By: Jim Verdonik
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:
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:
