In my previous article, I discussed the theory behind and definition of an accredited investor. In this article I'll explain how purchasers and issuers can properly show accredited investor status.
What proofs are adequate to show that a purchaser qualifies as an accredited investor?
The SEC has laid out particular requirements which must be fulfilled for a party to be qualified as an accredited investor, each of which is linked to the purchaser's business savvy or financial well-being. But even if everyone knows that the necessary requirements are met, purchasers and issuers must still take the proactive step of showing such to be true.
The manner in which purchasers and issuers can show that the applicable requirements are met depends upon which alternative to filing a registration statement the company offering the securities is attempting to use.
Regulation D, 506(b) and 506(c)
The most commonly utilized alternative requirements to filing a registration statement are provided in a set of SEC rules called Regulation D and fall into subcategories referred to as 506(b) and 506(c).
Section 506(b) of Regulation D allows issuers to sell securities without a registration statement so long as the securities offering is made only to a select, small group of known entities.
One requirement for using 506(b) is that purchasers must have an adequate level of sophistication.
If you read through 506(b), you will find that it states that any purchaser under 506(b) must have "such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment, or the issuer reasonably believes immediately prior to making any sale that such purchaser comes within this description."
This language is precisely in line with the spirit of what an accredited investor is meant to be, but it is also opaque. Section 506(b) itself provides no further description other than the sentence above on how the quoted language is to be interpreted, and so readers have been left to wonder what exactly constitutes things like sufficient "knowledge" and "experience."
In theory, by the quoted text alone, under 506(b) an issuer is allowed to sell securities to a purchaser without preparing a registration statement so long as it can effectively argue that the purchaser is sophisticated enough to evaluate the merits and risks involved in making the purchase. However, because exactly what this means is unclear, in practice theoretical determinations are almost never made to try to satisfy this language. Instead, because the SEC has clearly stated that certain parties qualify as accredited investors, issuers generally use an accredited investor analysis as a guidepost.
Once issuers have settled on using an accredited investor analysis for guidance, the question of how to satisfy the quoted text from 506(b) then becomes the following: "What exactly must a purchaser show an issuer in order for the issuer to argue that they ‘reasonably believed' that the purchaser was an accredited investor?"
The answer to this question has been borne out by consistent industry practice and usually takes the form of what is commonly called an "Accredited Investor Questionnaire."
An Accredited Investor Questionnaire is a relatively simple four- or five-page document distributed to potential purchasers in connection with a Section 506(b) offering. It consists of the list of parties who certainly qualify as accredited investors, accompanied by checkboxes for the purchaser to mark as applicable or inapplicable.
An Accredited Investor Questionnaire it is meant to do one thing: get the purchaser to state, in no uncertain terms, by checking an applicable box and signing on the corresponding signature page, that he or she is an accredited investor.
SEC rulings and investigations have confirmed that, when it comes to satisfying 506(b), so long as an issuer has distributed and received a completed Accredited Investor Questionnaire, the issuer can properly argue that it "reasonably believed" the purchaser was an accredited investor and so met the applicable sophistication requirement.
Section 506(c) of Regulation D, like 506(b), is a method of offering securities through alternative requirements to preparing a registration statement. But importantly, unlike 506(b), rather than consisting of an offering of securities only to a small group of known entities, 506(c) allows an issuer to solicit the general public in its sale.
In exchange for allowing for a broader audience of purchasers, 506(c) adds an additional wrinkle to proving purchaser sophistication.
Rather than using the language from 506(b) which refers to a purchaser's level of sophistication, 506(c) instead states that an issuer offering securities under 506(c) "shall take reasonable steps to verify that the purchasers . . . are accredited investors."
It is important to note precisely what the language from 506(c) is doing differently than 506(b) and the requirements that result. As we know, an accredited investor can be determined by doing an accredited investor analysis, the same as we did for 506(b).
Using the list of parties who certainly qualify as accredited investors as our backstop, if we run through the language of 506(c) we land at a different question than that which we answered for 506(b). Here, rather than focusing on reasonable belief the question becomes: "What exactly are ‘reasonable steps to verify' that the purchaser is an accredited investor?"
Section 506(c) itself provides guidance on this point, which should be read in conjunction with the aforementioned list.
The following are reasonable ways of verifying a purchaser's accredited investor status for purposes of 506(c):
- In regards to proving accredited investor status on the basis of income above $200,000 for an individual, or $300,000 together with a spouse:
- providing (i) a Form W-2, Form 1099, Schedule K-1 to form 1065, Form 1040 or other satisfactory IRS form for each of the preceding two years showing the threshold level of income, and (ii) a written representation from the potential purchaser that he or she has a reasonable expectation of reaching the income level necessary to qualify as an "accredited investor" during the current year.
- In regards to proving accredited investor status on the basis of net worth over $1 million:
- providing (i) bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments or appraisal reports from an independent third party issued within the preceding three months, (ii) a consumer report from at least one nationwide consumer reporting agency, and (iii) a written representation from the purchaser that all liabilities necessary to make a determination of net worth have been disclosed, or
- providing written confirmation issued within the prior three months from a registered broker-dealer, investment adviser registered with the SEC, a licensed attorney who is in good standing, or a Certified Public Accountant who is in good standing stating that such party has taken reasonable steps to verify that the purchaser is an accredited investor and that such party has determined that the purchaser is an accredited investor, or proof from the purchaser that they qualified as an accredited investor during their participation in a prior Section 506(b) offering which was held after September 23, 2013.
The SEC has provided rules which help companies to more easily sell securities without requiring them to prepare a registration statement. One alternative requirement which the SEC takes very seriously with these rules is applicable qualification of purchasers as adequately sophisticated, which lands on an accredited investor analysis.
Failing to properly follow the rules surrounding sophisticated purchasers and accredited investors can result in such penalties as fines, invalidation of the issuer's securities offering, the imposition of the requirement that the company complete a full registration statement whether or not it would have otherwise qualified for alternative requirements, and the issuer and the principals behind it being qualified as "bad actors," which could limit their abilities to issue securities in the future.
In sum, failing to follow the rules is not a mistake that anyone wants to make. If you are planning to do a securities offering exempt from requiring a registration statement, be sure that you step carefully and consult with legal counsel to help you understand the requirements involved.Download PDF