Relief for Pre-Verified Accredited Investors May Encourage Rule 506(c) Offerings
February 15, 2021
For the second time in nine days, I recently drove ten hours round-trip to drop my son off at school for spring semester. The first time around, he ended up returning home with me the next day for unexpected oral surgery to remove his wisdom teeth after completing his mandatory one-day COVID quarantine at school. But on his second return to school several days later, he was required by the university to undergo another round of COVID testing and isolation protocols all over again.
It’s pretty common for issuers in follow-on offerings to solicit investors from previous rounds first. Indeed, doing so is often mandatory when early investors have preemptive rights. If the particular offering exemption relied upon by the issuer includes an investor qualification requirement, the investor may need to endure the hassle of re-establishing his qualifications all over again in each subsequent round, sort of like my son’s repeat COVID testing and quarantining. And if the verification method required by a particular offering exemption is time consuming, expensive and invasive, the issuer may decide it’s not worth the trouble and instead opt for another exemption, or the investor may choose to invest in another company.
Such has been the case with the offering exemption under Rule 506(c) of Regulation D. As part of the Jumpstart Our Business Startups Act of 2012, Congress and the Securities and Exchange Commission created a new variation on the old private offering exemption to allow issuers to solicit investors by means of general solicitation (e.g., the internet), provided they sold only to accredited investors and used “reasonable methods” to verify qualification. Rule 506(c) is principles-based (requiring an objective determination as to whether a proposed verification method is reasonable in light of the particular facts and circumstances of each investor and transaction) with a few non-exclusive safe harbor methods, such as reviewing tax returns, brokerage statements, appraisal reports and credit reports, and obtaining written confirmation from the investor’s broker-dealer, investment advisor, lawyer or certified public accountant that the investor is accredited. But despite the great promise of the new rule to allow issuers to use the internet to find investors, the vast majority of private offerings are not being conducted under Rule 506(c) but rather old Rule 506(b), notwithstanding the restrictive prohibition on general solicitation. The overall consensus is that Rule 506(c) is significantly underutilized because the verification requirement is still perceived by many individual investors and issuers (deservedly or not) as an invasion of privacy, needlessly expensive and time consuming, despite the emergence of third party verification firms.
Recognizing that the burden of Rule 506(c)’s investor verification rule is exacerbated by the current requirement to repeat the intense scrutiny with each follow-on offering, the SEC, as part of the new exempt offering rules it adopted last November, relaxed the requirement as it would apply to previously verified investors. Specifically, an issuer may establish that a previously verified investor remains an accredited investor at the time of a subsequent sale under Rule 506(c) merely by having the investor provide a written representation that he continues to qualify, so long as the issuer is not aware of information to the contrary and the previous verification occurred within five years prior to the subsequent sale.
The five year window was added to the final rule to address concerns that permitting reliance on a prior verification over an unlimited period of time may not appropriately account for changes in financial circumstances and could result in issuers raising money from non-accredited investors. The SEC believes the five-year period is not so remote that the initial verification is no longer meaningful, and together with the preexisting relationship between the issuer and such investor, will appropriately balance cost and burden reduction with risk mitigation.
The relaxation of the verification rule for previously verified investors should make it easier for issuers to conduct, and encourage investors to be more willing to participate in, multiple offering rounds utilizing the internet or other general solicitation techniques under Rule 506(c).
The new exempt offering reform rules were published in the Federal Register on January 14, meaning that they would ordinarily become effective March 15 (60 days after publication). But as per my last blog post, there exists some uncertainty regarding whether any of the reforms will become effective, or at least when. That’s because President Biden ordered a “Regulatory Freeze Pending Review”, which provides, as to regulations that have already been published in the Federal Register but have not taken effect, that the heads of executive departments and agencies are instructed to consider postponing the rules’ effective dates for 60 days for the purpose of reviewing any questions of fact, law and policy the rules may raise. Consequently, issuers should sit tight until further confirmation from the SEC or the new administration as to the effectiveness of the accredited investor verification rule or any other aspect of the exempt offering reforms adopted by the SEC in November.