Last year, the Securities Exchange Commission (SEC) adopted Rule 506(c) of the Securities Act of 1933 (Securities Act), which, in a major departure from prior securities practice, allowed the use of general solicitation and general advertising (referred to throughout this article as general solicitation) in connection with unregistered offers and sales of securities; though it must be noted the SEC was compelled to take this step by legislative mandate. The new rule imposed three conditions to the application of the exemption: (1) the purchasers had to be accredited investors; (2) the issuer had to take “reasonable steps” to verify the accredited investor status of the purchasers; and (3) the terms of Securities Act Rules 501, 502(a), and 502(d) had to be observed.
In a recent speech to the 2014 Angel Capital Association Summit, the Director of the SEC’s Division of Corporation Finance, Keith Higgins, remarked that “one wonders why the new Rule 506(c) exemption has not caught on more widely with issuers who have long clamored for the general solicitation ban to be lifted.”
Although from September 2013, when Rule 506(c) became available, to March 2014, the SEC saw “almost 900 new offerings conducted in reliance on the exemption, raising more than $10 billion in new capital,” issuers still preferred to use “the old ‘private’ Rule 506 exemption (now called Rule 506(b)),” which, “during the same time period, was relied upon in over 9,200 new offerings that resulted in the sale of over $233 billion in securities.” He observed that some believe that issuers have shied away from the new Rule 506(c) exemption because of the requirement to take “reasonable steps to verify” accredited investor status. Expressing surprise that flexibility in verification approaches countenanced by the rule – which allowed a principles-based approach and provided specified methods for verification as safe harbor alternatives – did not find favor with issuers, he noted that the staff of the SEC’s Division of Corporation Finance (Staff) would not be receptive to entreaties to “provide guidance – presumably on a case-by-case basis – confirming that a specified principles-based verification method constitutes ‘reasonable steps’ for purposes of the rule’s requirement” because the “notion of the [S]taff reviewing and approving specific verification methods seems somewhat contrary to the very purpose of a principles-based rule” and because he remained unconvinced of the need for such Staff involvement.
However, such entreaties have had some effect, for the Staff recently issued guidance related to (1) the “reasonable steps” safe harbors for verifying accredited investor status under Rule 506(c) and (2) the accredited investor definition in Regulation D. (See the guidance at Securities Act Rules Compliance and Disclosure Interpretations, Questions 260.35–260.38 and Questions 255.48 and 255.49.) This guidance is further evidence that the Staff should be expected to issue ongoing interpretive guidance on Rule 506(c) as issuers continue to grapple with the rule’s requirements.
The guidance illustrates that the Staff narrowly construes the Rule 506(c) accredited investor verification safe harbors. However, even where a safe harbor is not available, the guidance makes clear that issuers can satisfy the verification requirement under the principles-based verification method. However, under that approach issuers must consider all relevant facts and circumstances and additional verification steps may be necessary where reasonable doubt remains about a purchaser’s accredited investor status.
This article briefly summarizes the Staff’s guidance, which will be of interest to public and private companies and investment funds that seek to rely on Rule 506 for securities offerings, especially those issuers seeking to use general solicitation under Rule 506(c).
Rule 506(c) Accredited Investor Verification Safe Harbors
Background. Rule 506(c)(2)(ii) sets forth non-exclusive and non-mandatory accredited investor verification methods that, if satisfied, serve as safe harbors for issuers who will be deemed to have satisfied the “reasonable steps” verification requirement. The safe harbor verification methods include, among others:
- when verifying a purchaser under the accredited investor annual income test, reviewing any Internal Revenue Service (IRS) form reporting a purchaser’s income for the two most recent fiscal years and obtaining a written purchaser representation that he or she has a reasonable expectation of reaching the required income level during the current year (Rule 506(c)(2)(ii)(A)); and
- when verifying a purchaser under the accredited investor net worth test, reviewing specified documentation evidencing the purchaser’s assets and liabilities dated within the prior three months and obtaining a written purchaser representation that all liabilities necessary to make a determination of net worth have been disclosed (Rule 506(c)(2)(ii)(B)).
As what constitutes “reasonable steps” is a principles-based determination, an issuer that does not satisfy any of the verification safe harbors can still satisfy the reasonable steps requirement using other verification methods.
The Rule 506(c)(2)(ii)(A) safe harbor is not available where IRS forms for the most recently completed year are not yet available (for example, the purchaser's 2014 IRS forms in an early 2015 offering). However, the Staff believes that an issuer could, under the principles-based verification method, satisfy the verification requirement by:
- reviewing IRS forms that report income for the two years preceding the most recently completed year (in our example, 2013 and 2012); and
- obtaining written purchaser representations that (i) an IRS form reporting the purchaser's income for the most recently completed year is unavailable, (ii) specify the purchaser’s income for the most recently completed year and that such amount satisfies the required accredited investor income level, and (iii) he or she has a reasonable expectation of satisfying the requisite income level for the current year.