Key Takeaways
- A March 12 no-action letter by the U.S. Securities and Exchange Commission (SEC) confirms an interpretation of Rule 506(c) that issuers can satisfy the requirement to take reasonable steps to determine whether an investor is accredited by including in the offer terms a sufficiently large minimum investment amount – $200,000 for natural persons and $1 million for legal entities.
- Investors must truthfully represent that they are accredited and did not receive third-party financing to meet the minimum investment in question.
- Issuers must also have no actual knowledge indicating that the investor’s representations in the prior bullet point are false.
The No-Action Letter
On March 12, the Staff of the SEC issued interpretive guidance in a no-action letter (the No-Action Letter) agreeing with an interpretation of Rule 506(c) proposed by a major international law firm (the Request Letter). The interpretation limits, under certain circumstances, the level of verifying documentation an issuer needs in order to establish that it took “reasonable steps” to confirm that each 506(c) investor is accredited under Rule 501(a). The No-Action Letter provides clarity with a simple fix to an issue that securities practitioners have faced since 2013.
Streamlining these verification steps under the No-Action Letter turns on whether the terms of a Rule 506(c) offering require investors to commit to a sufficiently large minimum investment. Specifically, setting the minimum investment or commitment amounts for any natural person to $200,000 and for a legal entity to $1 million can be relied on by issuers to establish that they have taken the “reasonable steps” required under Rule 506(c) to confirm whether an investor is accredited.
Apart from having an appropriate minimum investment amount in place, investors must (i) represent that they are in fact accredited, and (ii) represent that their investment funds have not been provided by third-party financing for the purpose of satisfying the minimum investment in question. Finally, issuers must have no actual knowledge that such investor representations are false.
Background on Rule 506(c)
Since Rule 506(c) was first adopted in 2013 under Release No. 33-9415 (July 10, 2013) (the Final Rule Release), issuers have been permitted to raise capital from accredited investors through private securities offerings using general solicitation. General solicitation permits issuers to get the word out about a private securities offering through social media and other public outreach targeting potential investors. Such outreach need not be limited to accredited investors, but anyone who commits to invest under Rule 506(c) must be an accredited investor as evidenced by the issuer having taken “reasonable steps to verify that purchasers of securities sold in any offering under [Rule 506(c)] are accredited investors.”
While what count as “reasonable steps” toward verification was addressed in the Final Rule Release, the language of Rule 506(c) itself provides less detail. For natural persons, the rule only goes so far as to set forth permissive language. Subsection (c)(2)(ii) lists safe harbor[1] verification methods that provide examples of verification steps that are “non-exclusive and non-mandatory.”
But page 20 of the Final Rule Release notes that issuers can use a “principles-based approach … when determining the reasonableness of the steps to verify that a purchaser is an accredited investor,” specifically noting that issuers can consider whether “the terms of the offering [include] a minimum investment amount.” Neither the rule nor the release, however, specifies which minimum investment amount to use.
The Request Letter posited specific minimum investment amounts and SEC Staff agreed with the amounts in the No-Action Letter – $200,000 for natural persons and $1 million for legal entities.[2]
Implications of the No-Action Letter
Setting the minimum investment amounts of a Rule 506(c) offering at $200,000 for natural persons and $1 million for legal entities can allow issuers to avoid the cumbersome verification steps that have become customary since Rule 506(c) was adopted in 2013. Prior to the No-Action Letter, issuers often opted to use third-party services to verify accredited investors’ status. Such services review each investor’s recent federal tax statements or evidence of assets and then provide the issuer with a letter confirming that the investor is accredited, satisfying the issuer’s requirement to take reasonable verification steps. While such services, or verification directly by the issuer, can be helpful for verifying investors near the threshold, relying on a safe harbor contemplating the collection of personal tax or asset documents proved to be cumbersome for certain investors.
Now, installing minimum investment amounts can establish that an issuer has taken the required reasonable verification steps. For this to work, each 506(c) investor must represent that it is an accredited investor and that no investment capital was financed by a third party to satisfy a particular minimum investment amount. The issuer must also have no actual knowledge that any such investor representation is false.
The Bottom Line
The No-Action Letter is expected to streamline the capital-raising process for 506(c) offerings that have the flexibility to require sufficiently high minimum investment amounts, a common feature of private funds. Relying on a high minimum investment amount was contemplated in the Final Rule Release for Rule 506(c), and the verification steps in the rule (e.g., collecting tax statements, evidence of certain assets) have since 2013 been listed as sufficient but not necessary to confirm accredited investor status. Now, however, the No-Action Letter provides some additional comfort for reducing the volume of verifying documents when each investor commitment must be sufficiently large.
[1] The verification steps in Rule 506(c)(2)(ii) are referenced here as a safe harbor because that section provides that the “issuer shall be deemed to take reasonable steps to verify” whether an investor is accredited by following the example steps provided.
[2] For legal entities whose accredited investor status relies on the status of its equity owners, each equity owner of such a purchaser must represent to the issuer that each equity owner of the purchaser will be individually subject to the applicable minimum investment or commitment amount of $200,000 for natural persons and $1 million for legal entities. This is in addition to such a purchaser being subject to a minimum of either $1 million or, if the equity owners are comprised exclusively of fewer than five natural persons (i.e., no legal entities), then $200,000 for each such equity owner.
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