For decades, small businesses seeking investors could avoid onerous and costly SEC registration requirements for their offerings by making them only available to “accredited investors” (wealthy and sophisticated investors) and only if they did not engage in “general solicitation” of investors through advertising or other public communications.
“General Solicitation” is Now Okay, But…
The 2012 JOBS Act lifted the long-standing ban on the “general solicitation” of investors. Enacted into law on April 5, 2012, Title II of the JOBS Act directed the SEC to eliminate the ban on general solicitation and advertising under Rule 506 provided the securities are sold only to accredited investors. As long an issuer takes “reasonable steps” to verify that purchasers of securities are accredited investors, such issuer may solicit investors and advertise its offering by virtually any means of communication, including print, television, and the Internet.
The SECs new rules implementing these changes went into effect on September 23, 2013. At the time, it was expected that there would be a flood of advertising from funds and companies looking to expand their efforts to attract money from high-net worth individuals as well as from institutional investors. But that flood largely remained a relative trickle. One reason was concern about what the SEC considered “reasonable steps” for verifying the qualifications of investors, especially given the wide net that advertising casts and the potentially large number of investors that might need to be verified.
In response to these concerns, the SEC’s Division of Corporate Finance issued guidance in July, 2014 as to what constitutes “reasonable steps” under Rule 506(c)(2)(ii)’s safe harbor provisions. Those safe harbors provide that the following constitute “reasonable steps” for verification under the annual income and net worth tests, respectively:
- 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
- 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)).
The SEC’s guidance clarified these provisions as applied in some common circumstances, and outlined steps that can be taken under the “principles-based verification method” in order to qualify for the safe harbor provisions:
- If IRS forms for the most recently completed tax year are unavailable, reviewing the forms for the last two years that are available will not satisfy the safe harbor provision. However, the guidance states that an issuer could reasonably conclude that a purchaser is an accredited investor and satisfy the verification requirement of Rule 506(c) under the principles-based verification method by:
- reviewing the Internal Revenue Service forms that report income for the two years preceding the recently completed year; and
- obtaining written representations from the purchaser that (i) an Internal Revenue Service form that reports the purchaser’s income for the recently completed year is not available, (ii) specify the amount of income the purchaser received for the recently completed year and that such amount reached the level needed to qualify as an accredited investor, and (iii) the purchaser has a reasonable expectation of reaching the requisite income level for the current year.
- Safe harbor is not available for tax forms from foreign jurisdictions, but an issuer could reasonably conclude that a purchaser is an accredited investor and satisfy the verification requirement of Rule 506(c) under the principles-based verification method by reviewing filed tax forms that report income where the foreign jurisdiction imposes comparable penalties for falsely reported information.
- Safe harbor is not availablewhere an issuer reviews the most recent tax assessment that is available but that is not dated within the prior three months, but an issuer could, under the principles-based verification method, satisfy the verification requirement if it uses the most recently available tax assessment when determining whether the purchaser satisfies the net worth test.
- Safe harbor is not available based on a review of a consumer report from a non-U.S. reporting agency, but an issuer could, under the principles-based verification method, satisfy the verification requirement by reviewing a consumer report from a non-U.S. consumer reporting agency that performs similar functions as a U.S. nationwide consumer reporting agency and taking any other steps necessary to determine the purchaser’s liabilities (such as a written purchaser representation that all liabilities have been disclosed).
The SEC concluded each of its clarifications with a caution that “where the issuer has reason to question” the reliability, completeness, or accuracy of the documents at issue, “it must take additional verification measures in order to establish that it has taken reasonable steps to verify that the purchaser is an accredited investor.”
If you have questions or concerns about Rule 506 or the steps that need to be taken to verify the qualifications of potential investors, please contact the experienced business attorneys at Yee Law Group, PC.
Yee Law Group, PC, L.L.P.: Sacramento/Roseville Business Attorneys
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This article has been prepared by Yee Law Group, PC, PC for informational purposes only and does not, and is not intended to, constitute legal advice. The information is not provided in the course of an attorney-client relationship and is not intended to substitute for legal advice from an attorney licensed in your jurisdiction.