As mandated by Congress in Section 201(a) of the Jumpstart Our Business Startups Act, in July 2013 the Securities and Exchange Commission (SEC) amended Rule 506 under Regulation D of the Securities Act of 1933, creating a new paragraph (c). Issuers claiming Rule 506(c) exemption from SEC registration requirements are now allowed to generally solicit potential investors, but only if all purchasers are “accredited investors” and if the issuer has taken “reasonable steps” to verify that status. For more information on Rule 506(c), click here. Although the SEC provided a list of non-exclusive safe harbor methods by which the reasonable verification requirement would be satisfied with respect to purchasers who are natural persons, market participants have been left with little guidance on how to fit within those safe harbors.  

Backed by twenty of the nation’s largest law firms, the Securities Industry and Financial Markets Association (SIFMA) recently issued a memorandum suggesting methods that registered broker-dealers and investment advisers (and potentially issuers and other market participants) could use to comply with the safe harbor requirements.[1] Soon after SIFMA’s memorandum, the SEC released new Compliance and Disclosure Interpretations (C&DIs) that also relate to the safe harbors.  

SIFMA Guidance on “Reasonable Steps”

One safe harbor provided by the SEC permits issuers to rely on the written confirmation of a registered broker-dealer or investment advisor (or a licensed attorney or certified public accountant) that the firm has taken “reasonable steps” to verify a purchaser’s accredited investor status. SIFMA’s memorandum suggests varying methods by which firms may satisfy this reasonable steps requirement, categorized by whether a firm is attempting to verify the status of a natural person or a legal entity. 

Verifying Natural Persons

SIFMA provides two methods by which it believes that a broker-dealer or investment advisor will have taken reasonable steps to verify its client’s accredited investor status. First, through the use of the “account balance method,” where the client:

  1. has been with the firm for at least six months;
  2. has (individually or jointly with spouse) at least $2 million in cash and marketable securities prior to making the investment[2]; and
  3. has made a number of written representations, including that the purchaser is not borrowing money to make the investment and that the investment is for the purchaser’s own account.

Alternatively, SIFMA believes reasonable verification steps have been taken through the “investment amount method,” where the client;

  1. has been with the firm for at least six months;
  2. invests at least $250,000 in a Rule 506(c) offering or makes an unconditional commitment in a Rule 506(c) offering, which is callable in whole at any time; and
  3. has provided a number of written representations, including that the proposed investment is less than 25% of the purchaser’s net worth.

Additionally, for either method, the firm must not be aware of any facts indicating the client is not an accredited investor and, in the case of a commitment under the investment amount method, must have knowledge that the client has fulfilled a call under a prior commitment.

The SIFMA guidance also attaches a proposed accredited investor questionnaire, which incorporates the purchaser representations applicable to these methods, as well as a proposed form of written confirmation that can be used by firms engaged in the verification process. 

Verifying Legal Entities

Entities can qualify as accredited investors on the basis of status alone or on a combination of status and assets. For any person[3] verifying the accredited investor status of a legal entity based on status alone (e.g., a bank or registered broker-dealer), SIFMA believes that a person has taken reasonable steps if he or she verifies such status at least annually, absent any facts indicating a likely change in the entity’s status. For any person verifying the status of an entity based on status and assets (e.g., a corporation with assets exceeding $5 million), SIFMA believes that a person has taken reasonable verification steps if:

  1. he or she confirms that the entity is named on the firm’s current list of clients that qualify as “institutional accounts” or as a Qualified Institutional Buyer; or
  2. the entity makes an investment exceeding $5 million and provides written representations that it was not formed for the purpose of making the investment and has made at least one prior investment in securities.

New SEC Interpretations on Status Verification

The new C&DIs illustrate that the SEC intends the safe harbors themselves to be narrow and strictly construed. Although the SEC provides a safe harbor allowing an issuer to rely on filed IRS forms showing a purchaser’s income for the two most recent years, the safe harbor is not available for persons holding analogous tax forms from a foreign jurisdiction or when a person’s IRS forms for the most-recently completed year are not yet filled. Furthermore, although the SEC provides a safe harbor allowing an issuer to verify net worth through tax assessments and consumer credit reports issued by “nationwide consumer reporting agencies," the tax assessment must be dated within the prior three months of the time of review and consumer reports from a non-U.S. consumer reporting agency will not secure the safe harbor.

In each case, the C&DIs note that, even if the information obtained to support the verification does not fit within a specific safe harbor provided by rule, the information may still be used to support verification as part of a “principles-based” approach. This approach often involves combining the information that is available with further verification steps (e.g., obtaining additional written representations from the purchaser when there is reason to question the reliability of his or her information).  

Please contact us if you have any questions or would like to learn more about accredited investor verification and how you can satisfy the reasonable verification requirement in a Rule 506(c) offering.

[1] The full memorandum released by SIFMA is available at http://www.sifma.org/issues/item.aspx?id=8589949595.

[2] This analysis takes into account certain assumed liabilities of the account holder, discussed in more detail in the SIFMA guidance.

[3] The SIFMA guidance indicates that this method should be available to any person verifying an entity’s status as an accredited investor, and not just for registered broker-dealers and investment advisors.

 

Topics:  Accredited Investors, Amended Regulation, C&DIs, General Solicitation, Registration, Regulation D, Rule 506(c), SEC, Verification Requirements

Published In: General Business Updates, Communications & Media Updates, Finance & Banking Updates, Securities Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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