and Form 1040) for the two most recent years, plus obtaining written representations that the purchaser has a reasonable expectation that his income for the current year will qualify for such status;
  • When determining accredited investor status based on net worth, reviewing bank and brokerage statements, tax assessments, appraisal reports from third parties, and consumer (credit) reports, dated within the prior three months, plus obtaining representations that the purchaser has disclosed all liabilities necessary to make a determination of net worth;
  • Obtaining written confirmation from a specified third party (i.e., a registered broker-dealer. SEC-registered investment adviser, licensed attorney in good standing, or certified public accountant duly registered and in good standing) that such person has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months and has determined such purchaser is an accredited investor; and
  • For any natural person who invested in an issuer’s Rule 506(b) offering as an accredited investor prior to the effective date (July 10, 2013) of new Rule 506(c) and continues to hold such securities, obtaining a certification by such existing investor at the time of a subsequent Rule 506(c) offering by the same issuer that such investor qualifies as an accredited investor.

In order to verify the status of natural person purchasers where one of the four methods described above is not used, or the status of purchasers that are not natural persons, issuers may gauge the reasonableness of their verification efforts in accordance with principles-based guidance offered by the SEC.  Under this principles-based approach, a number of factors may be relevant to the determination of whether “reasonable steps” have been used to verify accredited investor status, including, but not limited to:

  • 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 reminded issuers that the burden of proving an exemption from registration is on the issuer.  It also responded to concerns raised by numerous commentators about possible misuse of new Rule 506(c) by stating that the SEC staff will closely monitor the development of accredited investor verification practices by issuers, securities intermediaries and others.  It is important, therefore, that issuers engaging in offerings under new Rule 506(c) develop adequate processes to verify accredited investor status of purchasers and retain adequate records documenting the steps they take in such regard.

Reasonable Belief as to Accredited Investor Status

The SEC reiterated that the amendments to Rule 506(c) do not override the reasonable belief component of the definition of the term accredited investor in Rule 501(a), which provides that a purchaser may be accredited if the issuer “reasonably believes” the investor has that status.  Under this standard, an issuer conducting an offering under new Rule 506(c) would not lose the ability to rely on Rule 506(c) if an investor provided false information to an issuer, but the issuer took reasonable steps to verify the investor’s accredited status and, as a result, had a reasonable belief that the investor was accredited.

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