As more and more companies take advantage of the SEC’s recent rule change allowing general solicitation and advertising in private offerings, lots of interpretative questions on how to apply the new rules have arisen. Over the course of the last couple of months, the Staff at the SEC has provided some guidance on some of the more frequently asked questions. To help our readers keep up, I have included the Staff’s advice below with my own commentary.
Question: An issuer takes reasonable steps to verify the accredited investor status of a purchaser and forms a reasonable belief that the purchaser is an accredited investor at the time of the sale of securities. Subsequent to the sale, it becomes known that the purchaser did not meet the financial or other criteria in the definition of “accredited investor” at the time of sale. Assuming that the other conditions of Rule 506(c) were met, is the exemption available to the issuer for the offer and sale to the purchaser?
Answer: Yes. An issuer does not lose the ability to rely on Rule 506(c) for an offering if a person who does not meet the criteria for any category of accredited investor purchases securities in the offering, so long as the issuer took reasonable steps to verify that the purchaser was an accredited investor and had a reasonable belief that such purchaser was an accredited investor at the time of the sale of securities. [Nov. 13, 2013]
My Take: This interpretation should not be a surprise, but it is welcomed anyway. Rule 506(c) offerings require issuers to take reasonable steps and to form a reasonable belief that each investor is accredited, but Rule 506(c) does not contain an absolute belief standard. If an offering was to fail simply because an investor committed fraud on the issuer or an issuer relied on an erroneous third party verification of the investor’s accredited investor status, then it would make Rule 506(c) a very unpopular and hardly ever used exemption.
Question: An issuer intends to conduct an offering under Rule 506(c). If all of the purchasers in the offering met the financial and other criteria to be accredited investors but the issuer did not take reasonable steps to verify the accredited investor status of these purchasers, may the issuer rely on the Rule 506(c) exemption?
Answer: No. The verification requirement in Rule 506(c) is separate from and independent of the requirement that sales be limited to accredited investors. The verification requirement must be satisfied even if all purchasers happen to be accredited investors. Under the principles-based method of verification, however, the determination of what constitutes reasonable steps to verify is an objective determination based on the particular facts and circumstances of each purchaser and transaction. [Nov. 13, 2013]
My Take: The Staff is taking a very reasonable position here. It cannot be that you just assume that the investors are accredited, you must take some reasonable steps to make sure. That said, you probably don’t need to take too many steps if your investor is Warren Buffet.
Question: An issuer chooses to verify the accredited investor status of a purchaser in a Rule 506(c) offering by using the net worth verification method provided in the rule and, as required under this method, reviews the relevant documentation dated within the prior three months. If, at the time the purchaser decides to purchase securities in the offering, the previously submitted documentation is not dated within the prior three months of the time of the sale of securities, may the issuer continue to rely on the net worth verification method provided in the rule?
Answer: No. An issuer may satisfy the verification requirement of Rule 506(c) by either using the principles-based method of verification or relying upon one of the specific, non-exclusive verification methods listed in the rule. Although use of the non-exclusive verification methods is not required, an issuer that chooses to use one of the methods must satisfy the specific requirements of that method. In order to comply with the net worth verification method provided in the rule’s non-exclusive list, the relevant documentation must be dated within the prior three months of the sale of securities. If the documentation is older than three months, the issuer may not rely on the net worth verification method, but may instead determine whether it has taken reasonable steps to verify the purchaser’s accredited investor status under the principles-based method of verification. [Nov. 13, 2013]
My Take: My question is why is the issuer trying to verify this information itself? As I explained in a prior blog post, I don’t recommend an issuer verify this information itself. Why would you want to possess confidential financial information that could be stolen from you? Better to allow a third party to verify this information. Besides, if you make a mistake in determining whether the investor is accredited, then you probably have not taken reasonable steps. On the other hand, if you relied on a reputable third party for verification and they made a mistake, then you probably did take reasonable steps and your offering exemption is still valid.
Question: If the conditions of Rule 506(c) are not met in a purported Rule 506(c) offering, could the Securities Act Section 4(a)(2) private offering exemption be available to the issuer?
Answer: If the issuer has engaged in general solicitation, no. As stated in Securities Act Release No. 9415 (July 10, 2013), the mandate in the JOBS Act to permit general solicitation for a subset of Rule 506 offerings affects only Rule 506 and not Section 4(a)(2) offerings in general. The use of general solicitation continues to be incompatible with a claim of exemption under Section 4(a)(2). [Nov. 13, 2013]
My Take: This is the Staff’s position, so I would recommend following it. But, there is certainly an argument that Section 4(a)(2) must permit general solicitation given that Rule 506 is a safe harbor under Section 4(a)(2).
Question: Does Rule 506(e) require disclosure of past events that would no longer trigger disqualification under Rule 506(d), such as a criminal conviction that occurred more than ten years before the offering or an order or bar that is no longer in effect at the time of the offering?
Answer: No. Rule 506(e) requires only disclosure of events that would have triggered disqualification at the time of the offering had Rule 506(d) been applicable. Because events outside the applicable look-back period and orders that do not have continuing effect would not trigger disqualification, Rule 506(e) does not mandate disclosure of such matters in order for the issuer to be able to rely on Rule 506. [Dec. 4, 2013]
My Take: The Staff was answering a specific question as to whether Rule 506(e) mandated certain disclosures, not whether it was advisable to disclose criminal convictions regardless of Rule 506(e). We have always recommended that any problematic history in the backgrounds of the principals be fully disclosed to investors. I believe that if disclosures of certain “bad acts” would have caused an investor not to invest in your company, then it is in your best interest to tell them. You still need to be concerned about the anti-fraud rules under the Securities Act. Full disclosure in these cases is the best policy regardless of what is “required” to be disclosed.