Kiran’s analysis of the new SEC Title II rules are detailed and highlight some of the new issues related to the new SEC rules of Title II of the JOBS Act. If you are a current angel investor or intend to become an angel investor soon, pay particular attention to the new “verification” of accredited investors required for angels interested in investing in companies that might use “general solicitation”, aka “advertising”.
On July 11, the SEC approved new rules pursuant to Title II of the JOBS Act to lift the ban on general solicitation for securities offerings so long as all purchasers are accredited investors. As a key part of this, issuers will also be required to take “reasonable steps to verify” that each purchaser is accredited.
Historically, accredited investor verification has only required self-certification, where an individual checks a few boxes indicating that he is accredited and why he is accredited. Under this new rules, the SEC explicitly indicated that this will no longer be sufficient where general solicitation is used under the new exemption in Rule 506(c).
The Original Rule
In lieu of self-certification, the SEC adopted the proposal it released last August relying on a “principal based approach” where an issuer would need to balance a number of factors to determine what constituted “reasonable steps to verify.” These factors include:
- the nature of the purchaser and the type of accredited investor that the purchaser claims to be (i.e. if a purchaser is a well-known venture capital fund or a broker-dealer, then this is a positive; if they claim to be an individual making $201,000 then that is a factor);
- the amount and type of information that the issuer has about the purchaser (i.e. how well does the issuer know the person and their financial position); 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 (i.e. a high minimum investment would be a positive factor, broad open solicitation to a large number of people would be a negative factor, etc.)
The uncertainty cause by having to apply this factor test on a deal by deal (and persons individual by individual) basis was a huge concern when the SEC released the proposed rules last August.
The New Safe Harbors
Thankfully, the SEC has modified the prior proposal to provide 4 “non-exclusive” safe harbors where an issuer can be sure they have complied with the “reasonable steps to verify” standard unless they have knowledge to the contrary.
- Net Income Verification.* Review of an individual’s IRS documents including (W-2, 1099, K-1, 1040) for most recent two years, together with a written certification from the individual that they expect to continue to have enough income to qualify as accredited.
- Net Worth* – Review of the following documents, which must be dated within the prior 3 months, together with a written representation from such person that all liabilities have been disclosed
- For Assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments and appraisal reports issued by independent third parties
- For Liabilities: a credit report
- Third Party Verification: Written confirmation from one of the following that they have verified accredited investor status within the last 3 months:
- Registered broker-dealer
- Registered investment advisor
- Licensed attorney or CPA
- Pre-Existing Accredited Investors. Pre-existing investor of an issuer that were previously verified as accredited under 506(b)
*If relying on joint income or net worth with a spouse, then documents for the spouse must also be provided.
Issuers will likely need to have the ability to use all of these methods depending on the information available for their potential investors. Moreover, “reasonable steps to verify” is a separate and in addition to the requirement that all purchasers are accredited investors. This means that failure to verify would cause a violation of 506(c) even if all the purchasers are accredited.
It therefore seems likely that in order to efficiently use 506(c), issuers will need to rely on integrated solutions or platforms with built-in and automatic online verification methods (like SeedInvest).
“Reasonable Belief” Requirement Clarified
An issuer will be entitled to rely on a third party that has verified a person’s status as an accredited investor, provided that the issuer has a reasonable basis to rely on such third-party verification. Further, so long as the issuer took reasonable steps to verify that the purchaser was an accredited investor and had a reasonable belief that such purchaser was an accredited investor at the time of sale, they will not have violated the 506(c) exemption if an unaccredited investor purchases securities (i.e. by falsifying the verification materials).