I'm an attorney with Ward and
Smith PA. I also write a column about business and law for American Business
Journals, have authored multiple books and teach an eLearning course for
entrepreneurs. You can reach me at JFV@WardandSmith.com or JimV@eLearnSuccess.com. Or you can check out my
eLearning course at http://www.elearnsuccess.com/start.aspx?menuid=3075 or http://www.youtube.com/user/eLearnSuccessor or you can purchase my books
at http://www.amazon.com/Jim-Verdonik/e/B0040GUBRW
In my last article, we discussed how the SEC's Bad Actor
prohibition for Rule 506 private placement offerings was the SEC's way of
endorsing the old saying: "If you
lie down with dogs, expect to get fleas."
Let's continue our analysis of the SEC's recent Rule 506 (c)
changes through the eyes of dogs. The
SEC threw business trying to raise capital a bone by letting them advertise in
Rule 506 (c) private placements, but you have to learn new tricks about how you
verify that a purchaser is an "accredited investor" if you want to
chew on this bone.
Are the benefits of advertising worth it?
Will it cure your capital woes?
Or are the accredited investor verification a poison
pill that will kill your business?
Rule
506 (c) Advertising and General Solicitation
Here's a link to the page of the SEC's website that contains SEC Release
33-9415 about advertising and general solicitations in Rule 506 (c) private
placements:
http://www.sec.gov/rules/final.shtml
Most of the SEC's release explains Rule 506 (c) and the reasons for it,
but the full text of the Rule 506 (c) is at the end of the release.
When you try to predict how the SEC
will interpret and enforce Rule 506 (c), it's useful to remember that people at
the SEC didn't just wake up one day and say:
"I have a great idea. Let's
permit businesses to advertise for investors in private placements."
That's another way of saying that the
SEC will probably strictly enforce accredited investor verification rules and
anti-fraud provisions that relate to what you say in advertising and how you
say it. Think of it like going to your
father to let you do something your mother wouldn't let you do. Your mom might reluctantly go along with it,
but she will hold you to the letter of what you agreed with your father. Don't expect too many breaks.
To better understand advertising and
general solicitations, let's look at Rule 502 (c) which is incorporated into
Rule 506 (b) offerings, but is not incorporated into Rule 506 (c) offerings.
"Neither the issuer not any person acting on its behalf
shall offer or sell securities by any form of general solicitation or general
advertising. . . ."
Rule 502 (c) gives examples of
prohibited practices, which includes advertisements, articles notices and other
communications published in any newspaper magazine, or similar media or
broadcast over television or radio and any seminar or meeting whose attendees
have been invited by general solicitation or general advertising. Since Rule 502 (c) pre-dates the Internet,
Rule 502 (c) does not specifically mention websites and social media, but these
newer media are covered by Rule 502 (c).
Accredited
Investors Only
To qualify to advertise or conduct
another form of general solicitation, Rule 506 (c) states that all people and
organizations that purchaser securities must be "accredited
investors" Rule 506 (c) also requires you to take specific steps to verify
the purchasers actually meet the criteria for being accredited investors. You can't use Rule 506 (c) to advertise if
all you do is ask an investor whether they are accredited.
Two
Separate Tests
The SEC's release makes it clear that
you have to satisfy two separate tests if you want to rely on Rule 506 (c) to
advertise or conduct a general solicitation.
The release states that the verification requirement "is separate
from and independent of the requirement that all sales be limited to accredited
investors, and must be satisfied even if all purchasers happen to be
"accredited investors." The
SEC believes this separate requirement "will avoid diminishing the
incentive for issuers to undertake the reasonable verification steps envisioned
by the JOBS Act.
The bottom line is that being lucky
isn't a defense. You actually have to do
the work to verify accredited investor status if you want to advertise.
This two separate tests approach opens
the door for purchasers who actually are accredited investors to sue you and
your business for not taking reasonable steps to verify their status, if they
lose money by investing in your business.
So, if you just guess that your investors are accredited or if you just
take their word for it, you are giving the investors a gun to put to your head,
if the investors lose money. If they sue
you, fraud and who is at fault won't even be issues, if you advertised but you
failed to satisfy Rule 506 (c)'s verification standards. Of course, if the person actually isn't an
accredited investor, their case against you is even stronger.
This may change existing law (at least for
Rule 506 (c) offerings). Courts
frequently dismissed law suits in which investors claimed they were not
accredited investors, because the courts have ruled the investors should not
benefit from misleading the seller by signing false statements, unless
investors could show the seller knew the statements were false.
Accredited
Investor Definition
Let's briefly review who is an
accredited investor before we deal further with the more complicated
verification requirements of Rule 506 (c).
Rule 501 (a) of Regulation D lists
eight (8) types of "accredited investors." These include a variety of banks, investment
funds and other financial institutions, trusts, directors, executive officers,
general partners of the issuer (or of the issuer's general partner, if the
issuer is a partnership or limited partnership), and any corporation or other
entity if all its equity owners are accredited investors. Natural persons who satisfy one of the
following net worth or income tests are also accredited investors:
- A natural person whose individual
net worth, or joint net worth, with that person’s spouse, at the time of
purchase exceeds $1,000,000 (not including the value of their primary
residence or mortgage or other debt the home secures, unless the mortgage
or other debt exceeds the value of the primary residence); or
- A natural person who had an individual income in excess of $200,000 in each of the two most recent years that precedes the investment or joint income with that person’s spouse in excess of $300,000 in each of the two prior years who also has a reasonable expectation of reaching the same income level in the year the investment is made.
We note that Rule 501 (a) makes it
clear that someone can be an accredited investor in one of two ways:
- The
investor actually meets the criteria specified in Rule 501 (a); or
- The issuer has a "reasonable belief" that the investor meets the criteria specified in Rule 501 (a).
Rule 506 (c)'s verification
requirements apply to all eight (8) types of accredited investors specified in
Rule 501 (a). But the most vocal
concerns about the verification provisions relate to procedures for verifying
the income or net worth or individual investors. We discuss the reasons for these objections
in one of our other articles in this series of articles about Rule 506 (c).
We note, however, that the verification
requirement for other types of accredited investors also present
difficulties. For example, verifying
that all the equity owners of the investor are accredited investors may require
substantial effort. If you have an
investor that is owned by a series of corporations, limited liability companies
or other entities, you would have to trace back up the chain to the ultimate
equity owners at the end of the chain to determine whether the investor is an
accredited investor.
The SEC acknowledges that collecting
data may subject a business to other obligations under state and Federal
laws. Footnote 118 of the SEC's release
indicates:
"Information and documentation collected r these
verification purposes may be subject to federal and/or state privacy and data
security requirements."
Therefore, businesses that intend to
advertise should consult with legal counsel other than their securities
attorney to ensure that they have internal processes and infrastructure to
comply with applicable privacy and data security laws. Compliance with securities laws will not be a
defense for violating other laws.
Demonstrating t investors that you have systems to protect their
confidential financial information can help you raise capital from cautious
investors.
Reasonable
Steps to Verify Accredited Investor Status
Let's discuss in detail the verification requirement for
using Rule 506 (c) to raise:
"The issuer shall take reasonable steps to verify that
purchasers of securities sold in any offering under paragraph (c) of this
section are accredited investors."
This requirement to take "reasonable steps to
verify" accredited investor status is the meatiest part of the rule.
Footnote 116 of the SEC's release states the standard for
considering someone an "accredited investor" for purposes of Rules
505 and 506 (b) of Regulation D:
"Because an issuer must have a reasonable belief that a
purchaser is an accredited investor, the issuer could not form such reasonable
belief if it has knowledge that the purchaser is not an accredited
investor."
Later in the release, the SEC indicates that Rule 506 (c)
builds on top of the reasonable belief foundation that is included in the
accredited investor definition in Rule 501 (a):
"We believe the issuer will not
lose the ability to rely on Rule 506 (c) for that offering, 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."
Most businesses that sell securities have traditionally satisfied
this reasonable belief standard by simply asking investors to sign a document
that represents they are accredited investors.
The document often asks investors to specify which type of accredited
investor they are – usually by checking a box.
Some businesses might also ask investors to sign a net worth statement
that gives some specific numbers (usually by assigning values to general
classes of assets like cash, securities or real estate), but prior to Rule 506
(c) very few businesses asked for proof of accredited investor status other
than the investor's own written statements.
If an investment adviser, broker or investment banker is in the
transaction, they often have more detailed financial information about their
investor clients.
Rule 506 (c) doesn't eliminate your ability to
use Rule 506 (b) to sell securities without advertising, but you cannot
advertise or conduct a general solicitation under Rule 506 (c), unless you
comply with the "reasonable steps to verify" provision of Rule 506
(c).
Before the SEC finalized Rule
506 (c), the SEC received many comments from securities lawyers, investment
bankers and others about how difficult it is to verify an individual's net
worth by independent means other than self-verification by the investor. The problem is that even if an investor shows
you a list of $5 million of assets, you don't know that person's net worth,
because you have to deduct all liabilities to calculate net worth. If the investor hides liabilities, they may
not be an accredited investor. The SEC
deals with this problem by including in Rule 506 (c) a safe harbor provision
that lists the steps you have to take if you want to guaranty that you have
complied with Rule 506 (c)'s verification provision.
Rule 506 (c) creates a non-exclusive safe harbor for how to
comply with the "reasonable steps to verify" provision. Unlike some other safe harbors, the Rule 506
(c) safe harbor affords protection not only against the SEC taking action
against you, but if you fully comply with this safe harbor provision, you have
a guaranteed exemption from registration that will withstand attacks by
investors seeking damages and attacks by state securities regulators who assert
you should have complied with state securities laws, because you failed in your
attempt to qualify for the Rule 506(c) exemption that pre-empts many provisions
of state securities laws.
"The issuer shall be deemed to
take reasonable steps to verify if the issuer uses, at its option, one of the following non-exclusive and
non-mandatory methods of verifying that a natural person who purchases
securities in such offering is an accredited investor; provided, however, that the issuer does not have knowledge
that such person is not an accredited investor: "
Here is how you have to verify income and net worth to obtain the benefits of Rule 506 (c)'s safe harbor provision:
Income Verification
To verify
income to qualify for the safe harbor, you must review any Internal Revenue
Service form that reports the purchaser’s income for the two most recent years
before the investment date (including, but not limited to, Form W-2, Form 1099,
Schedule K-1 to Form 1065, and Form 1040) and you must obtain a written
representation from the purchaser (and their spouse's representation, if you
use the spouse's income to qualify the purchaser as an accredited investor)
that he or she has a reasonable expectation of reaching the income level
necessary to qualify as an accredited investor during the year the investment
occurs.
Net Worth Verification
·
Documentation 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; and
·
Documentation for
Liabilities: a consumer report from at least one of the nationwide consumer
reporting agencies.
Independent Expert Verification
Rule 506 (c) tries to deal with
these problems by allowing businesses to qualify for the safe harbor, and
investors to protect their confidential financial information, by allowing
businesses that raise capital to accept a written confirmation of compliance
with the safe harbor's verification process from any of the following:
·
A registered
broker-dealer
·
A registered
investment adviser
·
A licensed
attorney
·
A certified
public accountant
One of these independent
experts must confirm in writing "that such independent licensed or
registered expert has taken reasonable
steps to verify that the purchaser is an accredited investor within the
prior three months and has determined that such purchaser is an accredited
investor."
"While third-party confirmation by one of these parties
will be deemed to satisfy the verification requirement in Rule 506(c),
depending on the circumstances, an issuer may be entitled to rely on the
verification of accredited investor status by a person or entity other than one
of these parties, provided that any such third party takes reasonable steps to
verify that purchasers are accredited investors and has determined that such
purchasers are accredited investors, and the issuer has a reasonable basis to rely on such
verification."
Angel investor groups are seeking SEC confirmation that
their group could certify the accredited investor status of their members. Banks, trust companies and other financial
institutions might also want to offer this type of verification services to
their clients. Because these
organizations are not specifically mentioned in the safe harbor, however, the
business selling securities would have to determine whether it is reasonable to
rely on their verification. There is no
safe harbor from people challenging that decision.
"Under
Rule 506(c), issuers are required to take reasonable steps to verify the
accredited investor status of purchasers. Consistent with the Proposing
Release, whether the steps taken are “reasonable” will be an objective
determination by the issuer (or those acting on its behalf), in the context of
the particular facts and circumstances of each purchaser and transaction. Among
the factors that issuers should consider under this facts and circumstances
analysis are:
·
the nature of the purchaser 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.
The SEC's release goes on to
explain how these factors should be used to determine whether any particular
verification procedures satisfy the "reasonable steps to verify"
requirement of Rule 506 (c):
"These factors are interconnected
and are intended to help guide an issuer in assessing the reasonable likelihood
that a purchaser is an accredited investor – which would, in turn, affect the
types of steps that would be reasonable to take to verify a purchaser’s
accredited investor status. After
consideration of the facts and circumstances of the purchaser and of the
transaction, the more likely it appears
that a purchaser qualifies as an accredited investor, the fewer steps the issuer would have to take to verify
accredited investor status, and vice versa.
The SEC's release then gives examples of how these factors
should work:
For example, if the terms of the offering require a high minimum investment
amount and a purchaser is able to meet those terms, then the likelihood
of that purchaser satisfying the definition of accredited investor may be
sufficiently high such that, absent any facts that indicate that the purchaser
is not an accredited investor, it may be reasonable for the issuer to take
fewer steps to verify or, in certain
cases, no additional steps to verify accredited investor status other
than to confirm that the purchaser’s cash investment is not being financed by a
third party."
The release contains other examples of the factors businesses can consider to determine how much checking is necessary to satisfy the "reasonable steps to verify" requirement. The examples of relevant information about the purchaser the affects the required scope of the verification process include publicly available information about an officer's compensation in a proxy statement might be sufficient to verify the annual income requirement.
The SEC's release indicates that the SEC remains suspicious of
advertising and general solicitation when it indicates that the method the
investor became aware of the investment opportunity could increase the verification requirements:
"An issuer that solicits new
investors through a website available to the general public, through a widely
disseminated email or social media solicitation, or through print media, such
as a newspaper, will likely be
obligated to take greater measures to verify accredited investor status
than an issuer that solicits new investors from a database of pre-screened
accredited investors created and maintained by a reliable third party."
But the SEC's release reminds us that a business cannot
delegate its verification obligations, unless the issuer has a reasonable basis
to rely on such third-party verification:
"We do not believe as issuer will
have taken reasonable steps to verify accredited investor status if it, or
those acting on its behalf, required only that a person check a box in a
questionnaire or sign a form, absent other information about the purchaser
indicating accredited investor status."
Form D and Other Regulation Changes
"We are of a view that an issuer
will not be permitted to check both boxes at the same time for the same
offering. We remind issuers that once a
general solicitation has been made to purchasers in the offering, an issuer is
precluded from making a claim of reliance on Rule 506 (b), which remains
subject to the prohibition against general solicitation, for that same
offering."
In footnote 142, the SEC explains that this is to prevent purchasers who become interested in the offering from the general solicitation from being sold securities in the Rule 506 (b) offering.
We will discuss the Rule 502 (a) integration issues this
raises in another article in this series about Rule 506 changes.
·
File their Form D at least 15 days before they
begin a general solicitation or begin advertising.
·
Submit advertising and general solicitation
materials to the SEC.
·
Provide information about methods used to verify
accredited investor status.
·
Have warning legends in advertising and general
solicitation materials.
Transitions: Rue 506 (b) Offerings Currently Underway
If you have already sold
securities to investors in a Rule 506 (b) offering before Rule 506 (c) is effective
and want to continue the same offering with advertising or a general
solicitation, you can begin advertising and finish the offering pursuant to
Rule 506 (c), if for each new investor you comply with the "reasonable
steps to verify" provisions of Rule 506 (c). The new rule will not affect your exemption
for pre-Rule 506 (c) sales.
Record
Keeping
The SEC's release cautions businesses that rely on Rule 506 (c) about record keeping:
"because the issuer has the
burden of demonstrating that its offering is entitled to an exemption from the
registration requirements of Section 5 of the Securities Act, it will be
important for issuers and their verification service providers to retain
adequate records regarding the steps taken to verify that a purchaser was an
accredited investor."
Check applicable statutes of limitation
for how long any of the following can bring an action against you:
- The
SEC or Department of Justice for violating Federal securities laws,
- Investors
seeking damages
- State securities regulators who assert you should have complied with state securities laws, because you failed in your attempt to qualify for the 506(c) exemption.
Why is Rule
506 Important?
Rule 506 is an important rule because more than 90% of
securities offerings use Rule 506 as an exemption from registration
requirements. One reason for Rule 506's
popularity is that Rule 506 preempts state securities laws other than anti-fraud
laws and certain notice filing requirements.
Preempting state
securities laws allows securities offerings to close quickly and reduces
compliance costs. This is especially
useful in multi-state private placement offerings. If you limit sales to only accredited
investors, Rule 506 gives you great flexibility about what you tell investors
and how you tell it to them as long as you don't commit fraud. Now, you can also use advertising and conduct
a general solicitation in Rule 506 (c) offerings.
Beware of State Securities Laws
Advertising is
subject to state anti-fraud laws even if you comply with all the accredited
investor verification provisions of Rule 506 (c).
If you fail to
satisfy the verification provisions of Rule 506 (c), registration and other
provisions of state securities laws will not be pre-empted.
Penalties for Non-Compliance
If you don't have a
Federal exemption from registration, or if you don't comply with state
securities laws, the usual remedy is rescission. That means that investors have the right to
get their money back, plus interest. If
the business cannot pay the money back, officers and directors, investment
bankers and others might have personal liability.
Plaintiffs' lawyers,
who are unable to prove that your business committed any fraud, can win the
same damages that would be available if fraud had occurred if you advertise
without complying with Rule 506 (c).
Spillover
Effect of New Rule
Technically, new
Rule 506 (c) applies only to offerings where you choose to advertise or conduct
a general solicitation. The SEC's
release specifically states: "Therefore, the amendment to Rule 506 we
are adopting today does not amend or modify the requirements relating to
existing Rule 506(b)."
So, from the SEC's
perspective you can still use Rule 506 (b) to sell to accredited investors
without meeting the "reasonable steps to verify" accredited investor
status required by Rule 506 (c), if you don't advertise or otherwise conduct a
general solicitation.
That's the way it's
supposed to work. But we all know the
law of unintended consequences.
Self-verification by
investors of their accredited investor status is not contained in any SEC rule
or law. Self-verification developed as a
common industry practice. If industry
practices change, self-verification may no longer be a sufficient basis to form
a reasonable belief that someone is an accredited investor.As more businesses implement the new accredited investor verification procedures, courts might begin to apply the verification concepts of Rule 506 (c) to Rule 506 (b) and any other provision that refers to accredited investors.
If other businesses
that raise capital routinely check financial records from investors, it becomes
difficult to argue that this is too burdensome.
People may interpret failure to investigate beyond the investor's
self-verification statement as an indication that the business knew the
statement was not correct.
Articles
in Private Placement Series
In July 2013 the SEC made the biggest
changes to private placement capital raising rules since the SEC issued
Regulation D more than three decades ago.
More than 90% of private securities
offerings are affected by these changes.
The SEC's recent changes are a mixed
blessing for businesses selling securities.
These changes include:
- Prohibiting
using Rule 506 if someone affiliated with your business or with your
capital raising efforts has violated securities or other financial
industry laws.
- Adding
new Rule 506 (c), which allows you to advertise when you raise capital in
a private placement.
- Rule
506 (c) also requires you to take reasonable steps to independently verify
that all people who buy securities are "accredited investors,"
if you advertise your offering.
Our articles in this series about SEC
Rule 506 private placements help you decide how you can use these new rules to
raise the capital your business needs by balancing three competing factors:
- Advertising
effectiveness
- Budget
- Securities
law compliance
You have to get all three right to
successfully raise capital.
Here's a list of our articles that
discuss the primary issues you will face when you try to balance these three
objectives in your capital raising efforts:
- Advertising Messages Tweeting Your
Way to Securities Fraud in 140 Characters: What Do you Say in SEC Rule 506
(c) Advertising in Private Placements?
How do you decide what you say in
your advertising? How do you say
it? What current SEC and state
advertising rules can you use to guide your advertising decisions? Can you combine effective sales messages
with complying with securities laws?
Or is it an either or choice?
What's the point of advertising if securities laws prevent you from
selling effectively?
http://jimverdonikintersection.blogspot.com/2013/08/tweeting-your-way-to-securities-fraud.html
- Choosing the Right Media for your Advertising.
Don't Tweet when You Should Have
LinkedIn: Choosing Your
Advertising Media in SEC Rule 506 (c) Private Placements How do you advertise within your
budget? How do you identify your
"sweet spot" target investors and the right media to reach
them? What social media tools can
you use? How do you attract
accredited investors who meet SEC criteria for making investments? http://jimverdonikintersection.blogspot.com/2013/08/dont-tweet-when-you-should-have.html
- Building your Sales and Legal Team. Would
You Let Your Lawyer Run Your Sales Department? How Can You Build the Right Team for
Advertising in SEC Rule 506 (c) Private Placements? How do you build teams to help you do
effective advertising while still complying with SEC and state anti-fraud
rules? What role should your sales
team play? What role should your
lawyer play? How do you choose a
lawyer who can help you create effective advertising that also complies
with securities laws. http://jimverdonikintersection.blogspot.com/2013/08/would-you-let-your-lawyer-run-your.html
- Accredited Investor Verification. Will SEC Rule 506
(c)'s Permission to Advertise Cure Your Capital Woes or is Its Accredited
Investor Verification Requirement a Poison Pill? If you want to
advertise your securities offering, you must take reasonable steps to
verify that everyone you sell to is an "accredited
investor." You can't just rely
on the investor checking a box that tells you it is accredited. How much checking is
"reasonable"? How do you
qualify for the "safe harbor" the SEC included in Rule 506
(c)? What happens if you don't
obtain the right type of proof that the people you sell securities to are
"accredited investors?"
Why will some investors refuse to comply with your verification
requests? What can you do to
reassure investors about privacy issues and make the verification process
more convenient for investors?
http://jimverdonikintersection.blogspot.com/2013/07/sec-rule-506-c-sec-throws-new.html
- Beware of SEC Integration Rules: SEC
RULE 506 (c) Integration Pitfalls: Don't Use the SEC's New Advertising and
Solicitation Private Placement Rule to Saw Off the Limb You are Sitting
On Why should you look before
you leap into advertising? What
integration and related pitfalls does Rule 506 (c) create for businesses
that choose to advertise or engage in general solicitations? How do you sell securities to people who
are not accredited investors under another SEC private placement exemption,
if your advertising doesn't attract enough accredited investors to finance
your business?
http://jimverdonikintersection.blogspot.com/2013_07_01_archive.html
·
Getting Caught : How Will the SEC Know I'm Advertising in a
Rule 506 (c) Private Placement? How will the SEC know about your
advertising? Why isn't it a defense that
everyone else is breaking the rules? How
do you deal with the interim period when people are figuring out what the new
rules let you do and don't let you do? http://jimverdonikintersection.blogspot.com/2013/09/how-will-sec-know-im-advertising-in.html
·
Bad Actors: SEC's
Bad Actor Rule: When You Lie Down with Dogs Expect to Get Fleas
To
use Rule 506 (with or without advertising) you have to verify that a long list
of people who are affiliated with your business or with selling your securities
offering haven't violated securities or other financial industry laws. How do you make sure the SEC's Bad Actor
Prohibition for Rule 506 private placements from cut off your ability to raise
capital?
http://jimverdonikintersection.blogspot.com/2013/07/secs-bad-actor-rule-when-you-lie-down.html
- Identity Crisis at the SEC: Does
Filing Your Private Placement Tweets with the SEC make Sense?
What road blocks to effective advertising in private
placements is the SEC erecting? Why
are these blocking efforts doomed to fail? http://jimverdonikintersection.blogspot.com/2013/09/does-filing-your-private-placement.html
- Government Bouncer at the
Capitalist Club: SEC RULE 506 (c): Who is Allowed to Be a Capitalist? Why is the Government using Rule 506 (c)
to decide who is allowed to be a capitalist? Do you have what it takes to get past
the Government bouncer standing in your way at the door to the capitalist
club? Why can't you be a capitalist
too? http://jimverdonikintersection.blogspot.com/2013_09_01_archive.html
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