Last Thursday the Division of Corporation Finance released its latest set of Compliance and Disclosure Interpretations (C&DIs) related to defined terms in Rule 501 of Regulation D and accredited investor verification under Rule 506(c) of Regulation D .
Rule 506(c) permits general solicitation and advertising in private offerings of securities, provided all purchasers are accredited investors and reasonable steps are taken to verify their accredited investor status. The rule provides for a principle-based method of accredited investor verification (an objective determination in the context of the facts and circumstances of each purchaser and transaction), and four non-exclusive safe harbor methods of verification.
The first two new C&DIs address terms used in Rule 501 related to the definition of accredited investor, the remaining address accredited investor verification under various subsections of Rule 506(c) and, most notably, how you might use a principle-based verification method when a safe harbor method is unavailable.
What if a Potential Investor’s Income Is Reported In a Foreign Currency …
If a potential investor’s income is not reported in U.S. dollars you can convert their income to U.S. dollars to determine whether they qualify as an accredited investor using either: (i) the exchange rate in effect on the last day of the year for which income is being determined; or (ii) the average exchange rate for that year. [255.48]
How Do You Account for Assets or Property Jointly Held By Non-spouses …
If a potential investor jointly holds property or assets in an account with a person who is not their spouse, the property or assets may, to the extent of the potential investor’s percentage ownership, be included in the calculation of net worth. [255.49]
The Income-Based Accredited Investor Verification
The non-exclusive safe harbor for verifying accredited investor status under the income test includes reviewing IRS forms reporting income for the two most recent years and obtaining a written representation from the potential investor stating that they reasonably expect to reach the same level of income in the current year (506(c)(2)(ii)(A)).
What Happens In That Interim Period Between Year’s End and Completion of Taxes …
If a potential investor’s IRS forms for the most recent year are not yet available (i.e., during the period between the year’s end and when the potential investor’s taxes are complete, which could extend through October of the following year), then the safe harbor method of verification is not available.
In the alternative, CorpFin suggests the following principle-based method of verification:
- reviewing the potential investor’s IRS forms reporting income for the two years preceding the most recently completed year; and
- obtaining a written representation from the potential investor stating:
- that the IRS forms for the most recently completed year are not yet available;
- the amount of income received for the most recently completed year;
- that such income was sufficient to qualify as an accredited investor under the income test; and
- that the they reasonably expect to reach the requisite level of income in the current year. [260.35]
How Can You Use Foreign Tax Forms …
In a similar vein, if a potential investor is not a U.S. taxpayer then you cannot use comparable tax forms from a foreign jurisdiction in the place of IRS forms and still rely on the safe harbor method of verification.
The reason being is that in adopting the safe harbor the Commission relied in part on the fact that there are a number of penalties for lying to the IRS, thus IRS forms are likely to be sufficiently reliable evidence of income and therefore a reasonable means of verifying accredited investor status. This inference may not necessarily hold true in all foreign jurisdictions.
In such a case, CorpFin again suggests considering a principle-based method of verification, noting that you can reasonably verify accredited investor status by reviewing tax forms from a foreign jurisdiction where that jurisdiction imposes comparable penalties for falsely reported information. [260.36]
The Net Worth-Based Accredited Investor Verification
The non-exclusive safe harbor for verifying accredited investor status under the net worth test includes reviewing certain documentation pertaining to a potential investor’s assets (e.g., bank statements, brokerage statements, tax assessments, etc.) and liabilities (a consumer report from a nationwide consumer reporting agency) and dated within the prior three months (506(c)(2)(ii)(B)).
What If a Potential Investor’s Verifying Documents are Older Than Three Months …
On the asset side of things, if, for example, a potential investor’s most recent tax assessment is more than three months old it cannot be used in the net worth-based safe harbor method for verifying accredited investor status.
However, CorpFin once again suggests considering a principle-based method of verification, noting that where a potential investor’s most recent tax assessment shows a value that, after deducting liabilities, results in a net worth substantially in excess of $1 million, it may be sufficient to verify accredited investor status under the net worth test. [260.37]
How Can You Use Foreign Consumer Reports …
On the liabilities side of things, a consumer report from a non-U.S. reporting agency cannot be used in the net worth-based safe harbor method for verifying accredited investor status, even if the non-U.S. reporting agency performs similar functions to a U.S. nationwide consumer reporting agency.
Notwithstanding, under a principle-based method of verification, CorpFin advises that you could review such a report while taking other steps to determine a potential investor’s liabilities (such as seeking a written representation that all liabilities have been disclosed) in order to determine whether the potential investor has the requisite net worth. [260.38]
The burden always remains on an issuer to demonstrate that its securities offering conforms with the requirements of a claimed exemption.
With that caveat in mind, CorpFin warns that under a principle-based method of verification if, after reviewing the relevant materials, there is reason to question a potential investor’s accredited status then you must take additional steps to verify their status in order to establish that you have taken reasonable steps to verify.
For example, if a potential investor’s income for the most recently completed year barely exceeds the requisite threshold, if there is doubt as to the reliability of information provided in foreign tax forms, if there is reason to question whether a tax assessment reasonably reflects the value of asset or reason to question the extent of liabilities after reviewing a foreign consumer report, then you must take additional steps to verify a potential investor’s status as an accredited investor.