Simplified Rule 506(c) Investor Verification Takes Effect March 15
In music, meter describes the way the beats of the rhythm are “organized.” Meters are described by time signatures, written like fractions, such as 2/4, 3/2, or 3/4. Some meters are “simple,” but those that are more complex are called “compound.”
Although time signatures look like fractions, the top number and bottom numbers refer to different things. The top number tells the musician how many beats are in each measure, and the bottom number tells the musician what type of note equals one beat. For instance, with a 2/4 time signature, there are two beats in the measure, and each quarter note (e.g., ¼ note) gets a single beat, and with a 3/2 time signature, there are three beats in the measure, and a half note (i.e., ½ note) gets a single beat.
2/4 and 3/2 are simple meters because each beat is divided into two parts, each of which may be further subdivided into two more parts. Sometimes, the beats are subdivided into three parts instead of two parts. These are called compound meters. 6/4 and 9/2 are the compound meters exactly like 2/4 and 3/2, except the beats are subdivided into three, instead of two, beats.
If this sounds complicated, that’s because it is. Most beginning students play pieces with simple meter because they are, well… simpler.
Although few might think of securities laws as “simple,” sometimes, laws are more complicated than necessary. That has been the case with accredited investor verification under Rule 506(c). But that will change when a new rule becomes effective on March 15, 2021.
Investor Verification Under Rule 506
For many years, Rule 506(b) was the only private placement exemption under Rule 4(2) of the Securities Act of 1933. Rule 506(b) does not allow general solicitation or general advertising. But Rule 506(b) allows up to 35 unaccredited investors and allows issuers to rely upon an investor’s self-certification of their accredited status.
In 2012, the Jumpstart Our Business Startups Act directed the SEC to create a private placement exemption that permitted general advertising and general solicitation. The result was Rule 506(c).
Even though issues may advertise Rule 506(c) offerings, that rule continues to be less popular than Rule 506(b), which does not permit general advertising or general solicitation. That may be because, as initially adopted, Rule 506(c) contained stringent investor verification requirements. Like compound meter in music, the Rule 506(c) investor verification requirements were challenging and burdensome to investors and issuers.
Since Rule 506(b) allows investors to self-certify their accredited status, it is comparable to the less complicated simple meter. Given this, not surprisingly, Rule 506(b) has remained the private placement exemption of choice for most real estate funds and small business issuers.
Effective March 15, 2021, investor verification requirements will be relaxed, so Rule 506(c) issuers generally only will need to verify accredited status once every five years. These changes will remove barriers for real estate funds and small businesses that want to raise funds through advertised private placements. And the changes also will make it easier for accredited investors to invest in multiple Rule 506(c) investments.
Rule 506(c) Investor Verification Requirement
Rule 506(c) limits sales to accredited investors who meet net worth, asset, or income requirements. This won’t change, and Rule 506(c) offerings will continue to be limited to accredited investors.
When the SEC adopted Rule 506(c), it announced a “principles-based approach” for determining accredited investor status. This approach has allowed issuers to consider several factors when determining whether the verification methodology was reasonable. Some of the interconnected, non-exclusive factors the issuer might consider include:
· “The nature of the purchase 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.”
Safe Harbor for Verifying Accredited Investor Status
The principles-based method won’t change on March 15. However, most issuers haven’t been comfortable using this “facts and circumstances” approach. Instead, issuers rely upon a burdensome safe harbor.
Rule 506(c)’s safe harbors allow issuers to verify investor accredited status by one of three methods:
· Reviewing the investor’s prior two years’ income tax returns and obtaining written investor certification that the investor reasonably expects to reach the required income level ($200,000 for an individual and $300,000 for a married couple) in the current year;
· Reviewing recent (within the last three months) verification of the investor’s assets via bank or brokerage statements, appraisal reports, or similar documents and verify liabilities via a credit report;
· Obtaining written confirmation from the investor’s broker-dealer, investment advisor, attorney, or certified public accountant that the investor is accredited based upon information verified within the last three months.
These requirements were burdensome for investors, particularly if they invested in multiple 506(c) offerings. Plus, smaller issuers might not have the staff to analyze investor financials, even if the investors were willing to reveal this information.
These concerns prompted the creation of investor verification services. For a fee, these services review investor documentation and verify that the investor is accredited. However, this verification is costly and time-consuming. Plus, the safe harbor was burdensome to both investors and issuers, who had to update verification every three months for many repeat investors.
Simplified Income Verification for Rule 506(c) Investors
The revised rule doesn’t change the safe harbor verification process. Investors still will need to provide tax returns, brokerage, and financial statements, or an accountant, broker-dealer, or other professional must certify accredited status. However, most investors won’t have to frequently undergo intense scrutiny of their financial situations. Instead, they will undergo the verification process only once every five years. During the five-year period, investors may self-certify that they remain accredited.
The SEC also retained the principles-based investor verification approach and reiterated the three-prong inquiry in the adopting release. However, the SEC noted that issuers “are not required to use any of the methods in the non-exclusive list and can apply the reasonableness standard directly to the specific facts and circumstances presented by the offering and the investors.
The SEC also noted that “in some circumstances, the reasonable steps determination may not be substantially different from an issuer’s development of a ‘reasonable belief’ for Rule 506(b) purposes.
“For example, an issuer’s receipt of a representation from an investor as to his or her accredited status could meet the ‘‘reasonable steps’’ requirement if the issuer reasonably takes into consideration a prior substantive relationship with the investor or other facts that make apparent the accredited status of the investor. That same representation from an investor may not meet the ‘‘reasonable steps’’ requirement if the issuer has no other information about the investor or has information that does not support the view that the investor was an accredited investor.”
The SEC claims its approach provides issuers with flexibility to bypass the safe harbor by using a principles-based analysis to verify investor status. Still, most issuers should continue to comply with the safe harbor. And most issuers should utilize a reputable, third-party investor verification service rather than in-house investor verification.
However, by requiring formal investor verification only once every five years for most investors, the SEC has removed a significant barrier for both issuers who want to use Rule 506(c) and investors who want to invest in Rule 506(c) offerings.
© 2021 by Elizabeth A. Whitman
Any references clients and their legal situations have been modified to protect client confidentiality.
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