On July 3, 2014, the SEC released six new Compliance and Disclosure Interpretations relating to verification of prospective investors as accredited investors for purposes of Rule 506(b) and Rule 506(c). Two of these C&DIs are straightforward clarifications; the remaining four relate to two of the safe harbors established by the SEC for purposes of determining when an issuer has taken “reasonable steps” to verify the accredited investor status of a prospective investor in a Rule 506(c) offering.
First, the straightforward clarifications:
If prospective investor’s income is reported in a foreign currency, an issuer can rely on either the exchange rate in effect on the last day of the year for which the income was reported, or on the average exchange rate for that year.
If a prospective investor owns property or an account jointly with a person other than the prospective investor’s spouse, the value of that property or account can only be counted for net worth purposes to the extent of the prospective investor’s percentage of ownership in the joint property or account.
As for the C&DIs that relate to the safe harbors, the general theme of these questions and answers is that the safe harbor provisions in Rule 506(C) are narrow and should be strictly construed. However, just because an issuer is outside of one of the safe harbors doesn’t mean that the issuer can’t satisfy the “reasonable steps” test based on what the SEC refers to as the “principles-based approach,” with the caveat that more diligence will be necessary if the steps taken by the issuer provide any bases for questioning the quality of the information being supplied or the prospective investor’s accredited investor status.
The safe harbor in Rule 506(c)(2)(ii)(A) allows an issuer to rely on filed IRS forms showing a prospective investor’s income for the two most recent years. Two of the C&DIs relate to this safe harbor:
If filed IRS forms indicating a prospective investor’s income are not yet available for the two most recent years (e.g., because the offering is occurring in the first quarter of a year and the prospective investor hasn’t yet filed taxes for the immediately preceding year), then the safe harbor is not available. However, the issuer could still satisfy the reasonable steps test using the principles-based approach by reviewing the filed IRS forms for the two most recently available years and relying on investor representations regarding the year for which filed IRS forms are not yet available (unless this process turns up any red flags, such as income that barely surpasses the threshold amount).
Filed tax documents from foreign jurisdiction cannot be used to satisfy this safe harbor. However, tax returns from a foreign jurisdiction that impose penalties for false statements in tax returns that are similar to the penalties imposed in the U.S. could be relied upon in connection with satisfying the reasonable steps test using the principles-based approach (unless those tax documents indicate any red flags).
The safe harbor described in Rule 506(c)(2)(ii)(B) allows an issuer to verify net worth by relying on certain types of documents (such as tax assessments or consumer credit reports issued by one of the three U.S. national credit reporting bureaus) relating to assets and liabilities provided that the documents are dated within the prior three months and the issuer obtains a representation from the prospective investor that all liabilities necessary to make a determination of net worth have been disclosed. Two of the C&DIs relate to this safe harbor:
Even though tax assessments are typically only performed annually, a tax assessment older than three months can’t be used to satisfy the safe harbor, even if it is the most recently performed tax assessment. However, it could be possible for an issuer to satisfy the “reasonable steps” test under the principles-based approach by relying on a tax assessment that is more than three months old but shows assets that, after deducting liabilities, result in a net worth well in excess of $1 million (provided there are no red flags).
A report from a foreign consumer credit reporting agency analogous to one of the three national credit reporting bureaus in the U.S. cannot be used to satisfy the safe harbor. However, an issuer could satisfy the reasonable steps test under the principles-based approach by relying on a foreign consumer credit report and taking other reasonable steps to be certain that all liabilities have been disclosed (provided there are no red flags).
In sum, an issuer can use methods analogous to those outlined in the safe harbors to satisfy the reasonable steps test under the principles-based approach, but only if the issuer is actually analyzing the information and performing further follow up when there is reason to question the materials being relied upon, and not simply completing the steps by rote.