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 JFV@WardandSmith.com. Or you can check out my eLearning course http://www.youtube.com/user/eLearnSuccess or you can purchase my books at http://www.amazon.com/Jim-Verdonik/e/B0040GUBRW
As more and more technology platforms are launched to conduct Rule 506 (c) offerings, issuers are being offered the opportunity to have the technology platform operator verify the Accredited Investor status of the investors who purchase securities through their platform.
Under Rule 506 (c), issuers must have a reasonable basis for deciding to rely on any third party to do the verification for the issuer
What should issuers do to determine that they have a reasonable basis to rely on such third parties to verify the Accredited Investor status of investors who purchase securities through their platform?
What's the process for deciding whether you have a reasonable basis to rely on someone?
- The first step in deciding whether you have a reasonable basis in almost any legal matter is to have or obtain information to analyze.
- The second step usually involves analyzing the information you have to determine whether it is sufficient to justify making any decision.
- Last, if you decide you have enough relevant information, you usually compare the information you have to situations you already know are either reasonable or not reasonable.
Two types of information are relevant to whether you have a reasonable basis to rely on a third party to do the verification:
- The nature of the platform operator.
- The specific procedures the platform operator uses to verify Accredited Investor status.
In another article, we discuss principles based approaches to how to determine when it is reasonable to rely on third parties outside of Rule 506 (c)'s safe harbor provision.
The Platform Operator
Some platforms are operated by registered broker-dealers or investment advisers. Since registered broker-dealers and investment advisers usually have invested substantial resources in compliance departments and are subject to state and/or Federal regulation, issuers can obtain some comfort by dealing with platforms operated by registered broker-dealers and investment advisers. That's why registered broker-dealers and investment advisers are included in the people Rule 506 (c)'s safe harbor authorizes to verify accredited investors' financial documents (registered broker-dealers and investment advisers and licensed attorneys and accountants). This means the Rule 506 (c)'s safe harbor is available if a platform operated by a registered broker-dealer or investment adviser reviews the documents listed in the Rule 506 (c) safe harbor.
If the platform operator is not registered as a broker-dealer or investment adviser, you should conduct greater due diligence about both the platform's Accredited Investor verification process and whether the nature of platform's services and the fees the platform operator charges require the operator to register as a broker-dealer or investment adviser or is exempt from broker-dealer registration by Section 201 (c) of the JOBS Act or another reason.
Some platform operators sub-contract the Accredited Investor verification process. Issuers should ask the platform operator who actually conducts the verification process and determine whether it is reasonable to rely of that sub-contractor.
Specific Verification Procedures to Be Used
Immediately following the effectiveness of Rule 506 (c) most people wanted to stay within the safe harbor Rule 506 (c) provides. No one wants to take the risk of experimenting. But as Rule 506 (c) offerings become ubiquitous people will inevitably venture beyond the safe harbor.
Finding out the specific procedures the platform operator or subcontractor intends to use to verify Accredited Investor status for your offering is important for several reasons.
The first reason is to avoid confusion with Rule 506 (b) offerings and the different rules that apply to Accredited Investors in Rule 506 (b) offerings.
Many platforms continue to conduct Rule 506 (b) offerings. These platforms operate under the rules that applied before Rule 506 (c) became effective in September 2013.
Rule 506 (b) principles were approved by the SEC is the Lamp Technologies, Inc. (May 29, 1997) no action letter, which indicated that offerings to people a broker-dealer has pre-qualified as Accredited Investors did not constitute a general solicitation. The pre-qualification procedures are not as strict as Rule 506 (c)'s safe harbor.
The pre-qualification procedures are more detailed than simply requiring the investor to check or click on a box, but the Lamp Technologies no-action letter did not require credit checks or review of tax forms or bank account statements. Lamp Technologies imposed two conditions to pre-qualifying Accredited Investors by asking investors to self-certify their Accredited Investor status:
- Such self-certification have to be for investing generally and not for the purpose of investing in a specific identified offering.
- Investors have to wait 30 days after the self-certification before they can invest in any Rule 506 (b) offering.
These requirements disconnected the investor's self-certification from any specific offering. After 30 days, the pre-qualified investors are treated the same as all other pre-qualified customers of the broker-dealer and issuers can offer and sell to such pre-qualified investors without being deemed to be conducting a general solicitation.
Until September 2013, virtually all online investment platforms that conducted Rule 506 offerings operated under the principles stated in the Lamp Technologies no-action letter. The platforms didn't have more than one procedure for Accredited Investors. Then, the division of Rule 506 offerings into Rule 506 (b) offerings and Rule 506 (c) offerings created two sets of rules.
- In Rule 506 (b) offerings, platforms must continue to pre-qualify investors under the Lamp Technologies principles, because issuers are not allowed to conduct a general solicitation. Note that in Rule 506 (b) offerings the burden is on the broker-dealer to do the pre-qualification, because the pre-qualification process must be completed without referring to any specific offering by any issuer. Absent knowledge to the contrary, the issuer is entitled to rely on the broker-dealer's representation that all the investors have been pre-qualified correctly.
- In Rule 506 (c) offerings, platforms do not need to pre-qualify investors under the Lamp Technologies principles, because issuers are allowed to conduct a general solicitation, but only if the issuer takes reliable steps to verify that all the investors are Accredited Investors. Note that in Rule 506 (c) offerings the verification burden is in the issuer, not the platform operator. The platform operator is merely a service provider to the issuer in the verification process. That means the issuer has to take reasonable steps to verify that the issuer can rely on what the platform operator does.
The foregoing only discusses obligations of the issuer under Rule 506. Platform operators may have their own obligations under securities laws, including under broker-dealer and investmrnt adviser regulations.
Because the burden shifts to the issuer in Rule 506 (c) offerings, the issuer has a duty to investigate how any service provider is conducting the verification process and must determine that the verification process constitutes reasonable steps to verify the Accredited Investor status.
This means that issuer is not allowed to assume that the investors a platform operator pre-qualified for Rule 506 (b) offerings are Accredited Investors at the time of the issuer's Rule 506 (c) offering. That said, as we discuss in other articles, issuers may be able to take into account confirmation by a platform operator that an investor has a long history of investing in Rule 506 offerings as part of a principles based verification process. Such confirmation, when combined with a current self-certification by the investor for this particular offering, may satisfy the reasonable steps requirement of Rule 506 (c) even though it is outside Rule 506 (c)'s safe harbor provision.
Similarities in Platform Activities between Rule 506 (b) Offerings and Rule 506 (c) Offerings
The activity that takes place on a technology platform is very similar for both Rule 506 (b) offerings and Rule 506 (c) offerings:
- Issuers disclose information.
- Investors read information the issuer discloses.
- Communications channels may facilitate investors asking questions and issuers answering questions on the platform.
- The platform facilitates purchase orders and the exchange of securities for cash at the closing.
The primary differences between Rule 506 (b) offerings and Rule 506 (c) offerings at the platform level are which investors have access to offering information and can purchase securities in the offering and what criteria is used to decide which investors have access to offering information and can purchase securities in the offering.
Note that in a Rule 506 (b) offering both access to information and actual purchases must be limited to pre-qualified investors. In a Rule 506 (c) offering, information can flow freely to everyone. Only actual sales of securities are limited to verified Accredited Investors. Never the less, some platform operators restrict information access beyond what Rule506 (c) requires.
Differences in Off-Platform Activity between Rule 506 (b) Offerings and Rule 506 (c) Offerings
Off-platform activity in a Rule 506 (b) offering and a Rule 506 (c) offering may be very different. The activities that constitute a general solicitation may be taking place outside the platform - in social media, press releases or on the issuer's website or on another platform. But the platform operator may not be aware of the off-platform general solicitation activity.
Since many 506 (b) offerings continue to be conducted on the same platforms that have added Rule 506 (c) offerings, issuers should
- Verify that the platform operator knows the issuer is conducting a Rule 506 (c) offering.
- If the issuer is relying on the platform operator to verify Accredited Investor status, the issuer should ask the platform operator to explain the specific procedures the platform operator will use to verify Accredited Investor status in the offering.
- Before you close on a transaction verify that the platform operator other service provider actually took the verification steps the platform operator originally described.
- Obtain written representations from the platform operator or other service provider.
- Document all off-platform contact the issuer has had with investors.
Most platform operators have automated procedures for issuers to obtain such information, but because the burden is on the issuer to take reasonable steps to verify Accredited Investor status, issuers should not just assume that all platform operators will conduct the verification proces in compliance with the issuer's obligations.
The biggest issue is whether the platform operator will stay within Rue 506 (c) safe harbor. If not, the issuer should obtain the details of the verification procedure and discuss with legal counsel whether the details of the procedure satisfy the issuer's reasonable steps verification obligation.
Principles Based Reasonable Steps to Verify Accredited Investor Status
As we discuss in other articles, Rule 506 (c)'s safe harbor is not the only way to verify Accredited Investor status. Three basic principles are emerging beyond Rule 506 (c)'s safe harbor:
- Self verification by investors 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 attorneys, accountants, 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.
2014 SEC Enforcement Action Against Platform Operator
That the SEC is taking the last point very seriously is underscored by a November 2014 SEC enforcement action against an Internet platform operator. The platform primarily sold securities outside the United States, but had allowed 50 US persons to register on the platform, two US persons to purchase securities based only on a self-certification and one US person to purchase securities without any certification of Accredited Investor status.
Verification Requirement Builds on Earlier Legal Principles
The SEC's concerns about relying only on simple self-verification by investors using Internet platforms makes perfect sense from the perspective that allowing general solicitations and selling and closing transactions solely though Internet platforms automates and commoditizes the private placement process. Most people don't read the details of website agreements. So, a self-certification by an investor achieved by clicking in a website doesn't carry the same weight as an in-person signature on physical legal documents.
Requiring something different for important transactions, events and relationships is a long-established legal principle:
- Certain important documents and transactions (like deeds and wills) require a notary and/or other witnesses.
- Marriages require witnesses and affirmation that the marriage is entered into willingly. Marriage ceremonies invite people attending the wedding to object and provide grounds for why the marriage should not occur.
- Wills often include language that the person certifies they are of sound mind and is acting without coercion.
- Broker-dealers are required to "know their customers."
- Securities transfers often require a signature guaranty by a stock exchange member.
- Large corporate transactions often require delivery of legal opinions at the closing.
- The SEC requires audited financial statements and officer certifications for certain securities filings.
The reasonable steps to verify Accredited Investor status requirement is best understood as an extension of these more traditional ways to create greater comfort that a transaction or a statement is real and is made by people who have considered the importance of what they are doing.
When looked at from this perspective, issuers and their legal counsel are likely over time to become more comfortable with Accredited Investor verification procedures that fall outside Rule 506 (c)'s safe harbor as long as the verification process addresses the SEC's concern that automated self-certification by investors on a technology platform is not sufficient absent other factors that are reasonable verify the Accredited Investor status.
Of course, the major difference between principles based verification and the traditional examples described above is that you can locate a law that specifies what must be done in these traditional situations. If you decide to operate outside the Rule 506 (c) safe harbor, you take some risk that your decisions about what are reasonable steps in different circumstances will later be deemed to be wrong. For that reason, issuers and their legal counsel will initially rely primarily on Rule 506 (c)'s safe harbor. But the Angel Capital Association's Experienced Angel Group program referred to in another article shows that over time many industry practices will develop beyond Rule 506 (c)'s safe harbor.
Other Articles about Verifying Accredited Investor Status in Rule 506 (c) Offerings
This is one of a series of several articles about verifying Accredited Investor status in Rule 506 (c) offerings. The other articles deal with:
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?
How do you verify the Accredited Investor status of angel investors and angel groups using the Angel Capital Association's Experienced Angel Group Program? The Angel Capital Association Program might apply to some types of small investment funds described above, if they are dedicated to investing in early-stage companies and satisfy other criteria.
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:
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 JFV@WardandSmith.com. Or you can check out my eLearning course at http://www.youtube.com/user/eLearnSuccess or you can purchase my books at http://www.amazon.com/Jim-Verdonik/e/B0040GUBRW