While Section 201(a)(1) of the JOBS Act mandates that our amendments to Rule 506 require issuers using general solicitation in Rule 506 offerings “to take reasonable steps to verify that purchasers of the securities are accredited investors,” it does not specify the methods necessary to satisfy this requirement and instead requires issuers to use “such methods as determined by the Commission.” We believe that the purpose of the verification mandate is to address concerns, and reduce the risk, that the use of general solicitation under Rule 506 may result in sales to investors who are not, in fact, accredited investors.41
We also recognize, however, that it would be necessary that our proposed amendment to Rule 506 provide sufficient flexibility to accommodate the different types of issuers that would conduct offerings under proposed Rule 506(c) and the different types of accredited investors (such as natural persons, public and private for-profit and not-for-profit corporations, general and limited partnerships, business and other types of trusts, and funds and other types of collective investment vehicles) that may purchase securities in these offerings.
Markup of H.R. 2940, Access to Capital for Job Creators Act,Subcommittee on Capital Markets and Government Sponsored Enterprises, House Financial Services Committee, 112th Cong. (Oct. 5, 2011) (remarks of Representative Waters, explaining that she is introducing the amendment that requires issuers to take reasonable steps to verify accredited investor status because “we must take steps to ensure that those folks are indeed sophisticated”); 157 Cong. Rec. H7291 (daily ed. Nov. 3, 2011) (remarks of Representative Maloney (same)); 157 Cong. Rec. H7294 (daily ed. Nov. 3, 2011) (remarks of Representative Lee (same)).
We are proposing a requirement in Rule 506(c) that issuers using general solicitation “take reasonable steps to verify” that the purchasers of the offered securities are accredited investors. Whether the steps taken are “reasonable” would be an objective determination, based on the particular facts and circumstances of each transaction.
Under this proposed approach, issuers would consider a number of factors when determining the reasonableness of the steps to verify that a purchaser is an accredited investor. Some examples of these factors include:
• 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; and
• The nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount.
We discuss each of these factors in greater detail below.
Nature of the Purchaser.The definition of “accredited investor” in Rule 501(a) includes natural persons and entities that come within any of eight enumerated categories in the rule, or that the issuer reasonably believes come within one of those categories, at the time of the sale of securities to that natural person or entity. Some purchasers may be accredited investors based on their status, such as:
• A broker or dealer registered pursuant to Section 15 of the Securities Exchange Act of 1934 (the “Exchange Act”);42
See17 CFR 230.501(a)(1).
• An investment company registered under the Investment Company Act of 1940 (the “Investment Company Act”) or a business development company as defined in Section 2(a)(48) of that Act.43
Some purchasers may be accredited investors based on a combination oftheir status and the amount of their total assets, such as:
• A plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5 million;44
• An Internal Revenue Code (“IRC”) Section 501(c)(3) organization, corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5 million.45
See17 CFR 230.501(a)(3).
Natural persons may be accredited investors based on either their net worth or their annual income, as follows:
• A natural person whose individual net worth, or joint net worth with that person's spouse, exceeds $1 million, excluding the value of the person's primary residence (the “net worth test”);46
See17 CFR 230.501(a)(5).
• A natural person who had an individual income in excess of $200,000 in each of the two most recent years, or joint income with that person's spouse in excess of $300,000 in each of those years, and has a reasonable expectation of reaching the same income level in the current year (the “income test”).47
See17 CFR 230.501(a)(6).
As Rule 501(a) sets forth different categories of accredited investors, we expect the steps that would be reasonable for an issuer to take to verify whether a purchaser is an accredited investor under proposed Rule 506(c) would likely vary depending on the type of accredited investor that the purchaser claims to be. For example, the steps that may be reasonable to verify that an entity is an accredited investor by virtue of being a registered broker-dealer—such as by going to FINRA's BrokerCheck Web site48
—would necessarily differ from the steps that would be reasonable to verify whether a natural person is an accredited investor.
48This Web site is available athttp://www.finra.org/Investors/ToolsCalculators/BrokerCheck/.
We recognize that taking reasonable steps to verify the accredited investor status of natural persons poses greater practical difficulties as compared to other categories of accredited investors, and these practical difficulties likely would be exacerbated by natural persons' privacy concerns about the disclosure of personal financial information.49
As between the net worth test and the income test for natural persons, we recognize that commentators have suggested that it might be more difficult for an issuer to obtain information about a person's assets and liabilities than it would be to obtain information about a person's annual income,50
although there could be privacy concerns with respect to either test. The question of what type of information would be sufficient to constitute reasonable steps to verify accredited investor status under the particular facts and circumstances of each purchaser would also depend on other factors, as described below.
See, e.g.,letters from BrokerBank Securities, Inc. (“BrokerBank”) (“By the time most people accumulate a net worth of $1,000,000+ not counting their principal residence, they usually really want to keep their financial information very close to the vest.”); Federal Regulation of Securities Committee of the Business Law Section of the American Bar Association (“ABA”) (stating that “the Commission should be sensitive to the legitimate privacy concerns of purchasers” when considering the steps that issuers should take to verify accredited investor status); SecondMarket Holdings, Inc. (“SecondMarket”) (“In addition, legitimate privacy concerns may result in potential investors being unwilling to provide highly sensitive personal information outside of a clearly protective framework, which may cause such investors to avoid participating in Rule 506 offerings.”).
Seeletters from NASAA (July 3, 2012) (“Verification of net worth is more challenging because an individual could provide proof of assets but not liabilities.”); SecondMarket (indicating that, in its experience, the majority of natural persons who indicated that they were accredited investors did so based on the income test of Rule 501(a)(6), which can be verified through tax returns, Form W-2, Form 1099, or other income documentation, in addition to a pay stub from the current year, whereas verifying that a purchaser satisfies the net worth test may be very difficult; therefore, this commentator recommended that a “substantial minimum investment requirement,” coupled with representations by the purchaser, should be deemed sufficient evidence to presume that a purchaser satisfies the net worth test without requiring additional verification of that purchaser's accredited investor status).
Information about the Purchaser.The amount and type of information that an issuer has about a purchaser would be a significant factor in determining what additional steps would be reasonable to verify the purchaser's accredited investor status. The more information an issuer has indicating that a prospective purchaser is an accredited investor, the fewer steps it would have to take, and vice versa.51
Examples of the types of information that issuers could review or rely upon—any of which might, depending on the circumstances, in and of themselves constitute reasonable steps to verify a purchaser's accredited investor status—include, without limitation:
51If an issuer has actual knowledge that the purchaser is an accredited investor, then the issuer would not have to take any steps at all.
• Publicly available information in filings with a federal, state or local regulatory body—for example, without limitation:
○ The purchaser is a named executive officer of an Exchange Act registrant, and the registrant's proxy statement discloses the purchaser's compensation for the last three completed fiscal years; or
○ The purchaser claims to be an IRC Section 501(c)(3) organization with $5 million in assets, and the organization's Form 990 series return filed with the Internal Revenue Service discloses the organization's total assets;52
52Such an organization is required to make the Form 990 series returns available for public inspection.SeeInternal Revenue Service,Public Disclosure and Availability of Exempt Organizations Returns and Applications: Documents Subject to Public Disclosure, http://www.irs.gov/charities/article/0,,id=135008,00.html(last updated Sept. 21, 2011).
• Third-party information that provides reasonably reliable evidence that a person falls within one of the enumerated categories in the accredited investor definition—for example, without limitation:
○ The purchaser is a natural person and provides copies of Forms W-2; or
○ The purchaser works in a field where industry or trade publications disclose average annual compensation for certain levels of employees or partners, and specific information about the average compensation earned at the purchaser's workplace by persons at the level of the purchaser's seniority is publicly available; or
• Verification of a person's status as an accredited investor by a third party, such as a broker-dealer, attorney or accountant, provided that the issuer has a reasonable basis to rely on such third-party verification.53
53For example, in the future, services may develop that verify a person's accredited investor status for purposes of proposed Rule 506(c) and permit issuers to check the accredited investor status of possible investors, particularly for web-based Rule 506 offering portals that include offerings for multiple issuers. This third-party service, as opposed to the issuer itself, could obtain appropriate documentation or otherwise verify accredited investor status. Several commentators, in fact, have recommended that the Commission take action to facilitate the ability of issuers to rely on third parties to perform the necessary verification.Seeletters from NASAA (July 3, 2012) (recommending that the Commission allow an issuer to obtain the necessary verification through registered broker-dealers, provided that there are independent liability provisions for failure to adequately perform the verification); Massachusetts Securities Division (urging the Commission to adopt as a safe harbor or best practice the use of an independent party, such as a broker-dealer, bank, or other financial institution, that would verify the accredited investor status of potential purchasers). One commentator, however, expressedconcerns that some of the Web sites that currently offer lists of accredited investors could be used to facilitate fraud, noting that some offer lists based on “ethnicity, gender, and lifestyle—presumably to make [it] easier for scammers to relate to marks—and ominously, `seniors.' ” Letter from Moscovitz and Maxfield.
Nature and Terms of the Offering.The nature of the offering—such as the means through which the issuer publicly solicits purchasers—may be relevant in determining the reasonableness of the steps taken to verify accredited investor status. An issuer that solicits new investors through a Web site accessible to the general public or through a widely disseminated email or social media solicitation would likely be obligated to take greater measures to verify accredited investor status than an issuer that solicits new investors from a database of pre-screened accredited investors created and maintained by a reasonably reliable third party, such as a registered broker-dealer. In the case of the former, we do not believe that an issuer would have taken reasonable steps to verify accredited investor status if it required only that a person check a box in a questionnaire or sign a form, absent other information about the purchaser indicating accredited investor status. In the case of the latter, we believe an issuer would be entitled to rely on a third party that has verified a person's status as an accredited investor, provided that the issuer has a reasonable basis to rely on such third-party verification.
The terms of the offering would also affect whether the verification methods used by the issuer are reasonable. Some commentators have expressed the view that a purchaser's ability to meet a high minimum investment amount could be relevant to the issuer's evaluation of the types of steps that would be reasonable to take in order to verify that purchaser's status as an accredited investor.54
We believe that there is merit to this view. By way of example, the ability of a purchaser to satisfy a minimum investment amount requirement that is sufficiently high such that only accredited investors could reasonably be expected to meet it, with a direct cash investment that is not financed by the issuer or by any other third party, could be taken into consideration in verifying accredited investor status.
See, e.g.,letters from MFA (May 4, 2012) (stating that many hedge funds managed by its members obtain further assurance that investors meet the qualification standards in the Investment Company Act or the Investment Advisers Act of 1940, as applicable, through minimum investment thresholds that meet or exceed the net worth test of the accredited investor definition); NASAA (July 3, 2012) (“For example, if an investor makes an investment of $1 million in the issuer's securities, it would be reasonable for the issuer to assume that the investor has $1 million in net worth, even though it is not necessarily a certainty. NASAA would not oppose the creation of this type of specific safe harbor, provided the factors used to demonstrate the requisite net worth are set sufficiently high.”); SecondMarket (recommending that a “substantial minimum investment requirement,” coupled with representations by the purchaser, should be deemed sufficient evidence to presume that a purchaser satisfies the net worth test without requiring additional verification of that purchaser's accredited investor status). One commentator, however, disagreed with this approach, noting that “[w]hile a large investment amount may indicate that the investor is wealthy, it also might indicate that a non-wealthy investor is over-concentrated in the investment.” Letter from Massachusetts Securities Division.
These factors are interconnected, and the information gained by looking at these factors would help an issuer assess the reasonable likelihood that a potential purchaser is an accredited investor, which would, in turn, affect the types of steps that would be reasonable to take to verify a purchaser's accredited investor status. After consideration of the facts and circumstances of the purchaser and of the transaction, if it appears likely that a person qualifies as an accredited investor, the issuer would have to take fewer steps to verify accredited investor status, and vice versa. For example, if an issuer knows little about the potential purchaser who seeks to qualify under the natural person tests for accredited investor status, but the terms of the offering require a high minimum investment amount, then it may be reasonable for the issuer to take no steps to verify accredited investor status other than to confirm that the purchaser's cash investment is not being financed by the issuer or by a third party, absent any facts that may indicate that the purchaser is not an accredited investor.
Regardless of the particular steps taken, it would be important for issuers to retain adequate records that document the steps taken to verify that a purchaser was an accredited investor. Any issuer claiming an exemption from the registration requirements of Section 5 has the burden of showing that it is entitled to that exemption.55
SECv.Ralston Purina,346 U.S. 119, 126 (1953) (“Keeping in mind the broadly remedial purposes of federal securities legislation, imposition of the burden of proof on an issuer who would plead the exemption seems to us fair and reasonable.”).
We are mindful of the differing views expressed by commentators to date on how the Commission should implement the verification mandate of Section 201(a). A number of commentators have cautioned that unduly prescriptive or burdensome rules for verifying a purchaser's accredited investor status would have the potential to result in significant economic harm, could lead to reluctance on the part of issuers to access the relevant capital markets, or would contravene the purposes of the JOBS Act.56
Some commentators recommended approaches based on current practices or standards.57
One commentator, for example, stated that whether a purchaser is an accredited investor depends on the particular facts and circumstances, that the current practices already take these considerations into account, and that the Commission should therefore refrain from imposing any additional burdens on issuers or purchasers.58
Another commentator expressed similar views, recommending that the Commission adopt a principles-based non-exclusive safe harbor that would be flexible enough to accommodate new offering techniques and that would build on existing practices (such as broker-dealers' account-opening and suitability procedures).59
See, e.g.,letters from Committee on Securities Regulation of the New York City Bar Association (“NYC Bar Association”) (stating that unduly detailed or prescriptive verification rules would “have the potential to result in significant economic harm”); SecondMarket (asserting that “[p]lacing too heavy a burden on issuers and investors could have the undesired effect of inhibiting private capital formation” and that “issuers are likely to be unwilling or unable to assume the liability and cost that would arise from a significant documentary verification requirement”); NSBA (Aug. 2, 2012) (stating that “imposing additional burdens on Rule 506 issuers who engage in general solicitation or general advertising would make it more difficult for small firms to raise capital”); Small Biotechnology Business Coalition (“SBBC”) (stating that additional burdens on issuers seeking to utilize Rule 506 would make it more difficult for small firms to raise capital, and make it less likely that investors will invest in small firms); ABA (asserting that a verification requirement that imposes additional burdens on issuers or purchasers “would contravene the fundamental impetus for the JOBS Act”); MFA (June 26, 2012) (stating that “overly restrictive procedures * * * would have the effect of thwarting the purposes of Title II of the JOBS Act”).
See, e.g.,letters from BrokerBank (noting that self-certification of accredited investor status has been the “procedure that has been followed by the industry for decades” and urging the Commission to continue to allow self-certification of accredited status of individuals wishing to participate in Rule 506 offerings that utilize general solicitation); Phillip Goldstein, Bulldog Investors (“Goldstein”) (July 18, 2012) (urging that the Commission “promptly create a simple form that an issuer can provide to an investor to certify that he or she is accredited”); MFA (May 4, 2012) (stating that methods similar to those currently used by hedge fund managers, which include the identification by the purchaser of the qualification standards that it meets and minimum investment thresholds, would achieve the objectives of Section 201(a)); Securities Industry and Financial Markets Association (“SIFMA”) (urging that the requirement to take reasonable steps to verify should not impose a higher burden than the “reasonable belief” standard currently applicable to Rule 506 offerings and that an issuer should be deemed to have taken reasonable steps to verify if it has reasonable belief that the offeree is an eligible offeree).
58Letter from ABA.
59Letter from NYC Bar Association. For example, in connection with complying with anti-money laundering requirements, broker-dealers already obtain certain identifying information about their customers.
Other commentators stated that the verification mandate of Section 201(a) requires the Commission to enhance the current standard under which issuers determine that purchasers are accredited investors.60
In their view, the verification mandate of Section 201(a) calls for a standard that is higher than the current reasonable belief standard in the Rule 501(a) definition of accredited investor and such higher standard is needed in light of the greater likelihood of fraudulent activities resulting from the removal of the prohibition against general solicitation. Therefore, these commentators believe that the Commission must mandate the specific steps that issuers must take in order to form a reasonable belief that a purchaser is an accredited investor.61
Seeletters from Fund Democracy; Moscovitz and Maxfield; NASAA (July 3, 2012); Ohio Division; Public Citizen.
We also received a number of comments on specific methods that should or should not be viewed as reasonable steps for verifying accredited investor status. For example, some viewed a representation from the purchaser that it is an accredited investor as sufficient,62
while others asserted that such a representation alone would not be enough.63
Several commentators stated that the verification of accredited investor status should require the production of documentary evidence.64
One commentator recommended that only registered broker-dealers, and not other intermediaries, be permitted to verify accredited investor status on behalf of issuers because registered broker-dealers are subject to existing regulatory schemes, including Commission oversight.65
Other commentators recommended allowing issuers to rely on third-party firms to verify accredited investor status.66
Some commentators suggested that purchasers be required to submit a letter from a third party with knowledge of the purchaser's financial status (such as a certified public accountant or attorney) indicating that the purchaser is an accredited investor,67
while another commentator suggested that, in combination with an independent professional's certification as to the purchaser's accredited investor status, the purchaser be required to certify his or her accredited investor status under penalty of perjury.68
Another commentator stated that issuers should be allowed to rely on basic information about a purchaser that they may already have (for example, that the purchaser is an officer of a Fortune 500 company).69
One commentator suggested that the Commission adopt an approach under which a minimum investment of 50% of the net worth or total assets requirement under the applicable category of accredited investor, coupled with a certification by the investor, would be deemed to constitute “reasonable steps” to verify accredited investor status.70
Another commentator suggested that investors be permitted to self-certify their accredited investor status so long as at least 30 days have passed between the first date of public solicitation and the date of investment.71
62Letters from Goldstein (June 3, 2012); Mona Shah & Associates; SIFMA; JC Williams II, Tucson Business Development Group (“Williams”).
63Letters from Fund Democracy (stating that a representation from the purchaser that it is an accredited investor would not satisfy the statutory mandate that the issuer take steps to verify accredited investor status); John C. Nimmer (“Nimmer”); Ohio Division (“A `check-the-box' approach to investor self-verification of accredited status will not suffice because the Title II issuer must have more than a belief that a prospective purchaser is accredited.”).
Seeletters from Massachusetts Securities Division (stating that verification should require issuers to determine whether investors are accredited based on documentary evidence, rather than just representations from potential investors); NASAA (July 3, 2012) (recommending that the Commission require issuers to obtain documents such as tax returns, recent pay stubs, brokerage statements, tax assessment valuations, appraisals, list of liabilities (including a sworn statement that all material liabilities have been disclosed), organizational documents, balance sheets, and quarterly statements); Ohio Division (recommending that the issuer should “review financial statements and/or tax returns evidencing actual satisfaction of accredited investor thresholds” and, with respect to entities claiming to be accredited investors, should review “regulatory letters or certificates approving or confirming the entity's status as a bank, insurance company, registered investment company, business development company, or small business investment company”).
65Letter from SecondMarket (also suggesting that the Commission establish specific guidelines that registered broker-dealers must follow with respect to the verification process in order to be an approved “accreditation verification provider”).
Seeletters from National Investment Banking Association (“NIBA”) (recommending that if a FINRA member firm is not involved in the offering, then the issuer could satisfy the verification mandate by relying on a third-party report obtained from an investigatory firm indicating that a purchaser is an accredited investor; if a broker-dealer is involved in the offering as a placement agent, the issuer could satisfy the verification mandate by obtaining and reviewing a form from the broker-dealer that describes the process undertaken by the broker-dealer to establish accredited investor status for a purchaser); NSBA (Aug. 2, 2012) (stating that “[r]equiring investors to provide to issuers an independent professional's certification as to the investor's accredited investor status and requiring the investor to certify his or her own status under penalty of perjury would provide a high degree of protection against non-accredited investors asserting accredited investor status in Regulation D offerings”); Sigelman Law Corporation (asserting that third-party verification of accredited investor status should not be limited to broker-dealers but that independent third-party professional intermediaries “registered with the Commission and sworn to follow the protocol rules” should be allowed to provide such services).
Seeletters from Frank Nagy; Williams.
68Letter from NSBA (Aug. 2, 2012) (stating that Section 1746 of Title 28 of the United States Code authorizes this approach). One commentator stated that self-certification under penalty of perjury, in and of itself, should be sufficient. Letter from Nimmer.
69Letter from AngelList.
70Letter from MFA (June 26, 2012).
71Letter from SBBC (noting that such a “cooling off” period will help discourage impulse investments and will permit the issuer and the investor to assess one another).
We believe that the approach we are proposing appropriately addresses these concerns by obligating issuers to take reasonable steps to verify that the purchasers are accredited investors, as mandated by Section 201(a), but not requiring them to follow uniform verification methods that may be ill-suited or unnecessary to a particular offering or purchaser, given the facts and circumstances. We also expect that such an approach would give issuers and market participants the flexibility to adopt different approaches to verification depending on the circumstances, to adapt to changing market practices, and to implement innovative approaches to meeting the verification requirement, such as the development of third-party databases of accredited investors. In addition, we anticipate that many practices currently used by issuers in connection with existing Rule 506 offerings would satisfy the verification requirement proposed for offerings pursuant to Rule 506(c).