Staff Guidance, Accredited Investors, and "Reasonable Steps": Rewriting the Safe Harbor for Income Verification
Rule 506(c) allows issuers to market private placements through general solicitations. They must, however, take "reasonable steps" to make certain that they sell only to accredited investors. The rule provides some non-exclusive safe harbors with respect to the "reasonable steps" that will ensure conformity with the rule.
With respect to income, the safe harbor essentially requires verification based upon an IRS form. As the rule states:
- In regard to whether the purchaser is an accredited investor on the basis of income, reviewing any Internal Revenue Service form that reports the purchaser's income for the two most recent years (including, but not limited to, Form W-2, Form 1099, Schedule K-1 to Form 1065, and Form 1040) and obtaining a written representation from the purchaser that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year;
The safe harbor, therefore, suggests that a variety of documents can be submitted to meet the requirement. Moreover, while the safe harbor speaks about the "income" for the year, presumably any combination of these documents would be sufficient to show that the investor had annual income in excess of the thresholds in Regulation D.
The staff received a question, however, as to the verification of income for a year when the relevant "form" was not yet completed. As the question stated:
- Rule 506(c)(2)(ii)(A) sets forth a non-exclusive method of verifying that a purchaser is an accredited investor by, among other things, reviewing any Internal Revenue Service form that reports the purchaser's income for the "two most recent years." If such an Internal Revenue Service form is not yet available for the recently completed year (e.g., 2013), can the issuer still rely on this verification method by reviewing the Internal Revenue Service forms for the two prior years that are available (e.g., 2012 and 2011)?
The existing safe harbor seemed to implicitly address that question. The safe harbor was not limited to tax returns. Income could also be verified through the submission of a variety of forms, whether W-2s or 1099s or other IRS forms. These forms might not show the "income for the . . . most recent year" but would establish that the investor exceeded the relevant threshold.
Yet the staff took the opportunity to effectively expand the reach of the safe harbor. The staff conceded that the safe harbor was not available in these circumstances ("No, the verification safe harbor provided in Rule 506(c)(2)(ii)(A) would not be available under these circumstances."). Nonetheless, it then proceeded to rewrite the safe harbor and make it available.
- We believe, however, that an issuer could reasonably conclude that a purchaser is an accredited investor and satisfy the verification requirement of Rule 506(c) under the principles-based verification method by:
- reviewing the Internal Revenue Service forms that report income for the two years preceding the recently completed year; and
- obtaining written representations from the purchaser that (i) an Internal Revenue Service form that reports the purchaser's income for the recently completed year is not available, (ii) specify the amount of income the purchaser received for the recently completed year and that such amount reached the level needed to qualify as an accredited investor, and (iii) the purchaser has a reasonable expectation of reaching the requisite income level for the current year.
This is a substantial change in, and weakening of, the safe harbor.
First, the requirement at least implicitly ties verification to the need for a tax return. It is enough to show that "an Internal Revenue Service form that reports the purchaser's income for the recently completed year is not available." Since individuals often have multiple sources of income (W-2, 1099, K-1, etc), no single IRS "form" will report "income for the "recently completed year" except a tax return. Thus, even if other IRS forms are available, as long as the tax return is unfiled, self-certifified, and without accompanying documentation it is permitted.
Second, the advice does not address the possibilty that the filing date of the tax return can be manipulated. Extensions (the first of which is more or less automatic) can result in tax returns not being filed for a year or longer.
Third, the staff replaced the need for a document filed under penalties of perjury (an IRS document) with self certification, which has no such requirement. The staff took this position despite the fact that the Commission emphasized in the adopting release the importance of requiring documentation that was subject to "penalties for falsely reporting information." See Exchange Act Release No. 69959 (July 10, 2013) ("With respect to the verification method for the income test, there are numerous penalties for falsely reporting information in an Internal Revenue Service form, and these forms are filed with the Internal Revenue Service for purposes independent of investing in a Rule 506(c) offering.").
Fourth, while the interpretation requires the examination of IRS documents for two earlier years, it does not impose any explicit obligations that must arise from that analysis. Where, for example, the earlier year shows an income amount that does not qualify, the guidance does not specify that this requires greater diligence. Indeed, the guidance provides that in some cases further investigation (additional verification) will be required but does not reference data from the earliest of the returns.
- Where the issuer has reason to question the purchaser's claim to be an accredited investor after reviewing these documents, it must take additional verification measures in order to establish that it has taken reasonable steps to verify that the purchaser is an accredited investor. For example, if, based on this review, the purchaser's income for the most recently completed year barely exceeded the threshold required, the foregoing procedures might not constitute sufficient verification and more diligence might be necessary.
The guidance alters the income safe harbor in a manner arguably inconsistent with the representations made in the adopting release in Rule 506(c). The safe harbors were designed to eschew self-certification. They were designed to implement the "reasonable steps" requirement primarily through third party documentation of income and net assets. The guidance in this case, however, has undone much of that approach, permitting self certification in place of third party verification.
The ABA Journal is again accepting nominations for their Blawg 100. Please consider nominating the Race to the Bottom. Instructions for doing so are here.