Reasonable Steps to Verify
Third Party Certification Procedure Designed to Comply with New SEC Rules Permitting General Solicitation in Reg D Private Offerings
By Gary J. Kocher
Overview On July 10, 2013, the Securities and Exchange Commission (“SEC”) adopted rules to eliminate the prohibition against general solicitation and general advertising in certain securities offerings under Rule 506 of Regulation D (“Reg D”) under the Securities Act of 1933, as amended (“Securities Act”), as mandated by the Jumpstart Our Business Startups Act (“JOBS Act”). These rules, which became effective on September 23, 2013, provide significant opportunities for start-ups and other private issuers to expand the scope of marketing activities in connection with private placements under Reg D. However, with these expanded opportunities, the SEC has increased the level of diligence that issuers must undertake to verify the status of purchasers as “accredited investors” within the meaning of Rule 501.
Following the enactment of the new rules and the related SEC guidance, there has been significant adverse reaction in the angel capital community in respect of investors having to provide highly sensitive, personal financial information to start-ups as a means of satisfying the accredited investor test in Reg D private placements utilizing general solicitation. This Client Alert focuses on the verification provisions of new Rule 506(c) and provides a proposed certification letter that can be completed by trusted third party advisors that is designed to allow issuers to comply with their obligation to take reasonable steps to verify the status of purchasers of their securities.
Offerings Involving Use of General Solicitation -- New Rule 506(c)
Under new Rule 506(c), an issuer may use general solicitation and general advertising in a securities offering that satisfies the other applicable requirements of Reg D if the issuer takes reasonable steps to verify that all of the purchasers are accredited investors. An issuer generally is required to consider all relevant facts and circumstances to assess whether the verification steps taken are reasonable for purposes of relying on Rule 506(c). Rule 506(c) mandates an objective, principles-based verification process in lieu of rigid rules. Under this standard, issuers are required to consider the particular conditions surrounding the offering to determine whether the process used to verify each purchaser’s accredited investor status is sufficient, including:
Reasonable Steps to Verify 2
• 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;
• the manner in which the purchaser was solicited to participate in the offering; and
• the terms of the offering, such as minimum investment amount. The adopted guidance sets forth a flexible approach toward assessing these factors, including a nonexclusive list of methods that may be used to verify that purchasers who are natural persons are accredited investors. An issuer shall be deemed to have taken reasonable steps to verify accredited investor status if the issuer uses one of the following methods of verifying (provided that the issuer does not know that the person is not accredited):
• reviewing copies of Internal Revenue Service forms reporting a purchaser’s income for the two most-recent years and obtaining the purchaser’s written representation that the purchaser has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year;
• reviewing one or more of the following types of documentation, dated within the prior three months, and obtaining the purchaser’s written representation that all liabilities necessary to make a determination of net worth have been disclosed: o for assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments and appraisal reports issued by independent third parties; and o for liabilities: a credit report from at least one of the nationwide consumer reporting agencies;
• obtaining a written confirmation from a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney or a certified public accountant (a “Permitted Third Party Verifier”) that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months and has determined that such purchaser is an accredited investor; or
• for any natural person who purchased an issuer’s securities as an accredited investor prior to the effective date of Rule 506(c) and remains an investor of the issuer at the time of the Rule 506(c) offering conducted by the same issuer, obtaining the purchaser’s written certification that the purchaser is an accredited investor.