JOBS Act Puts Spotlight on Investor Accreditation Practices

When the Jumpstart Our Business Startups Act, known as the JOBS Act, was enacted last year, a key piece was eliminating solicitation and advertising restrictions on hedge funds and private securities offerings. That gift, however, may come with the cost of greater scrutiny on how issuers verify that the investors they are targeting are sophisticated enough to qualify.

A proposed, but not yet finalized, rule by the Securities and Exchange Commission makes it clear that an issuer soliciting new investors through a publicly available Website, social media, or newspaper ads and billboards would be obligated to take greater measures to verify investor status.

What exactly, should those greater efforts entail? The industry is pitching plenty of ideas—including certification from an accounting firm, third-party introducing databases, and independent screening services— but the SEC, thus far, hasn't offered much of a blueprint. Instead of detailing specific steps to verify accredited investor status, it has taken a more flexible, principle-based approach.

Under its proposed rule, the Commission says issuers should consider a number of factors, including: the nature of the purchaser and the type of accredited investor that the purchaser claims to be; the amount and type of information that the issuer has about the purchaser; and the nature of the offering. It adds that not requiring “uniform verification methods” is intended to “give issuers and market participants the flexibility to adopt different approaches to verification depending on the circumstances, to adapt to changing market practices, and to implement innovative approaches.”

“Proposing to require issuers to use specified methods of verification would be impractical and potentially ineffective in light of the numerous ways in which a purchaser can qualify as an accredited investor,” the proposed rule says. 

The lack of specific remedies doesn't mean the SEC intends to give securities issuers a pass on how they verify that investors qualify for their offerings. Chairman Elisse Walter has made it clear that whatever approaches are devised they will be scrutinized. “It will be crucial that the Commission staff carefully review the effects of permitting general solicitation,” she said in a November speech, prior to being appointed chairman of the SEC. “There are many aspects of the new rule that we will need to analyze—its effects on capital formation, whether the rule is accompanied by an increase in fraudulent activity, what techniques issuers use to verify accredited investors and whether they are effective, and whether investors that enter the private offering market have sufficient financial sophistication and information available to understand the risks of their investments.”

Jay Gould, a partner with the law firm Pillsbury Winthrop Shaw Pittman, says the renewed focus on investor accreditation follows years of the private fund industry sliding into a mere cursory “check-the-box” approach. While 20-30 years ago, thorough pre-evaluation of clients or targeting only those with pre-existing relationships was the norm, more recent years have seen evaluation standards decline. “When hedge funds really proliferated in the last 15 years or so, a lot of that stuff just didn't get done any more,” he says.

Instead, funds began to rely primarily on the representations in subscription agreements. “You sent out a questionnaire, people answered the questions, and unless the guy was pushing a Safeway cart down skid row there was really no reason to think he or she was not an accredited person or a qualified client.”

The requirement of having a pre-existing substantial relationship with the investor similarly fell by the wayside or became loosely interpreted, all under the blinking eyes of regulators. Brazen fund managers even began to brag openly that “nobody checks this stuff any way” and “nobody really knows if anyone is accredited.”

A few years ago, such talk began to wake up regulators, who then began to once again pay more attention to procedures for verification, Gould says. By the time the JOBS Act was enacted last April it became clear that these laissez faire approaches were coming to an end.

At the time, Gould expected that the Commission would go back to some of these old standards of requiring a balance sheet or income statement, or some kind of independent verification. “But they really didn't do that in the rule,” he says. “They just said it is mushy, so if somebody has a job where it is obvious they make $200,000 a year then you can rely on that, or you can outsource it, or rely on third parties. You just have to come up with something that makes sense for you.”

SEC FACT SHEET

The following is from a fact sheet, published by the Securities and Exchange Commission, on “Proposes Rules to Implement JOBS Act Provision About General Solicitation and Advertising in Securities Offerings”:

JOBS Act

The JOBS Act, enacted earlier this year, directed the SEC to remove the prohibitions on general solicitation or general advertising for securities offerings relying on Rule 506. By requiring the SEC to remove these restrictions, Congress sought to make it easier for companies to inform the public that they are seeking to raise capital through the sale of securities.

In particular, Section 201(a)(1) of the JOBS Act directs the SEC to amend Rule 506 to permit general solicitation or general advertising provided that all purchasers of the securities are accredited investors. It also says that “[s]uch rules shall require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission.”

The Proposed Rules

Rule 506

Under the proposed rules, companies issuing securities would be permitted to use general solicitation and general advertising to offer securities, provided that:

The issuer takes reasonable steps to verify that the purchasers of the securities are accredited investors.

All purchasers of securities are accredited investors, because either:

They come within one of the categories of persons who are accredited investors under existing Rule 501.

The issuer reasonably believes that they meet one of the categories at the time of the sale of the securities.

Under Rule 501, a natural person qualifies as an accredited investor if he or she has individual net worth—or joint net worth with a spouse—that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person. Or, if he or she has income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.

In determining the reasonableness of the steps that an issuer has taken to verify that a purchaser is an accredited investor, the proposing release explains that issuers are to consider the facts and circumstances of the transaction. This includes, among other things, the following factors:

The type of purchaser and the type of accredited investor that the purchaser claims to be.

The amount and type of information that the issuer has about the purchaser.

The nature of the offering, meaning:

The manner in which the purchaser was solicited to participate in the offering.

The terms of the offering, such as a minimum investment amount.

The SEC's proposing release notes that proposing specific verification methods that an issuer must use “would be impractical and potentially ineffective in light of the numerous ways in which a purchaser can qualify as an accredited investor … We are also concerned that a prescriptive rule that specifies required verification methods could be overly burdensome in some cases, by requiring issuers to follow the same steps, regardless of their particular circumstances, and ineffective in others, by requiring steps that, in the particular circumstances, would not actually verify accredited investor status.”

The proposed rules would preserve the existing portions of Rule 506 as a separate exemption so that companies conducting 506 offerings without the use of general solicitation and general advertising would not be subject to the new verification rule.

Source: SEC.

This has led to considerable debate about whether a principle-based approach is preferable to having hard-and-fast rules. Some contend that issuers want clear-cut rules “so they know how to avoid them,” says Gould.

Steve Nadel, an investment management lawyer with the law firm Seward & Kissel, says he was somewhat surprised by the approach taken by the SEC. “We were expecting all kinds of rules, and what came out was a very bare-bones rule that essentially says you have to ensure that reasonable procedures are in place to verify accredited investor status,” Nadel says.

The SEC's vague requirement has already sparked creative thinking on the many ways that issuers could assess investor accreditation. “My guess is that, at some point, this probably creates a whole new business,” Nadel says. “I wouldn't be surprised if somewhere down the road you are going to have almost a centralized organization or company and all it is, basically, is an accredited investor screening site. There is a huge business potential.”

He points out that a variety of third-party investment advisory firms would be well-poised to enter this space. They probably have the understanding and mechanics and wherewithal to achieve something like this.

Philip Segal, a New York lawyer who specializes in corporate investigations and due diligence, often for hedge funds, says it will be important to see what safe harbor provisions may be appended to the SEC's accreditation demands. In the past, if it was revealed that an un-accredited investor slipped past screening, “it wasn't the end of the world,” he says. “Now, the SEC is going to ask what did you do to check, and you are not going to be able to take a mulligan.”

Segal says it is important to note that Walter's speech indicated that “suitability” and the sophistication of an investor could be just as important as the monetary metrics of accreditation. “If all of a sudden you inherit $2 million dollars, but you live in a little rent-controlled apartment and know nothing about finance, you are an accredited investor maybe, but should you be in an ultra-short hedge fund and do you even understand what that means?”

While some suggest that suitability determinations may be left to courts to decide, Segal suggests it will be prudent to tackle both evaluations at the same time. “If you find no evidence of any kind of sophistication you'll need to do some investigation before you take the money.”

Proper due diligence requires a human touch and, perhaps, a bit of detective work, Segal says. The key to satisfying regulators of a good faith approach is to go beyond mere bank queries, as a banker likely has no idea what liabilities or judgments might exist elsewhere. At a bare minimum, a search should be conducted of online news sites for mentions of a potential investor. But desktop computer searches alone are not enough.

Checks of paid database services and an in-person trip to a local courthouse can help build a more complete snapshot of an investor, Segal says, adding that the added cost of a more labor-intensive search can still amount to less than $2,000, peanuts compared to the hundreds of thousands of dollars hanging in the balance.