What “Accredited Investor” Or Other Investor Type Definitions Apply In Exempt Offerings Rules?
By: William A. Price, Esq., Growthlaw.com, Warrenville, IL
What is an accredited investor and why should a small business owner care?
SEC rules and most state securities laws have much less stringent requirements for preregistration of offerings and types of disclosures required to sell to “accredited” investors than they do for members of the general investing public. The “accredited” status rules provide such exemptions only for people and institutions with enough resources to properly evaluate investment risks, and, in the case of individuals, with enough resources to absorb losses. Public offerings, which are registered, are much more expensive and take longer than private offerings, which can reach qualified buyers without being subject to public offerings rules — in other words, are “Exempt.” This article deals with the definitions of investor types in SEC and Illinois securities laws and rules, from “accredited” through “sophisticated”, or otherwise qualified so various types of exempt offerings could be made to them.
- Public Offerings Are The Default Rule, And Are Very Expensive (As Is Failure To Register)
Federal and state securities laws were enacted as a result of many frauds and market abuses.[1] These were extensive enough to make the default rule for selling securities very strict.
Section 5 of the federal Securities Act requires every offer or sale of a “security” to be registered and approved by the SEC or a state securities department before sale, unless an exception to registration applies.[2] The same Section, and regulations under same, prohibit pre-sale communications that are not accompanied by a prospectus that has been approved by the SEC or a state agency. The Section does, however, make an exception for institutions or institutional buyers that are “accredited investors”. These can receive communications not including a full prospectus to determine possible interest in a deal without the same restrictions as apply to ordinary investors.[3]
The public offering process is usually extremely expensive. An Oxford Economics survey done recently for PriceWaterhouseCoopers had 83% of CFO’s involved estimating that they had spent more than $1 million in one-time costs for initial public offerings, apart from the costs of underwriting. Underwriters added 4-7% more to offering costs, plus an average of $4.2 million of fees and costs required by underwriting organizations to complete the offering process.[4]
Failure to comply with federal or state securities law registration requirements can also be expensive. Penalties can include a permanent prohibition on ever again offering or selling securities, cancellation of all sales, and return to investors of all invested funds.[5] Deliberate failure to abide by registration requirements SEC civil penalties start at $80,000 for individuals and $400,000 for institutions, per violation.[6]
- Exceptions To Public Offering Requirements Often Limit Communications And Investments To Accredited Investors
Many of the most significant exceptions to advance registration of securities sales and approval of sales materials are included in Regulation D, which is codified in 17 C.F.R. Sections 230.500 through 230.508. (Rules 500 through 508), see Appendix list of references to “Accredited” investors and/or investor sophistication requirements in same.
The SEC has provided a convenient chart which gives an overview of the exemptions from public offerings, along with the various investor types permitted in each. See https://www.sec.gov/smallbusiness/exemptofferings/exemptofferingschart. This article does not summarize the characteristics (what amount of capital can be raised, public versus private circulation, etc…) of such exemptions, which are dealt with at more length in the full chart. The investor numbers and qualifications provisions for each are summarized as follows:
| Section 4(a)(2) | Regulation D | Regulation Crowdfunding | Regulation A | Intrastate | |||||
| Rule 506(b) | Rule 506(c) | Rule 504 | Tier 1 | Tier 2 | Sec. 3(a)(11) | Rule 147 | Rule 147A | ||
| Transaction by an issuer not involving any public offering. See SEC v. Ralston Purina Co. | Unlimited accredited investors. | Unlimited accredited investors. Issuer must take reasonable steps to verify that all purchasers are accredited investors | None | Investment limitations based on annual income and net worth | None | Non-accredited investors subject to investment limits | Offerees and purchasers must be in-state residents | Offerees and purchasers must be in-state residents | Purchasers must be in-state residents |
| Applies to all Reg D, crowdfunding, and other exceptions | Up to 35 sophisticated but non-accredited investors | Up to 35 sophisticated but non-accredited investors | Up to 35 sophisticated but non-accredited investors | 10% of investor net worth max. | 10% of investor net worth max. | ||||
In-state offerings in Illinois, as well as federal offerings seeking an exemption from public offerings rules (preemption is not assumed, see Brown v. Earthboard Sports USA, Inc., 481 F.3d 901 (6th Cir., 2007)) must comply with the Illinois Securities Law and regulations under same. The Illinois Securities Department has a guide for issuers at https://www.cyberdriveillinois.com/departments/securities/sellingsec.html. This lists fees and general requirements. A guide to Regulation D exempt offerings is at http://www.cyberdriveillinois.com/departments/securities/regd.html. Fees, forms, offering limits, and places to file the state forms are covered. 14 Ill. Adm. Code Section 420 provides for an exemption under Section 4(D) of the Illinois Securities Law for offerings which comply with federal Regulation D standards, and imposes state sophistication requirements for unaccredited investors.[7]
- Definition of “Accredited Investor”
SEC commissioners and others in the annual SEC forum on capital formation have suggested revisions to the identity and net worth standards for accredited investors over recent years. The current definitions are still in effect, however, and should guide promoters and their counsel in preparing and conducting private offerings.[8]
Section 230.501(a) defines an “accredited investor” as:
” any person who comes within any of the following categories, or who the issuer reasonably believes comes within any of the following categories, at the time of the sale of the securities to that person:
(1) Any bank as defined in section 3(a)(2) of the Act, or any savings and loan association or other institution as defined in section 3(a)(5)(A) of the Act whether acting in its individual or fiduciary capacity; any broker or dealer registered pursuant to section 15 of the Securities Exchange Act of 1934; any insurance company as defined in section 2(a)(13) of the Act; any investment company registered under the Investment Company Act of 1940 or a business development company as defined in section 2(a)(48) of that Act; any Small Business Investment Company licensed by the U.S. Small Business Administration under section 301(c) or (d) of the Small Business Investment Act of 1958; any plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5,000,000; any employee benefit plan within the meaning of the Employee Retirement Income Security Act of 1974 if the investment decision is made by a plan fiduciary, as defined in section 3(21) of such act, which is either a bank, savings and loan association, insurance company, or registered investment adviser, or if the employee benefit plan has total assets in excess of $5,000,000 or, if a self-directed plan, with investment decisions made solely by persons that are accredited investors;
(2) Any private business development company as defined in section 202(a)(22) of the Investment Advisers Act of 1940;
(3) Any organization described in section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;
(4) Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer;
(5) Any natural person whose individual net worth, or joint net worth with that person’s spouse, exceeds $1,000,000.
(i) Except as provided in paragraph (a)(5)(ii) of this section, for purposes of calculating net worth under this paragraph (a)(5):
(A) The person’s primary residence shall not be included as an asset;
(B) Indebtedness that is secured by the person’s primary residence, up to the estimated fair market value of the primary residence at the time of the sale of securities, shall not be included as a liability (except that if the amount of such indebtedness outstanding at the time of sale of securities exceeds the amount outstanding 60 days before such time, other than as a result of the acquisition of the primary residence, the amount of such excess shall be included as a liability); and
(C) Indebtedness that is secured by the person’s primary residence in excess of the estimated fair market value of the primary residence at the time of the sale of securities shall be included as a liability;
(ii) Paragraph (a)(5)(i) of this section will not apply to any calculation of a person’s net worth made in connection with a purchase of securities in accordance with a right to purchase such securities, provided that:
(A) Such right was held by the person on July 20, 2010;
(B) The person qualified as an accredited investor on the basis of net worth at the time the person acquired such right; and
(C) The person held securities of the same issuer, other than such right, on July 20, 2010.
(6) Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;
(7) Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person as described in §230.506(b)(2)(ii); and
(8) Any entity in which all of the equity owners are accredited investors.”
SEC No Action Letters and court decisions have further clarified this definition, and the further restrictions on solicitation based on same. So, for instance, grantor trusts where all grantors had assets above $1 million were held accredited.[9] A debtor in bankruptcy did not misrepresent the accredited status of a wife who had been jointly advised on investments with her husband, even though she invested separately, where their joint assets were worth more than $1 million.[10] For numeric limits on numbers of investors, Section 230.501(e) states that spouses or relatives who share the same household with a purchaser are not counted.[11]
- Proof of Accredited Status
Once the SEC establishes its prima facie case that a defendant has violated Section 5’s registration provisions, the defendant bears the burden of proving an exemption from the registration provisions applies to each transaction in which the defendant participated.[12] Part of this proof relates to the “accredited investor” status with respect to exemptions under Regulation D. The issuer has to have a “reasonable belief” the potential investor is accredited.[13]
Cases where proof was acceptable: Potential investor affidavits or other representations as to level of assets or other qualifications used to be sufficient to prove accredited status.[14] Warnings in a placement memo about restriction to accredited investors, advance certification by an investor of accredited status in a detailed questionnaire, and certification of accuracy of that representation by an investment adviser (and through same, the adviser’s employer) were enough to hold an issuer’s reliance on the investor’s accredited status reasonable in another case.[15] A guarantor of a note submitted in payment of a subscription agreement amount due for a limited partnership interest was a holder in due course, who took free of claims that the purchase was fraudulent, and so had no duty to investigate the accredited status representations of LP interest investors.[16]
Cases where penalties applied, since there was not enough proof: Issuers who offered securities to investors who they did not know in advance were accredited could be penalized.[17] Criminal intent could be inferred where the questionnaire did not define “accredited” and the issuer merely explained same on demand, without more knowledge of such status by persons filling out a questionnaire that merely asked if they were “accredited.”[18] Sales to an investor who did not provide certification or proof of accredited status could not be proved to be to a properly accredited person, since the lack of information meant neither the issuer nor the dealer had a “reasonable belief” the investor was accredited.[19] Lack of proof of accredited status for 299 investors from multiple states defeated a claim of exemption from registration requirements in another case.[20]
Absence of evidence is not evidence of absence: On the other hand, the SEC lost a summary judgment motion in one case even though there were 3,400 investors, since the agency could not prove that more than 35 of them were non-accredited.[21] Similarly, an issuer who failed to keep track of who had seen all of the 300 offering kits sent out could not be penalized, since there was no proof these potential investors were not accredited.[22]
Proof of other allowable investor types may also be required: In another case, lack of proof of offerings having been made to large institutional (and therefore accredited buyers) meant that a private offering allegedly to such institutions could not be separated from a simultaneous offering to the public, and so lacked exemption.[23]
The issuer is responsible for compliance: An issuer who tried to suggest responsibility for tracking total numbers of unaccredited buyers lost in a Fifth Circuit case in 2003.[24]
A “Safe Harbor” Set of Proofs of Accredited Investor Status: Even though the items of proof listed in the “safe harbor” provision of Rule 506(c)(2)(ii) are only specified as proof of accredited investor status for offerings under that Rule, the list contained has, effectively, become the “gold standard” for what needs to be in the issuer’s due diligence file for proof of a “reasonable basis” for belief in such status under Rule 501(a) since the adoption of Rule 506(c):[25]
“(ii) Verification of accredited investor status. The issuer shall take reasonable steps to verify that purchasers of securities sold in any offering under paragraph (c) of this section are accredited investors. The issuer shall be deemed to take reasonable steps to verify if the issuer uses, at its option, one of the following non-exclusive and non-mandatory methods of verifying that a natural person who purchases securities in such offering is an accredited investor; provided, however, that the issuer does not have knowledge that such person is not an accredited investor:
(A) 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;
(B) In regard to whether the purchaser is an accredited investor on the basis of net worth, reviewing one or more of the following types of documentation dated within the prior three months and obtaining a written representation from the purchaser that all liabilities necessary to make a determination of net worth have been disclosed:
(1) With respect to assets: Bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments, and appraisal reports issued by independent third parties; and
(2) With respect to liabilities: A consumer report from at least one of the nationwide consumer reporting agencies; or
(C) Obtaining a written confirmation from one of the following persons or entities that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months and has determined that such purchaser is an accredited investor:
(1) A registered broker-dealer;
(2) An investment adviser registered with the Securities and Exchange Commission;
(3) A licensed attorney who is in good standing under the laws of the jurisdictions in which he or she is admitted to practice law; or
(4) A certified public accountant who is duly registered and in good standing under the laws of the place of his or her residence or principal office.
(D) In regard to any person who purchased securities in an issuer’s Rule 506(b) offering as an accredited investor prior to September 23, 2013 and continues to hold such securities, for the same issuer’s Rule 506(c) offering, obtaining a certification by such person at the time of sale that he or she qualifies as an accredited investor.”
Note that Rule 506(c) allows examination of documentation for a spouse as sufficient for proof of accredited status for the other spouse.
Practical note: Since very few investors want issuers to know the details of their taxes or finances, certification by one of the institutions or professionals noted in 506(c)(2)(ii) is the usual item contained in due diligence files.
- Investor Requirements For Non-Accredited Investors: Sophisticated, Or Otherwise Qualified?
Rule 506, among other exemptions from registration, allows offerings to up to 35 non-accredited investors. These investors must, however, have enough knowledge and experience to be able to evaluate the merits of the offering — i.e., be “sophisticated.” Issuers need a reasonable basis for determining potential investor’s level of sophistication before accepting their funds.[26] 14 Ill. Adm. Code 130.420 (c) imposes the following sophistication requirements for unaccredited investors in exempt offerings:
“In all sales to nonaccredited investors in this State, the issuer and any person acting on its behalf shall have reasonable grounds to believe, and after making reasonable inquiry shall believe, that one of the following conditions is satisfied:
1) the investment is suitable for the purchaser upon the basis of the facts, if any, disclosed by the purchaser as to his or her other security holdings and as to his or her financial situation and needs; for the purpose of this condition only, it may be presumed that if the investment does not exceed 10% of the investor’s net worth, it is suitable; and
2) the purchaser, either alone or with his or her purchaser representatives, has such knowledge and experience in financial and business matters that they are capable of evaluating the merits and risk of the prospective investment.
SEC Regulation A+ imposes no sophistication requirements, but limits investments of a “qualified purchaser” (one who is offered investments under Regulation A+) to no more than 10% of the investor’s net worth.[27] This would also meet the Illinois Section 4D test, as detailed in Section 130.420(c)(1) above.
SEC Rule 144A, discussed in more detail in another chapter of this text, restricts some sales to “qualified institutional buyers.”[28]
The Investment Company Act, Section 3(c)(7), restricts some sales in transactions to “qualified purchasers” where issuers are not required to register under that Act.[29]
A “Qualified Purchaser” is defined in 15 U.S. Code Section 80a-2(51) as:
” (i) any natural person (including any person who holds a joint, community property, or other similar shared ownership interest in an issuer that is excepted under section 80a–3(c)(7) of this title with that person’s qualified purchaser spouse) who owns not less than $5,000,000 in investments, as defined by the Commission;
(ii) any company that owns not less than $5,000,000 in investments and that is owned directly or indirectly by or for 2 or more natural persons who are related as siblings or spouse (including former spouses), or direct lineal descendants by birth or adoption, spouses of such persons, the estates of such persons, or foundations, charitable organizations, or trusts established by or for the benefit of such persons;
(iii) any trust that is not covered by clause (ii) and that was not formed for the specific purpose of acquiring the securities offered, as to which the trustee or other person authorized to make decisions with respect to the trust, and each settlor or other person who has contributed assets to the trust, is a person described in clause (i), (ii), or (iv); or
(iv) any person, acting for its own account or the accounts of other qualified purchasers, who in the aggregate owns and invests on a discretionary basis, not less than $25,000,000 in investments.”
Appendix: Regulation D Exemptions Rules References To “Accredited Investors”:[30]
Rule 501(e)(1) specifies the following as not included in numerical limits under Rule 506(b):[31]
“(i) Any relative, spouse or relative of the spouse of a purchaser who has the same primary residence as the purchaser;
(ii) Any trust or estate in which a purchaser and any of the persons related to him as specified in paragraph (e)(1)(i) or (e)(1)(iii) of this section collectively have more than 50 percent of the beneficial interest (excluding contingent interests);
(iii) Any corporation or other organization of which a purchaser and any of the persons related to him as specified in paragraph (e)(1)(i) or (e)(1)(ii) of this section collectively are beneficial owners of more than 50 percent of the equity securities (excluding directors’ qualifying shares) or equity interests; and
(iv) Any accredited investor.”
Rule 502(b) requires provision of certain information to non-accredited investors where an offering is exempt under Rule 506(b), but not if an exemption is sought under Rule 504, or the sale is to an accredited investor.
Rule 503 limits notices of changes in numbers of non-accredited investors to no more than 35 for offerings under Rule 504 or 506.
Rule 504(b) allows general solicitation and resale otherwise restricted under Rule 502(c) and 502(d) if the offering is intrastate, under a state law permitting general solicitation of accredited investors.
Rule 506(b)(2) requires that non-accredited investors be qualified to evaluate an investment solicitation are required to have enough sophistication to be able to evaluate the offering, for that offering to be exempt under Rule 506(b) or 506(c).
Rule 506(c)(2) requires that all investors in an offering under that exemption be accredited.
[1] See “Securities Law History”, https://www.law.cornell.edu/wex/securities_law_history, accessed 3/4/2019.
[2] 15 U.S.C. Section 77e(a)-(e).
[3] 15 USC Section 77e(d).
[4] https://www.pwc.com/us/en/services/deals/library/cost-of-an-ipo.html, accessed 3/4/2019.
[5] See. e/g., Matter of Scott William Burnim and the Trade Group West, Respondents, Illinois Securities Department File No. 1700111.
[6] https://corpgov.law.harvard.edu/2016/01/24/calculating-sec-civil-money-penalties/, accessed 3/4/2019.
[7] http://www.ilga.gov/commission/jcar/admincode/014/01400130sections.html, accessed 3/27/2019.
[8] Cf. Remarks of SEC Commissioner Luis A. Aguilar, Dec. 27, 2014, https://www.sec.gov/news/statement/spch121714laa.html, accessed 3/27/2019.
[9] Davis v. St. Anselm Exploration Co. (D. N.M., 2014).
[10] McGraw v. Collier (In re Collier), 497 B.R. 877 (Bankr. E.D. Ark., 2013).
[11] Shailja Gandhi Revocable Trust v. Sitara Capital Mgmt., LLC (N.D. Ill., 2012).
[12] Sec. & Exch. Comm’n v. Luna (D. Nev., 2014)
[13] 17 C.F.R. Section 230.501(a), discussed in People v. Ristau, 20 Cal.Rptr.3d 864, 123 Cal.App.4th 1436 (Cal. App., 2004).
[14] See, e.g. Wright v. National Warranty Co., 953 F.2d 256 (6th Cir., 1992) (affidavits).
[15] Brooks v. Euclid Systems Corp., 151 Md.App. 487, 827 A.2d 887 (Md. App., 2003).
[16] National Union Fire Ins. Co. of Pittsburgh, Pa. v. Woodhead, 917 F.2d 752 (2nd Cir., 1990).
[17] See, e.g., Moses v. Carnahan, 186 S.W.3d 889 (Mo. App., 2006).
[18] People v. Ristau, 20 Cal.Rptr.3d 864, 123 Cal.App.4th 1436 (Cal. App., 2004).
[19] Sec. & Exch. Comm’n v. AIC, Inc. (E.D. Tenn., 2013).
[20] Sec. & Exch. Comm’n v. Causwave, Inc. (M.D. N.C., 2018).
[21] Sec. & Exch. Comm’n v. Schooler (S.D. Cal., 2015).
[22] Faye L. Roth Revocable Trust v. Ubs Painewebber, 323 F.Supp.2d 1279 (S.D. Fla., 2004).
[23] Anegada Master Fund, Ltd. v. PXRE Grp. Ltd., 680 F.Supp.2d 616 (S.D. N.Y., 2010).
[24] U.S. v. Tucker, 345 F.3d 320 (5th Cir., 2003).
[25] 17 C.F.R. Section 230.506(c)(2)(ii), 501(a).
[26] Brown v. Earthboard Sports Usa, Inc., 481 F.3d 901 (6th Cir., 2007)
[27] 17 C.F.R. Section 230.256, discussed in Lindeen v. Sec. & Exch. Comm’n, 825 F.3d 646 (D.C. Cir., 2016).
[28] 17 C.F.R. Section 230.144A, discussed in Commercial Bank v. Smith Shellnut Wilson LLC (Miss. App., 2018).
[29] 15 US Code Section 80a-3(c)(7).
[30] 17 C.F.R. Sections 230.500-230.508.
[31] 17 C.F.R. Section 230.01(e)(1).
The post What “Accredited Investor” Or Other Investor Type Definitions Apply In Exempt Offerings Rules? appeared first on GrowthLaw.