In an important development, the SEC Division of Corporate Finance has issued a No Action Letter, which provides additional guidance on what the SEC deems to be “reasonable steps” for an issuer to verify that investors are accredited under Rule 506(c). The incoming letter asked the SEC to concur that, in an offering conducted under Rule 506(c), an issuer will have taken reasonable steps to verify accredited investor status if the issuer:

1. receives written representations that the purchaser is an accredited investor;
2. receive written representations that the purchaser’s minimum investment amount is not financed in whole, or in part, by any third party for the specific purpose of making the particular investment;
3. requires a minimum investment amount of at least $200,000 for natural persons and at least $1,000,000 for legal entities; and
4. has no actual knowledge that the purchaser is not an accredited investor, or that any of the minimum investment was financed by a third party, for the specific purpose of making the particular investment.

This signal from the SEC will be met with great interest from issuers who rely on Rule 506(c), a safe harbor under Regulation D for private placements of securities made under Section 4(a)(2) of the Securities Act of 1933. Rule 506(c) allows an issuer to generally solicit their offering of securities, provided that all purchasers in the offering are accredited investors (as defined in Rule 501), and the issuer takes “reasonable steps” to verify that the purchasers are, in fact, accredited. At the time of its adoption under the JOBS Act in 2012, Rule 506(c) was intended to provide issuers raising capital with a choice: forego general solicitation and rely upon a different Reg D exemption, or use general solicitation, but take additional steps to vet investors under Rule 506(c).

Though the allure of generally soliciting securities under the rule is obvious, in practice, it is often overshadowed by certain ambiguities in the adopting release to the rule, as well as the administrative difficulties attendant to properly conducting a 506(c) offering. The combination of which render the exemption disfavored when compared to other private placement safe harbors.

One issue is that in the adopting release to the rule, the SEC stated that if the minimum investment amount in an offering was sufficiently high, then absent contrary facts necessitating otherwise, the issuer may not need to take additional steps to verify accredited investor status. Though the SEC has never retreated from this position, it also never provided guidance regarding the investment amount that might qualify an offering for relaxed treatment. As a result, issuers have been  reticent to take advantage of this suggested relief from investor verification.

A second issue regarding the utility of Rule 506(c) concerns  the non-exclusive and non-mandatory verification methods found in Rule 506(c)(2)(ii). Although these verification methods are not required to rely on the 506(c) exemption, they are often treated as the floor by which the SEC measures “reasonable steps” to verify accredited status. In theory, these rules provide certainty. In practice, however, the methods listed are often unattractive to issuers who wish to raise capital in a manner that is efficient and respects investor privacy. For example, Rule 506(c)(2)(ii)(A) states that an issuer who reviews two years worth of tax returns will have properly vetted individuals as accredited on the basis of personal income. Rule 506(c)(2)(ii)(B) is not much better, as it requires that an issuer to review, among other items, bank statements, brokerage reports and third-party appraisals to conclude that an investor is accredited based on net worth.

Altogether, the ambiguity regarding whether the “reasonable steps” can be relaxed, as well as the practical difficulties of the methods of verification set forth in the rule, make the verification process under Rule 506(c) unappealing for many issuers. As a result, even with the prospect of general solicitation, Rule 506(c) is often bypassed in favor of Rule 506(b).  

Now, issuers face less uncertainty in deciding whether reasonable steps have been taken to verify accredited investor status. In its response, the SEC stated that, although whether an issuer has taken reasonable steps remains a facts and circumstances analysis, if the issuer within the particular transaction presented in the incoming letter could, in fact, satisfy the foregoing list of conditions, then such issuer could reasonably conclude that it had taken reasonable steps to verify that its purchasers are accredited under 506(c). Though this response was based upon, and subject to, the representations that were presented in the incoming letter, make no mistake: the importance of this response should not be overlooked. Though it may technically be limited to the facts in the letter, the SEC’s response will be used as a north star for issuers who desire to generally solicit their offerings, and who think they can conduct their offerings in accordance with the conditions set forth in the letter without sacrificing the amount of dollars capable of being raised.  

Our attorneys continue to monitor these developments and will provide updates as they become available. Please contact your Dinsmore attorney if you have any questions.