Monday, September 30, 2013

An Argument for Self-Certification under Rule 506(c) and the New Crowdfunding Exemption

The SEC’s new Rule 506(c) exemption, mandated by the JOBS Act, allows issuers to solicit anyone to purchase securities, through public advertising or otherwise, as long as they only sell to accredited investors (or investors that the issuer reasonably believes are accredited investors). For most individuals, accreditor investor status depends on the investor’s annual income and net worth.

The crowdfunding exemption added by the JOBS Act allows issuers to sell securities to anyone, accredited or not, but the amount of securities each investor may purchase depends on the investor’s net worth and annual income. (For more on the new crowdfunding exemption, see my article here.)

Because of these requirements, it is important under both exemptions to know the net worth and annual income of each investor.

NOTE: Many people are referring to Rule 506(c) as “crowdfunding” but the actual crowdfunding exemption is something different. Brokers and others selling under Rule 506 began calling that crowdfunding as a marketing ploy to capitalize on the popularity of crowdfunding. Some academics have adopted that usage, which I think is unfortunate and only leads to confusion.

The simplest way to deal with these requirements would be to allow investors to self-certify. If an investor tells the issuer his net worth is $1.5 million, the issuer should be able to assume this is correct, unless the issuer has reason to suspect otherwise. This is not, unfortunately, the SEC’s approach in Rule 506(c). The SEC still has not adopted the rules required to implement the new crowdfunding exemption, but it’s unlikely to take this simple self-certification approach in those rules either.  

In a Rule 506(c) offering, Rule 506(c)(2)(ii) requires “reasonable steps” to verify that any natural person who purchases is an accredited investor. The issuer may do that verification itself, or it may rely on written representations from registered broker-dealers, registered investment advisers, licensed attorneys, or CPAs that they have taken reasonable steps to verify the investor’s status.

Under the non-exclusive safe harbor in Rule 506(c)(2), those reasonable steps could include review of, among other things, the investor’s tax filings, bank statements, brokerage statements, credit report, tax assessments, and appraisal reports. Obtaining and reviewing this information will increase the cost of using the exemption and force investors to divulge confidential financial information that they would probably prefer to keep to themselves.

Why not self-certification? Obviously, people might lie. I might exaggerate my income or net worth in order to qualify to invest in a Rule 506(c) offering or to purchase more securities in an offering pursuant to the crowdfunding exemption. Securities would be sold under Rule 506(c) to investors who aren't supposed to buy them. In crowdfunding offerings, investors could buy more securities than they're supposed to buy.

But these requirements are designed to protect the investors. If I choose to lie about my status, why shouldn’t I forfeit that protection? Why should the issuer be burdened with additional costs just because some investors are willing to lie? As long as the issuer acts in good faith and has no reason to know an investor is lying, what’s the argument for punishing the issuer by denying the exemption? If we want to discourage people from lying about their net worth and annual income, we should punish the liars, not the innocent issuer.

C. Steven Bradford, Securities Regulation | Permalink


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