Barclay Damon
Barclay Damon

Legal Alert

SEC (Finally) Sets Rules on Rule 506 General Solicitation

On July 10, 2013, the Securities and Exchange Commission (the “SEC”) issued final Rules (the “Final Rules”) lifting the ban on general solicitation in certain offerings under Rule 506, as required by the JOBS Act.

It has been a long time in the making. The JOBS Act became law in April 2012. While the Act required the SEC to take action within 90 days, it did not issue proposed regulations until August 2012. Now, eleven months later, come the Final Rules.

Section 201(a)(1) of the JOBS Act requires the SEC to amend Rule 506 of Regulation D under the Securities Act of 1933 (the “Securities Act”) to permit general solicitation (advertising) in offerings where all of the purchasers are “accredited investors”.1 Section 201(a)(1) also directs the SEC to adopt rules that “require the issuer to take reasonable steps to verify that purchases of the securities are accredited investors, using such methods as determined by the Commission.”

The Final Rules provide that the issuer must take reasonable steps to verify that all purchasers of securities sold in reliance of the new Rule 506(c) are accredited investors. The Final Rules go on to list four “non-exclusive and non-mandatory” means of verifying that a purchaser is an accredited investor. An issuer that employs one of the four methods is deemed to have taken “reasonable steps to verify” unless the issuer knows that a purchaser is not really an accredited investor.

Since an individual’s accredited investor status can be determined based on income ($200,000 [$300,000 joint] in each of the past two years and reasonable expectation of the same in the current year), the first listed verification method is reviewing copies of Federal income tax documents filed with the IRS (W-2, 1099, K-1, 1040) for the two most recent years and obtaining a written representation that the purchaser has a reasonable expectation of reaching the required level of income in the current year.

The other means by which an individual qualifies as an accredited investor is having a net worth of $1,000,000 (net of equity in his/her primary residence). The second verification method prescribed is to obtain bank and brokerage statements, and if the nature of the assets require it, appraisal reports dated within three months of the determination date to show the asset side of the purchaser’s balance sheet, while on the liability side, obtaining a consumer credit report and a written representation from the purchaser that all relevant liabilities have been disclosed.

Determining an individual’s net worth by this method is clearly an imperfect science. Nevertheless, following the SEC’s dictates it will satisfy the requirement to take “reasonable steps to verify.”

The third listed verification methodology is obtaining written confirmation that the purchaser is an accredited investor (dated within three months of the determination date) from a broker dealer, SEC-registered investment advisor, attorney or CPA. This method could prove popular since investors may be more comfortable sharing their financial information with their financial advisor, lawyer or accountant than with the issuer.

One limitation of the Final Rules and the adopting release is that they provide little guidance (and no safe harbors) on the standards or methodologies to be used by the professionals in providing the confirmation. If the financial advisor, lawyer or accountant replicates the steps dictated in one of the first two SEC verification methods, is that sufficient? It remains to be seen if professionals will warm to this task, since the proposing release points out that they could face both SEC and state sanctions for being wrong.

The fourth listed verification methodology applies only to individuals who purchased securities in an issuer’s 506 offering as accredited investors prior to the effective date of the Final Rules and continue to hold those securities. These individuals can participate in 506(c) offerings by the same issuer by simply self-certifying that they are accredited investors.

The four listed verification methodologies apply only to verifying the accredited investor status of individuals. The Final Rules do not specify verification methods for other purchasers. To determine whether a legal entity is an accredited investor, reasonable steps to verify may include a review of publicly-available records. For example, the status of banks, insurance companies, broker dealers can be determined from regulatory records available on-line.

Regardless of the verification method used, it will be up to the issuer to demonstrate it is entitled to the exemption from registration provided in Rule 506(c). Therefore, issuers should maintain good records of the “reasonable steps to verify” they employed.

Taking advantage of Rule 506(c) to market an offering should not change an issuer’s compliance requirements under New York’s state securities laws. Issuers who offer to the institutional market and who have traditionally relied on New York’s “private placement” exemption will likely continue to do so absent State guidance, since Rule 506 (including 506(c)) continues as an exemption under Section 4(a)(2) of the Securities Act (“transactions by an issuer not including any public offering”).

The enthusiasm that accompanied the passage of the JOBS Act has long since ebbed and “Crowdfunding” (which would give small investors enhanced access to private deals) remains a far-off dream still awaiting SEC action. Nonetheless, when the Final Rules take effect 60 days after publication in the Federal Register, taking these “reasonable steps to verify” may lead issuers to far broader audiences for their 506 offerings.

If you have any questions on the content of this alert, please contact John P. Lowe, Jr. at (585) 295-4499 or jlowe@hblaw.com, or any other attorney in our Corporate practice area.


1 Rule 501 of Regulation D defines “accredited investor” as certain categories of institutional investors, such as banks and insurance companies, and any business entity with more than $5,000,000 in total assets. “Accredited investors” also include individuals that meet one of two tests: a net worth (not including equity in their main residence) of $1,000,000; or income in excess of $200,000 (or jointly with a spouse of $300,000) in each of the past two years and a reasonable expectation of the same level of income in the current year.