SEC Amends 506(c) Accredited Investor Verification
By Kevin Vela
Recently, the SEC agreed to amend its rules in order to simplify and improve the agency’s complex exempt offering framework. The amendments (1) modernize and simplify the Securities Act integration framework for registered and exempt offerings; (2) set clear and consistent rules governing offering communications between issuers and investors; (3) increase offering and investment limits for certain exemptions; and (4) harmonize certain disclosure requirements and bad actor disqualification provisions. Effective as of March 15, 2021, these amendments will better facilitate capital formation and expand investment opportunities while preserving important investor safeguards.
One of these changes updated the accredited investor verification requirements under Rule 506(c), which is a common federal exemption utilized by startups to broadly solicit capital from accredited investors.
What is 506(c)? And why is it important?
For years, general solicitation and advertising was prohibited by the SEC. In other words, an issuer (i.e. startup company) could not publicly market its offerings. This changed in 2012 when Congress passed the JOBS Act, which created the 506(c) exemption. The 506(c) exemption allows issuers to generally solicit and advertise their offerings, but only to accredited investors.
Mechanics of 506(c)
Rule 506(c) permits issuers to generally solicit and advertise an offering, provided that:
- all purchasers in the offering are accredited investors,
- the issuer takes reasonable steps to verify their accredited investor status, and
- certain other conditions in Regulation D are satisfied.
Issuers wishing to solicit or advertise under 506(c) must take reasonable steps to verify the accredited investor status of purchasers. Rule 506(c) sets out a principles-based method for accredited investor verification, requiring an objective determination by the issuer as to whether the steps taken in verification were “reasonable” in context of the particular facts and circumstances of each purchaser and transaction.
The non-exhaustive list for accredited investor verification from Rule 506(c) previously included:
- Reviewing IRS documentation (i.e. tax returns) that state income levels and obtaining a written representation from the investor that the investor has a reasonable expectation of reaching the same income level necessary to qualify as an accredited investor during the current year
- Reviewing bank statements, brokerage statements, and other similar reports to determine net worth
- Obtaining written confirmation of the investor’s accredited investor status from one of the following persons: a registered broker-dealer, an investment adviser registered with the SEC, a licensed attorney, or a CPA
The amended Rule has added a new verification method whereby an issuer that previously took reasonable steps to verify a purchaser’s accredited investor status may satisfy its verification obligation over the next five years by obtaining a written representation at the time of sale that the purchaser remains an accredited investor, and the issuer is not aware of any information to the contrary. This is a huge improvement for startups since many investors invest over and over again into their portfolio companies.
In addition to the newly adopted amendments to 506(c), the SEC reiterated its principles-based and three-prong accredited investor inquiry. The SEC also emphasized that issuers are not required to use the verification methods outlined in the non-exclusive list, and can apply the reasonableness standard to the specific facts and circumstances of the offering and the investors.
While adding this 5-year safe period for repeat accredited investors definitely helps, issuers (i.e. startups) should still remain diligent with proper steps for investor verification when relying on Rule 506(c).