Thursday, September 19, 2013

SEC Rule 506 (c): Who Is Allowed Be A Capitalist?

By Jim Verdonik
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 or Or you can check out my eLearning course at or or you can purchase my books at

Everyone knows you need a license drive a car.
You also need a license from the Government to be a doctor or a lawyer or an accountant or stock broker.
Wow! It seems like the Government likes to restrict access to all the good paying jobs.
Maybe that's why Government makes it difficult to make an investment, unless you are already mega rich.
You don't need a Government license for minimum wage jobs like flipping burgers at MacDonald's or greeting people at Wal-Mart.  The Government lets anyone work in low paying jobs.
Why do you need a special Government permission to make good money, but Government allows anyone to work for the minimum wage?
Maybe the Government licenses doctors, lawyers, accountants and stock brokers because people pay them a lot of money.  Or, maybe people pay them a lot of money, because Government license requirements limit competition.
Does this sound like another version of the question:  Which came first, the chicken and the egg?
People have long debated whether the benefits of Government licenses justify the increase in cost associated with Government licenses.  Few people change their minds.
But let's examine the basic motivation for limiting the ability of people to make investments.  Supposedly, Government licenses exist to protect the public from people who aren't competent to perform services. 
But does the same rationale apply to investors?  What explains why the Government imposes restrictions on who is allowed to make different types of investments?  Does licensing investors make any sense?
Investors give money.  They don't collect money.  And money is fungible.  One person's money is no better or worse than another person's money.  So, limiting who can invest doesn't promote higher quality investing.
Then why is the Government so intent on limiting who can make investments?
Let's talk about the SEC's recent rule change for Rule 506 (c) private placements under Regulation D that requires businesses to verify that an investor is an "accredited investor."
You used to be able to take someone's word for it, if they told you that they are an "accredited investor."
Now, if you want to advertise your offering, you have to check financial documents people must give you to prove they are an "accredited investor."
It's kind of like a store clerk or bar tender who checks your driver's license before they sell you a beer or wine.
But instead of your driver's license, the clerk or bar tender asks to see your bank statements or tax returns.  That's much more intrusive into personal finances and exposes you to identity theft and other risks. 
Why would the Government want to increase these risks for investors?  Identity theft occurs a lot more often than securities fraud.  So, Government seems to be struck in time warp fighting an old enemy while new enemies are creating bigger dangers.
Why is the Federal Government using SEC Rule 506 (c) to decide who is allowed to be a capitalist?  Are the benefits worth the risks and the inconveniences?
Many people the new Rule ostensibly seeks to protect don't want this protection.
The new verification requirement is already annoying many investors.  The Angel Capital Association announced a few days after the new rule was released that the new SEC rule could kill angel investing:

We'll discuss the accredited investor verification process SEC Rule 506 (c) imposes at length below and why many investors oppose the new verification requirements.

Crowd Funding Rules Delayed

But first let's clarify that this new rule is not the crowd funding rule that the JOBS Act also mandated in April 2012.  The crowd funding rules mandated by the JOBS Act are intended to allow businesses to raise small investments from small investors via the Internet.  The crowd funding rule is supposed to mimic websites that allow people to pay for new products in advance so the business can produce the new product to sell to them.  Currently, these websites can't sell securities.  They can only sell products.  Businesses cannot offer their early customers the right to buy their shares through these websites – at least not in the United States.
So, if you see a business that is offering a great new product that you think will make a lot of money, the Government makes it difficult for you to invest, unless you are already rich.
The SEC has made no progress on the "crowd funding" rules that Congress and the President ordered the SEC to issue in April 2012, because the SEC opposes the concept of small investors using the Internet to make small investments in businesses.
So, small investors will continue to be shut out of investing in young companies that raise capital.  The SEC thinks this type of investing is a bone that's reserved only for the big dogs.  The SEC's message to little dogs is to get lost.
Accredited Investors Only
Let's review the definition of accredited investors before we deal further with the verification requirements of Rule 506 (c).
Rule 501 (a) of Regulation D defines "accredited investors" to 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, corporations and other entities all of whose owners are accredited investors and natural persons who satisfy one of the following net worth or income tests: 
  • 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 unless the mortgage 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 or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year (the year in which the purchase is made).
Rule 506 (c)'s verification requirements apply to all the types of accredited investors.  But most of the concerns about the verification provisions relate to verifying the income or net worth of individuals.
Nevertheless, the verification requirement for other types of accredited investors may present difficulties.  For example, verifying that all the owners of an entity are accredited investors will create headaches for both investors and businesses that try to raise capital.
Reasonable Steps to Verify Accredited Investor Status
Let's discuss the verification requirement for using Rule 506 (c), which says:
"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.

Reasonable steps is a pretty ambiguous standard.  How do you know if you have taken reasonable steps?
That's why the SEC provides a "safe harbor" rule.  That means that the SEC won't challenge whether you have taken reasonable steps if you comply with the specific things listed in the safe harbor rule.
Income Verification Safe Harbor
To verify whether someone's income qualifies for the accredited investor verification safe harbor, you have to:
  • 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);
  • 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 Safe Harbor

To verify whether someone's net worth qualifies for the accredited investor verification safe harbor, you must review one or more of the following types of documents that are dated during the three months before the investment date and you must obtain a written representation from the purchaser (and their spouse's representation, if you use the spouse's net worth to qualify the purchaser as an accredited investor) that all their liabilities necessary to make a determination of net worth have been disclosed:

  • 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.

  • Documentation for Liabilities: a consumer report from at least one of the nationwide consumer reporting agencies.
Naturally, many investors don't want to turn over their tax documents and bank statements to every business they invest in.  Investors value their privacy and they don't want to open the door to identity theft.

Another reason why some angel groups fear the effect of this new rule on their investments is that the SEC is encouraging businesses that don't follow the safe harbor rule to impose high minimum investment requirements for their private placements.

The SEC's statement underlined below indicates that high minimum investment requirements reduce the risk that someone is not an accredited investor.  The SEC encourages high minimum investment requirements by giving this example in its release that issued new Rule 506 (c):

"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."

So, the easiest thing for a business that is trying to raise capital to do is to impose a high minimum investment requirement.  It's certainly easier than requiring investors to give you their tax documents and bank statements.  

The SEC's bias towards high minimum investments favors very high net worth investors over middle class people who also meet the accredited investor requirements of Rule 506 (c), but whose total net worth is not high enough to prudently invest a large amount in a single business.

The mega rich can have diversified investment portfolios even if they invest $500,000 in a single business.  Middle class people can't diversify risk if they have to invest large amounts in a single business.

So, SEC policy will force many middle class investors to choose between opportunity and diversifying risk.

Is that sound Government policy?    

If the best businesses impose high minimum investment requirements that many angel investors cannot meet, angel investors will be left to pick over the deals with the highest risks and the lowest rates of return.  The reason is that the "hottest" investment opportunities will have the bargaining leverage to impose high minimum investment requirements.  Other businesses that generate less investor interest are likely to have lower investment minimums.  So, middle class people will be shut out of hot deals and limited to investing in the "leftovers." 

Now, some might say these things are necessary to protect poor and middle class people against scammers.

No doubt there are scammers out there.  When weren't there?  But other rules already prohibit securities fraud.  If the anti-fraud rules are inadequate, wouldn't it make more sense to fix the anti-fraud rules than to divide the world of investors into the rich and the not rich.

And why would the Government think its ok for scammers to steal money from "accredited investors?"

We certainly know enough rich people who do dumb things.  So, we don't believe that that rich people are smarter than other people.  Do we?

Besides, other securities rules require businesses to sell securities only to people who are sophisticated about investing and have the experience to evaluate the investment.  These other rules already prohibit sales to unsophisticated investors.  Why does it matter how much money someone has, if they understand the investment risks?

Well, maybe it's because poor people shouldn't be gambling with the little money they have.  But then why does the Government run state lotteries and license casinos?  Protecting poor people's limited budgets doesn't seem very important to theGovernment when the Government is profiting from the scam.

So, the end result of the SEC's efforts to protect investors from themselves is that:

·         Working class Americans will continue to be totally shut out of the ability to do private investments, because the SEC is delaying crowd funding rules.


·         Middle class Americans are being discouraged from doing private investments by new accredited investor verification rules.

Both of these efforts will push greater reliance on investing in publicly traded stocks that trade at much higher prices than in private investments.  So, the SEC's protection comes at an opportunity cost to Americans who are not among the mega rich.  Only the mega rich will have the valuable Government license to:

·         Buy at low prices in private transactions.


·         Re-sell in public markets at much higher prices.

A license to buy low and sell high is a pretty valuable thing to own.

Why does our Government give this license only to rich people?

Is this any way to run a capitalist economy?

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?
  • 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?
  • 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.
  • 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?
  • 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?
·         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?
·         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?
If you would like to learn more about learning how to grow your business or other issues important to your success, you can reach me at or Or you can check out my eLearning course at or or you can purchase my books at

No comments:

Post a Comment