Wednesday, April 1, 2015

Verifying Accredited Investor Status in Rule 506 (c) Offerings Using Angel Capital Association's Experienced Angel Group Program

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 you can check out my eLearning course or you can purchase my books at
The old saying is that "you can't see the forest for the trees."
Focusing on details can sometimes cause us to miss the big picture.
Accredited Investor verification in Rule 506 (c) offerings is a good example of that.
Much of our attention has been focused on the safe harbor Rule 506 (c) provides for verifying the Accredited Investor status of natural persons.
We risk forgetting that the safe harbor is really just an example of how we might choose to comply with the principles based rule that issuers must take steps that are reasonable under the facts and circumstances to verify Accredited Investor status in Rule 506 9c) offerings.  Complying with the safe harbor provision of Rule 506 (c) is useful, because it brings certainty, but it won't always be practical.
People who are raising capital usually have to be very flexible in dealing with investors.  Investors are in a position to walk away from deals for any reason or no reason.  And they walk away quite often.  Issuers are used to accommodating investor requests.
So, if investors refuse to supply the documents 506 (c)'s safe harbor requires, issuers who are trying to raise money will want to find a way to close the deal without complying with the safe harbor.
Accordingly, lawyers will need to answer this question: Is accepting a self-certification from an investor about their Accredited Investor status always incompatible with taking reasonable steps to verify Accredited Investor status?
The answer is that in a principle based rule almost nothing is always acceptable or unacceptable.  It almost always depends on facts and circumstances.
The Angel Capital Association ("ACA") has devoted substantial efforts to making it easier for angel investors to participate in Rule 506 (c) offerings.  That effort includes its Established Angel Group ("EAG") program.  The Angel Capital Association is promoting its EAG program to provide issuers with a way to fulfill their duty to take reasonable steps to verify Accredited Investor status in Rule 506 (c) offerings without angel investors providing the financial documents Rule 506 (c)'s safe harbor requires.
The Established Angel Group program is a two-step process:
First, the Angel Capital Association determines that an angel group or fund is an Established Angel Group.  This certification is provided to allow the EAG to invest in 506 (c) offerings if the Established Angel Group is the investment vehicle for its members.
The Established Angel Group also helps its members show issuers that the members are Accredited Investors.  The Angel Capital Association lists several ways for Established Angel Groups to help members demonstrate their Accredited Investor status without showing financial information to the issuer:
  • The Established Angel Group can issue letters to individual angel investors that the angel investors can present to issuers who are conducting Rule 506 (c) offerings to demonstrate that they are Accredited Investors for deals the individual wants to invest in even if the EAG itself is not investing in the offering. 
  • The Angel Capital Association indicates that issuers could also obtain a self-certification from the investor that the investor is an Accredited Investor and is a member of an Established Angel Group and the issuer can verify the investor's self-certification by looking for the investor's name on a list of member's names on the EAG's website.      
The ACA suggests these methods would be sufficient for issuers to satisfy Rule 506 (c)'s requirement that the issuer must take reasonable steps to verify Accredited Investor status.

Follow this link to the Angel Capital Association's Established Angel Group program:
Here's how the Angel Capital Association describes the criteria an angel group needs to satisfy to become an Established Angel Group:
"Certification criteria includes six required criteria and three other recommended, but not required, factors:
Required Criteria
1. A private group formed with the purpose of investing in earlystage companies
2. All members are accredited investors who selfcertify they are accredited investors and are aware of the risks associated with investing in earlystage companies
3. All members are vetted before they join via three or more of the following:
(a) Recommended/referred by a current member
(b) Interviewed by members or a committee
(c) Complete an application that includes professional history, academic background, and investing history/ interests
(d) Approved by the Board or other designated approving authority
(e) Other reasonable vetting (i.e. background checks, review of financial documents…) 
4. The group has a code of conduct
5. The group has an established deal/investment process in which investors can invest their own money or participate in the group’s investment decisionmaking process.
6. The group has a process for members to affirm accredited status periodically (no less than annually)
Other Recommended Practices (not required)
1. The group convenes or participates in regular education sessions for members about facets of early stage investing
2. At least one group member has invested in a Rule 506 deal in the past
3. The organization or person is a member of a professional organization, such as ACA
The Angel Capital Association's website indicates that Established Angel Group status is open to any form of angel group (including investment funds) that meet the listed criteria.  But the ACA's website also indicates that it will not certify an organization as an EAG, if either (i) the organization makes "recommendations" with respect to its members making investments or the group or any employee receives any "transaction-based compensation." 
These two exclusions are criteria the SEC uses to determine that someone is a broker-dealer, although investment advisers also make recommendations about purchasing securities.  So, the EAG program is designed to exclude professional advisers who organize investment groups.
The ACA's website rightly indicates that each issuer must make its own determination whether to rely on EAG membership (and how to verify EAG membership) to fulfill the issuer's obligation to take reasonable steps to verify Accredited Investor status.
Now, let's talk about factors issuers should consider in determining whether to accept EAG status as sufficient to satisfy the issuer's reasonable steps to verify obligation.
The approach taken by the Angel Capital Association relies on the principles based approach to verification and is outside Rule 506 (c)'s safe harbor provision.  The ACA cites a speech given by an SEC official at an ACA event as indication the SEC approves the ACA's approach.  Of course, when SEC staff speaks at such events, they always remind the audience that the views expressed are the personal views of the staff member and are not the official views of the SEC.
Before we look at what an SEC staff member has said about the ACA's certification program, let's discuss several important aspects of the Angel Capital Association's Established Angel Group program:
  • The ACA is not one of the four groups included in the SEC's safe-harbor – it's not licensed a lawyer or accountant and it's  not a registered broker-dealer or registered investment adviser.
  • The Angel Capital Association is in effect deputizing angel groups and investment funds who are approved by the ACA to certify that individual angel investors are Accredited Investors.
  • Representations to the ACA that the EAG reviews financial documents (like tax forms, bank and brokerage account statements and credit reports listed in Rule 506 (c)'s safe harbor) is one of several options an angel group can use to achieve EAG status.  It's not required.
  • Self-certification by investors is acceptable if it is combined with other reasonable verification steps.
  • Most of the other steps on the EAG program involve personal contacts.  The EAG program is based on a system of club members vouching for one another.  The approach is based on the premise that if the investor in question is acceptable to the other members of the club, an issuer should be able to accept the club members' judgement about the person's Accredited Investor status.
March 2014 Speech by SEC's Director of Corporate Finance to Angel Capital Association
The Angel Capital Association's website includes a link to a March 28, 2014 speech by Keith Higgins to an Angel Capital Association meeting.  Mr. Higgins was the SEC's Director of the Division of Finance.
Mr. Higgins begins by stating that: "The legislative history of the JOBS Act made it clear that self-certification – without something more – was not enough if the ban [on general solicitation] was to be lifted."
In explaining that issuers could satisfy their reasonable steps to verify obligation outside the safe harbor contained in Rule 506 ©, Mr. Higgins indicated:
"The other method, however, is the principles-based verification method in which the issuer would look at the particular facts and circumstances to determine the steps that would be reasonable to verify that someone is indeed an accredited investor.  Although the verification method must be objectively reasonable, the principles-based method is intended to provide issuers with significant flexibility in deciding the steps needed to verify a person’s accredited investor status and to avoid a “one size fits all” approach."
"Under this principles-based approach, the documentation that a person must provide, if any, will depend on the answers to questions such as:
*       How much information about the prospective purchaser does the issuer already have?  The more information the issuer has indicating that the person is an accredited investor, the fewer verification steps that it may have to take to comply with the rule’s requirement.  A person’s investments in previous Rule 506 offerings or membership in an established angel group is also information about the person that may affect the likelihood of the person being an accredited investor and therefore may be useful in determining the steps that would be reasonable for an issuer to verify the person’s accredited investor status.  The issuer would, of course, still need to consider any other relevant facts in making its final determination about the person’s accredited investor status.
*       How did the issuer find the prospective investor?  A person that the issuer located through publicly-accessible and widely-disseminated means of solicitation may need to undergo a greater level of verification scrutiny than a person who may have been pre-screened as an accredited investor by a reasonably reliable third party.
*       Are the terms of the offering such that only a person who is truly an accredited investor could participate?  The ability of a purchaser to satisfy a minimum investment amount requirement that is sufficiently high such that only accredited investors, using their own cash, could reasonably be expected to meet it is relevant in deciding what other steps are needed to verify accredited investor status. "
Mr. Higgins also clarified that licensed lawyers and accountants and registered  broker-dealers and investment advisers are not the only people who can verify Accredited Investor status for issuers:
"Lastly, the Commission envisioned a role for third parties that may wish to enter into the business of verifying the accredited investor status of prospective investors on behalf of issuers and allowed for such third party verification under the principles-based approach as long as the issuer has a reasonable basis to rely on such third party."
So, with all this ambiguity about verification, can you have the SEC staff bless the verification procedures you use?
Mr. Higgins in his speech to the Angel Capital Association referred to above indicated the SEC's staff was not ready to review and approve specific verification processes, but he also indicated:
"While the staff may not be in a position at this point to provide guidance on what constitutes “reasonable steps” under particular circumstances, I also believe the staff will not be quick to second guess decisions that issuers and their advisers make in good faith that appear to be reasonable under the circumstances."
Despite the Angel Capital Association's website's link to Mr. Higgins' speech, we note that the speech falls a little short of:
  • Specifically approving the Angel Capital Association's Established Angel Group program.
  • Identifying the specific steps issuers should take to verify that a potential investor is a member of an Established Angel Group.
But Mr. Higgins speech provides useful guidance for issuers who desire to accommodate angel investors who do not want to provide the financial information required to comply with Rule 506 (c)'s safe harbor, whether by relying on the Angel Capital Association 's Established Angel Group program or by other means:
  • Self verification combined with other knowledge the issuer already has or obtains about the investor can be sufficient in some circumstances.
  • Issuers can rely on people other than licensed attorneys and accountants and registered broker-dealers and investment advisers to verify Accredited Investor status in some circumstances.
  • The SEC is most distrustful of self-verification by investors where the investment is being made solely through an Internet platform and there is no other contact with the investor.
This brings us to the big question: Should issuers rely on the Angel Capital Association's Established Angel Group program instead of complying with Rule 506 (c)'s safe harbor?
Since the principles based verification depends on individual facts and circumstances, it's difficult to conclude that the Angel Capital Association's Established Angel Group program is a reliable indicator of Accredited Investor status in all situations.
Any program that tries to create a national standard and certification is only as strong as its monitoring and enforcement mechanisms.  Without active monitoring and enforcement, it's unlikely that all angel groups will fully implement EAG standards.  Without any basic to be assured that the program has successfully created national uniformity, the reasonable basis approach throws us back to looking at individual angel groups.
Many angel groups are loosely run organizations with no paid staff.  Volunteer organizations often suffer from the same problem – good intent and lack of follow through.  Some angel groups have not made much effort in the past to verify that all their members are Accredited Investors.  Have they really purged their membership lists in response to Rule 506 (c)? 
The Angel Capital Association's Established Angel Group program attempts to provide "professional standards" for angel groups by rewarding angel groups that meet the standards.  The problem is that a once a year application approval by the Angel Capital Association may not be enough to ensure that loosely run angel groups actually implement the procedures they describe on their EAG applications.
It would be prudent for issuers who wish to rely on the EAG program to probe beyond the ACA's annual approval and seek to determine whether the particular angel group in question is actually complying with the Angel Capital Association's standards.  This might be in the form of a representation from the EAG in question that it continues to be in full compliance at the time of the investment with the representations the EAG made to the Angel Capital Association.
We should also note that if an issuer is aware of information that contradicts representations, the issuer cannot rely on the representations.
If issuers examine angel groups on a group by group basis, some of the efficiency advantages that platforms offer for expeditiously closing transactions will be lost.  But until the SEC specifically creates a safe harbor for the Ange Capital Association's Established Angel Group program, issuers should look at the Established Angel Group program as a good start toward taking reasonable verification steps, but try to obtain additional information to support relying on the EAG program for each particular angel group.
Other Articles about Verifying Accredited Investor Status in Rule 506 (c) Offerings
This is one of a series of articles about verifying Accredited Investor status in Rule 506 (c) offerings.  The other articles deal with:
What is a reasonable basis for deciding you can use a technology platform operator to verify the Accredited Investor status in Rule 506 (c) offerings?  

How do you verify the Accredited Investor status of small private investment funds, corporate partners, vendors who accept securities as partial payment for services and other entities? 
We discuss the general requirement to take reasonable steps to verify Accredited Investor status and the details of Rule 506 (c)'s verification safe harbor provision in an earlier article:
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