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Rule 506(c) General Solicitation Offerings: SEC Issues Additional Guidance on Investor Verification

Corporate and Securities Law Alert | July 14, 2014
By: Neil P. Casey and Lori S. Smith

Rule 506(c) under the Securities Act of 1933 (the "Securities Act") permits issuers to engage in general solicitation and/or general advertising when offering and selling securities pursuant to Rule 506 so long as all purchasers of the securities are accredited investors (as defined in Rule 501(a)) and the issuer has taken reasonable steps to verify that such purchasers are accredited investors.[1]  In adopting Rule 506(c), the Securities and Exchange Commission (SEC) set forth a principles-based approach for an issuer to conclude that it has taken reasonable steps to verify an investor’s status as an accredited investor and also enumerated certain verification steps which would be presumed sufficient  in regard to individual investors (i.e. non-exclusive safe harbors).[2]  On July 3, 2014, the SEC Division of Corporation Finance staff issued six new Compliance & Disclosure Interpretations (C&DIs) with respect to (i) the definition of accredited investor under Rule 501(a) and (ii) the safe harbors under Rule 506(c) for verifying the status of an individual investor as an accredited investor.[3]  These new C&DIs are summarized below.

“Accredited Investor” Definition

Foreign Currencies May Be Converted At Year-End or Yearly Average Exchange Rate

The new C&DIs clarify that for purposes of determining whether an investor meets the income threshold for an accredited investor under Rule 501(a)[4], any income denominated in a foreign currency should be converted to US dollars by applying either the exchange rate in effect as of the last day of the calendar year for which income is being measured or the average of the exchange rate during such year.  (C&DI Question 255.48)

Jointly Held Assets Are Counted According to Percentage Interest

In calculating whether an investor meets the net worth threshold for an accredited investor under Rule 501(a)[5], the new C&DIs state that assets (including accounts and other property) that are jointly held by the investor with another party who is not the investor’s spouse may be included to the extent of the investor’s ownership percentage of such jointly held assets.  (C&DI Question 255.49)

“Safe Harbor” Issues

Most Recent Tax Form Not Yet Available

Rule 506(c)(2)(ii)(A) provides a non-exclusive safe harbor for an issuer to verify that an individual investor is an accredited investor on the basis of annual income by reviewing any IRS form (e.g., Form W-2, Form 1099, Schedule K-1 and Form 1040) that reports the investor’s income for the “two most recent years”.  According to the new C&DIs, if the investor’s relevant IRS form is not yet available for the most recently completed year (e.g., 2013), the issuer cannot rely on this safe harbor by reviewing the IRS forms for the two most recently completed years that are available (e.g., 2012 and 2011).  However, the SEC staff indicates that the issuer may be able to satisfy the principles-based verification method by reviewing such older forms and obtaining written representations from the investor that (i) the IRS form for the most recently completed year is not available, (ii) specify the amount of the investor’s income for the most recently completed year and that such amount reached the level necessary to satisfy the income requirement for accredited investors and (iii) the investor has a reasonable expectation of achieving the required income level in the current year.  However, the SEC also notes that if the issuer has reason to question the investor’s claim to accredited investor status, further inquiry may be necessary (for example, if the investor’s stated income for the most recently completed year barely exceeds the threshold).  (C&DI Question 260.35)

Foreign Tax Authority Forms

The C&DIs also state that an issuer cannot rely on the Rule 506(c)(2)(ii)(A) safe harbor by reviewing tax forms from foreign taxing authorities, noting that there are numerous penalties for filing false IRS returns, which may not be the case in foreign jurisdictions.  However, an issuer could potentially rely on tax forms of foreign taxing authorities to reasonably conclude that an investor is an accredited investor in accordance with the principles-based verification approach if it were able to determine that the foreign taxing authority imposed comparable penalties for falsely reported information.  Again, the SEC notes that if the issuer has reason to question the investor’s claim to accredited investor status after reviewing these forms, it would be required to engage in additional verification measures under the principles-based method of verification.  (C&DI Question 260.36)

Tax Assessment More Than 3 Months Old

Rule 506(c)(2)(ii)(B) provides a non-exclusive safe harbor for an issuer to verify that an investor is an accredited investor on the basis of net worth by reviewing certain documentation of the investor’s assets and liabilities dated “within the prior three months.”  Tax assessments, which are one of the enumerated types of documentation, are typically issued only on an annual basis.  The C&DIs state that an issuer cannot rely on this safe harbor by reviewing a tax assessment that is more than three months old, even if it is in fact the most recently available assessment.  However, the SEC staff does state that under the principles-based approach to verification, an issuer could reasonably conclude that an investor met the net worth test if, for example, the most recently available assessment shows an asset value which, after deducting the investor’s liabilities, would result in a net worth substantially greater than the $1 million threshold.  (C&DI Question 260.37)

Foreign Consumer Reports

The safe harbor provided by Rule 506(c)(2)(ii)(B) requires that the issuer review a consumer report from one of the “nationwide consumer reporting agencies” to determine a potential investor’s liabilities.  The new C&DIs state that an issuer could not rely on this safe harbor if it relied on a consumer report from a non-US consumer reporting agency that performs similar functions as a US consumer reporting agency.  However, the consumer report of a non-US consumer reporting agency could serve as the basis for a principles-based verification by the issuer taking any other steps necessary to determine the investor’s liabilities, which could include, for example, obtaining a written representation from the investor that all liabilities have been disclosed.  (C&DI Question 260.38)

Conclusion

The new C&DIs provide some helpful guidance on two discrete issues related to foreign currency conversion and jointly held assets in calculating whether an investor meets the relevant income or net worth thresholds to qualify as an accredited investor.  As for the verification safe harbors, the common theme of the new C&DIs appears to be that if the available sources of information do not fall squarely within the express requirements of a safe harbor, the issuer will not be able to rely on that safe harbor to satisfy its obligation to take reasonable verification steps.  However, any failure to satisfy the safe harbor conditions should not be the end of the analysis because sources of information that do not meet the safe harbor requirements, when supplemented by other confirmatory due diligence and verification steps, can often be used as the basis for a principles-based verification of the investor’s status outside the safe harbor.

For more information regarding this Client Alert, please contact Neil P. Casey (212.631.4414; caseyn@whiteandwilliams.com) or Lori S. Smith (212.714.3075; smithl@whiteandwilliams.com) in our New York office.


[1] Please see prior White and Williams LLP Securities Alerts dated July 15, 2013 and September 11, 2013 at http://www.whiteandwilliams.com/resources-alerts-SEC-Repeals-Ban-on-General-Solicitation.html and http://www.whiteandwilliams.com/resources-alerts-General-Solicitation-and-Public-Private-Placements-Navigating-the-Minefield-Planted-by-New-and-Proposed-SEC-Rules.html

[2] If an issuer is not able to rely on one of the verification safe harbors, it is required to make an objective determination that the verification steps it took were reasonable in light of the particular facts and circumstances of the investor and the transaction, taking into account various factors described in the SEC’s adopting release.

[3] The SEC’s Compliance & Disclosure Interpretations (Questions 255.48, 255.49 and 260.35 to 260.38) can be found starting at: http://www.sec.gov/divisions/corpfin/guidance/securitiesactrules-interps.htm#255.48

[4] The income threshold requires an investor to have (i) individual income in excess of $200,000 in each of the two most recent years or (ii) joint income with his or her spouse in excess of $300,000 in each of those years.

[5] The net worth threshold requires an investor to have an individual net worth, or joint net worth with his or her spouse, in excess of $1,000,000.

This correspondence should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult a lawyer concerning your own situation and legal questions.
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