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SEC Issues New C&DIs on Accredited Investor Definition and Rule 506(c) "Reasonable Steps" Verification Safe Harbors
Practical Law Legal Update 8-573-4525 (Approx. 5 pages)
SEC Issues New C&DIs on Accredited Investor Definition and Rule 506(c) "Reasonable Steps" Verification Safe Harbors
by Practical Law Corporate & Securities
| Published on 03 Jul 2014 • USA (National/Federal) |
The SEC issued new compliance and disclosure interpretations (C&DIs) on the definition of accredited investor under Rule 501(a) and the safe harbors for taking "reasonable steps" to verify accredited investor status under Rule 506(c).
On July 3, 2014, the SEC's Division of Corporation Finance issued new compliance and disclosure interpretations (C&DIs) addressing:
- The definition of accredited investor under Rule 501(a) of Regulation D under the Securities Act (Questions 255.48 and 255.49, C&DIs: Securities Act Rules).
- The safe harbors for taking "reasonable steps" to verify accredited investor status under Rule 506(c)(2)(ii) (Questions 260.35 to 260.38, C&DIs: Securities Act Rules).
The new C&DIs are summarized below.
Definition of Accredited Investor
The new C&DIs address questions about the net worth test for natural persons under Rule 501(a)(5) and the annual income test for natural persons under Rule 501(a)(6).
- Net worth test and jointly-held assets. Where an issuer is determining a natural person's accredited investor status under the net worth test, it may include in the prospective purchaser's total assets any assets in accounts or properties held jointly with another person who is not the purchaser's spouse, to the extent of the purchaser's ownership percentage (Question 255.49).
- Annual income test and foreign currencies. Where an issuer is determining a natural person's accredited investor status under the annual income test, but the prospective purchaser's annual income is not reported in US dollars, the issuer may use either the exchange rate in effect on the last day of the year for which income is being measured or the average exchange rate for that year (Question 255.48).
For more on the definition of accredited investor under Rule 501(a), see Practice Note, Section 4(a)(2) and Regulation D Private Placements and Standard Document, Investor Questionnaire.
Safe Harbors for Taking Reasonable Steps to Verify Accredited Investor Status under Rule 506(c)(2)(ii)
An issuer conducting a private placement under Rule 506(c) must take reasonable steps to verify that each purchaser in its offering is an accredited investor. Rule 506(c)(2)(ii) sets out specific verification methods that serve as safe harbors for verifying a natural person's accredited investor status. An issuer that complies with one of these safe harbors will be deemed to have satisfied the reasonable steps verification requirement.
However, the Rule 506(c)(2)(ii) safe harbors are non-mandatory and non-exclusive. Because the question of whether an issuer's verification steps are reasonable under Rule 506(c) is ultimately a principles-based determination, an issuer can still satisfy the reasonable steps requirement even if it does not use any of the safe harbor methods specified in Rule 506(c)(2)(ii).
The Annual Income Test Safe Harbor under Rule 506(c)(2)(ii)(A)
When IRS income tax forms for the most recently completed year are not yet available
The Rule 506(c)(2)(ii)(A) safe harbor requires the review of Internal Revenue Service (IRS) forms that report the prospective purchaser's income for the "two most recent years." If IRS forms for the most recently completed year are not yet available (for example, the purchaser's 2013 IRS forms in an offering being conducted in early 2014), the Rule 506(c)(2)(ii)(A) safe harbor would not be available.
However, the SEC staff believes that an issuer could still reasonably conclude that a purchaser is an accredited investor and satisfy Rule 506(c)'s reasonable steps verification requirement under the principles-based verification method by:
- Reviewing IRS forms that report income for the two years preceding the most recently completed year (in this example, 2012 and 2011).
- Obtaining written representations from the purchaser:
- stating that an IRS form reporting the purchaser's income for the most recently completed year (2013) is not available;
- specifying the purchaser's income for the most recently completed year (2013) and that the purchaser's income reached the level needed to qualify as an accredited investor; and
- stating that the purchaser has a reasonable expectation of reaching the required income level for the current year (2014).
Acceptability of income tax forms from foreign jurisdictions
Where a prospective purchaser is not a US taxpayer and therefore cannot provide IRS forms, the issuer may not rely on its review of comparable non-US tax forms to satisfy the Rule 506(c)(2)(ii)(A) safe harbor.
However, the SEC staff believes that an issuer could still reasonably conclude that a purchaser is an accredited investor and satisfy Rule 506(c)'s reasonable steps verification requirement under the principles-based verification method by reviewing filed tax forms that report income as long as the foreign jurisdiction imposes penalties for falsely reported information comparable to the corresponding penalties imposed by the IRS. (Question 260.36)
The Net Worth Test Safe Harbor under Rule 506(c)(2)(ii)(B)
Requirement that documents be dated "within the prior three months"
The Rule 506(c)(2)(ii)(B) safe harbor requires the review of specified documents, "dated within the prior three months," showing the purchaser's assets and liabilities. An issuer reviewing a purchaser's tax assessment, one of the documents specified in Rule 506(c)(2)(ii)(B), would not be able to rely on this safe harbor if the tax assessment is dated more than three months earlier.
However, the SEC staff believes that an issuer could still reasonably conclude that a purchaser is an accredited investor and satisfy Rule 506(c)'s reasonable steps verification requirement under the principles-based verification method if it uses the most recently available tax assessment when determining whether the purchaser meets the net worth test. For example, if the most recent assessment shows a value that, after deducting the purchaser's liabilities, results in a net worth substantially in excess of $1 million, that may be sufficient verification that the purchaser satisfies the net worth test. (Question 260.37)
Requirement to review a consumer report from a US nationwide consumer reporting agency
The Rule 506(c)(2)(ii)(B) safe harbor requires the review of a consumer report from one of the "nationwide consumer reporting agencies" to determine the purchaser's liabilities. An issuer reviewing a report from a non-US consumer reporting agency that performs similar functions as a US nationwide consumer reporting agency would not be able to rely on this safe harbor.
However, the SEC staff believes that an issuer could still reasonably conclude that a purchaser is an accredited investor and satisfy Rule 506(c)'s reasonable steps verification requirement under the principles-based verification method by reviewing the non-US report and taking any other steps necessary to determine the purchaser's liabilities when calculating total net worth (for example, obtaining a written representation from the purchaser that all liabilities have been disclosed). (Question 260.38)
Where There is Reason for Doubt, the Issuer Must Take Additional Verification Measures
In each of the C&DIs addressing the Rule 506(c)(2)(ii) safe harbors, the SEC staff stresses that if the issuer has any reason to question the reliability of the prospective purchaser's documents or the accuracy of the underlying information, it must take additional verification measures to satisfy Rule 506(c)'s reasonable steps verification requirement.
For more on the reasonable steps verification requirement, see Practice Note, JOBS Act: Regulation D and Rule 144A General Solicitation Summary and Standard Document, Accredited Investor Representation Letter for Rule 506(c) Offering.