Tag: Accredited Investor

Guidance on Accredited Investor Verification

The Securities and Exchange Commission revised the private placement rules last year to permit public private-placements. Of course it took some prodding from Congress in the JOBS Act to get that change. The law and the new regulation require the issuer to take “reasonable steps” to determine that the investor is an “accredited investor.”

The SEC rule has four non-exclusive safe harbor methods which meet the verification requirement. One of those methods is to rely on the written confirmation of accredited investor status issued by a registered broker-dealer or investment adviser. The Securities Industry and Financial Markets Association has put together guidance on that verification method.

For individuals, SIFMA recommends that the investor have been a client for at least six months so the firm has sufficient knowledge. Second, SIFMA recommends that the broker or adviser obtain a representation from the investor that he or she is not borrowing money to make the investment.

To make the determination, SIFMA has two methods. In the account balance method, the investor must have at least $2 million with the broker or adviser. This assumes $1 million liabilities. If the investor discloses debt greater than this, obviously the account balance threshold will increase.

The second method is the investment amount method. In this situation, the investor must commit at least $250,000 to the investment and represent that it is less than 25% of the investor’s net worth.

I’m not sure the guidance breaks new ground, but its good to see some filling in the holes. The SEC safe harbor also permits CPAs and lawyers to issue the accredited investor verification. It will be interesting to see if the bar association and PCAOB offers any guidance to its members.

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Accredited Investor Verification

rich accredited investor

When Congress imposed a lifting of the ban on advertisements for private placements, it also imposed a mandate that the fundraiser “take reasonable steps to verify that purchasers of the securities are accredited investors.” The methods for verification were to be determined by the Securities and Exchange Commission.

The SEC, to its credit, did not impose impose strict methods for verification. It largely decided to allow fundraisers to use a principles-based approach. The SEC did include four non-exclusive safe harbors for verification.

Congress thought that lifting the ban would invigorate fundraising. But funds and companies have been reluctant to use it. According to a speech by Keith Higgins, only 10% of private placements have used the Rule 506(c) methods. Since September 2013, there were 900 offerings that raised $10 billion under Rule 506(c). But there were over 9,200 offerings that raised $233 billion under the old Rule 506(b) regime.

With the verification requirement, the outcome and backlash has been that fundraisers should only use one of the four methods. That of course, is silly. It’s safe, but overly cautious. The SEC did specifically state that reliance on an investor’s self-answered questionnaire alone is not taking reasonable steps. You will need to look at your potential investor and find out some additional information.

That investigation adds time and and energy. For private equity funds, it’s probably a step that should be taken anyhow. Investor defaults on capital calls is a bad thing. You want to make sure that your potential investor will be able to make the contributions over course of the expected timeline of capital calls. That’s a bit different than a one time contribution to a hedge fund or private company investment.

Minimum investment goes a long way to meeting the reasonable steps. If an investor is making a $1 million investment then presumably the investor has the $1 million new worth which is the accredited investor baseline test. The SEC did not specifically endorse this standard. The concern is that the investor may have borrowed the money to make the investment. The SEC is clearly worried about shady operators getting little old ladies to mortgage their homes to make risky investments.

For me, the biggest concern is the overhang of the proposed changes to Regulation D that were put up for comment at the same time the SEC lifted the ban. That injects too much uncertainty into the fundraising process. The SEC stated that there will likely be a grace period and some transitional relief. But its hard to plan a fundraising that could take 12 months with that kind of uncertainty.

I was interested in using Rule 506(c) because of the uncertainties around the definition of general solicitation and advertising. It would be great to eliminate potential foot-faults. I could sleep better at night, not worrying about whether an employee would mention fundraising at an industry event. The company could respond to media requests and could correct misinformation in the media about the fundraising.

But the SEC has left too much uncertainty in the process to fully embrace a Rule 506(c) offering.

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The Upcoming Changes to the Accredited Investor Standard

Monopoly man

Section 413 of the Dodd-Frank Act requires the Securities and Exchange Commission to review the accredited investor definition by July 21, 2014, the fourth anniversary of President Obama’s signing of the  law. In a letter to Congressman Scott Garrett, SEC Chair Mary Jo White said that the Commission staff has begun a comprehensive review of the accredited investor definition. The letter was specifically a response to questions from Congressman Garrett.

I have no doubt that the current definition of accredited investor using income or net worth for individuals excludes people who should not be excluded from private securities offerings. I also have no doubt that it also allows in people who are not financially sophisticated enough to analyze the investment opportunity. For example, the SEC Commissioners fail the income test based on their salaries as commissioners. (I have no doubt they meet the net worth test.)

I do like the clear line drawn by the standard. I also like that a company can use reasonable belief to rely on questionnaire submitted by the investor to prove its accredited investor standard.

The new standards imposed by the SEC to verify accredited investor status under the permitted general solicitation are causing many to avoid that option. Few individuals are going to want to supply tax returns or W-2s to make an investment opportunity.

In reading the questions asked by Congressman Garrett it seems clear to me that he wants the definition expanded to create a larger pool of potential investors.

The GAO report on the accredited investor standard highlights net worth as the most important measure of an investor for private placements.  The report has some great analysis of potential changes to the standard.

The deadline is still months away, but I expect there will be significant changes to the definition.

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The Confusing Analysis of Whether You Are An Accredited Investor

accredited investors

There are few commentators who think the current definition of “accredited investor” is a particularly good definition for individuals who should be investing in private placements of securities. Basing the standard on income and net worth does give you a perspective that the person could withstand the potential loss of investment. The definition has become even more important as the ban on general solicitation and advertising has been lifted. That’s going to leave a lot of potential investors and a lot of companies seeking capital trying to figure it out.

The income test of $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year, provides an interesting model. It’s reasonably verified with tax returns. Although I suspect few investors will want to turn over their tax returns to potential investment targets.

There is some uncertainty about the meaning of “spouse” for same-sex couples, given the Windsor decision that struck down the Defense of Marriage Act.

A humorous aspect of the income test is that the SEC Commissioners’ salaries are less than $200,000. Therefore, they each fail the accredited investor income test, unless a spouse is earning at least $150,000.

The asset test is even more difficult because assets now exclude the value of the home. Except if the mortgage balance is higher than the value of the home, then the negative value of the home is included in the asset test.

Of course the first problem is figuring out the value of your home and comparing it to the mortgage balance. I like that Zillow says my house is worth more than my mortgage, but is that an authoritative source for use in an accredited investor analysis?

Then the SEC also requires an home equity advance or mortgage increase in the prior sixty days to be a liability in calculating net worth, even if it does not put the house underwater. During the comment period, a concern was raised that an unscrupulous actor could convince grandma to mortgage her home, converting equity into cash that earns her the accredited investor standard.

The biggest problem is proving net worth to meet the accredited investor standard. You need to prove how much your house is worth, the mortgage balance, the timing of the mortgage origination, the timing of any home equity draws, all of your liabilities, and lastly your assets. merely producing a bank statement showing $1 million in cash in the bank is not enough to have take “reasonable steps” to conclude that a person is an “accredited investor.’

You can review the ridiculousness of the asset test in a new investor bulletin from the SEC: Investor Bulletin: Accredited Investors (.pdf) SEC Pub. No. 158.

John Smith fails the test because he took an additional draw on the home equity line in the past sixty days. But in two months he once again becomes an accredited investor. He did nothing but wait and his financial situation did not change. But two months later he can be an angel investor and invest in a start-up company.

James Lee fails the test because his house is $100,000 underwater and pulls him $80,000 short of the accredited investor standard. But as soon as Zillow makes a good positive update, he becomes an accredited investor. He did nothing but wait for the real estate market to recover. But then he can invest in a hedge fund.

References:

Investor Bulletin: Accredited Investors (.pdf) SEC Pub. No. 158

What’s Next For Private Funds Now that the SEC has Lifted the Ban on General Solicitation

SEC Seal 2

On Wednesday, the Securities and Exchange Commission adopted a new rule that will allow private funds to advertise. (Perhaps “private fund” is not the right label anymore.) Of course it’s not as simple as merely removing the word “not” and allowing public advertising of private placements.

The new rule creates a new option. It creates a public private placement. A fund manager or company can publicly advertise the offering so long as all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verify that such purchasers are accredited investors

The existing option is still viable that operates under the regulatory regime as it existed before 10:00 am yesterday. I suppose it’s a private private placement.

One concern I had was how a public private placement under the new Rule 506(c) would affect a private fund under its Section 3(c)1 or 3(c)7 exemption under the Investment Company Act. Private funds are precluded from relying on either of these two exemptions if they make a public offering of their securities. The SEC explicitly addressed this concern.

As we stated in the Proposing Release and reaffirm here, the effect of Section 201(b) is to permit private funds to engage in general solicitation in compliance with new Rule 506(c) without losing either of the exclusions under the Investment Company Act.(page 48 of Release 33-9415)

Another concern was whether the SEC was eliminating the “reasonable belief” standard that an investor is accredited under the new Rule 506(c) offerings. The SEC specifically addressed this concern.

We note that the definition of accredited investor remains unchanged with the enactment of the JOBS Act and includes persons that come within any of the listed categories of accredited investors, as well as persons that the issuer reasonably believes come within any such category.

My last concern was what it meant to take “reasonable steps to verify” that investors are accredited. The SEC stuck with its principles-based approach, but did provide four non-exlusive methods for verifying accredited investor status for individuals.

The principles-based approach requires you to take an “objective determination … in the context of the particular facts and circumstances.” That’s a bit messy. I was hoping the SEC would explicitly state that a minimum investment of $1 million would be enough. If the investor has $1 million, then the investor has $1 million of net worth and meets the accredited investor threshold. The SEC states that the minimum investment is a highly relevant factor.

The SEC expresses some concern that the cash investment could be financed by the issuer or a third party. Those are legitimate concerns given the potential for fraud by shady operators who would hide behind such a bright line test. But it does cause me a headache.

Clearly there will need to be some additional recordkeeping when it comes to a public offering of a private placement.

The SEC also passed a rule banning “bad actors” from having a substantial role in a private placement, regardless of whether it is public or private. I’ll take a closer look at that one later.

Lastly, the SEC is proposing changes to the Form D required to filed with a private placement. There are many changes in that rule. More than I expected.

  • the filing of a Form D no later than 15 calendar days in advance of the first use of general solicitation in a Rule 506(c) offering;
  • the filing of a closing Form D amendment within 30 calendar days after the termination of a Rule 506 offering; and
  • additional information on Form D about the offering

In addition, the rule is proposing a new disclosure on advertising materials in public private placements. The new rule 509 will require all issuers to include: (i) legends in any written general solicitation materials used in a Rule 506(c) offering; and (ii) additional disclosures for private funds if such materials include performance data.

The SEC is also proposing amendments to Rule 156 under the Securities Act that would extend the guidance contained in the rule to the sales literature of private funds.

There is a lot to digest. Looks like my weekend will be spent reading SEC releases and rules.

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DOMA, the SEC, and the Accredited Investor

us supreme court and compliance

The US Supreme Court ruled on same sex marriages and removed the broad federal definition of marriage that applies to over a thousand laws and regulations. Decision in US v. Windsor (.pdf) One of those regulations is from the Securities and Exchange Commission and affects fundraising for private funds and other private placements.

One of the standards for private placements of securities is that an investor generally needs to meet the definition of “accredited investor.” For an individual that means a (1) net worth, excluding the primary residence, of $1 million, or (2) annual income in excess of $200,000 in each of the two most recent years or joint income with a spouse in excess of $300,000.

Section 3 of the Defense of Marriage Act mandated that the word “spouse” refer only to a person of the opposite sex who is a husband or a wife.” 1 U.S.C. § 7 (1997)

Less than 10 years ago, the Massachusetts Supreme Judicial Court went through a laundry list of legal rights that couples enjoy once they are married. In the landmark Goodridge decision, that court decided that “spouse” should not be limited to a man and a woman. It affects a broad spectrum of rights granted by the government to people who are married.

The US Supreme Court decided that Section 3 of the Defense of Marriage Act is unconstitutional. Therefore, the accredited investor definition’s use of the word “spouse” is no longer restricted by DOMA to a person of the opposite sex who is a husband or a wife.

In the states that allow same-sex marriage, an issuer should now be able to allow a same-sex married couple to combine their income to meet the standard. I don’t think the SEC needs to take any action for this to happen.

In states that allow civil unions, the answer is a bit murkier and depends on the rights granted under state law. The civil union law would need to deem the two participants to be “spouses.” That is exactly what Illinois did in its civil union law:

“Party to a civil union” means a person who has established a civil union pursuant to this Act. “Party to a civil union” means, and shall be included in, any definition or use of the terms “spouse”, “family”, “immediate family”, “dependent”, “next of kin”, and other terms that denote the spousal relationship, as those terms are used throughout the law. SB1716

What is even murkier is a married couple who move to a state that does not recognize same sex marriage. Are they still “spouses” if not recognized by their state of residence? Justice Scalia raises this issue in his dissent.

Whether you agreed with DOMA or not, it made a very bright line test for “spouse”. That line is now more complicated for determining if a potential investor is an “accredited investor.”

This may become even more complicated when the SEC finally issues the regulation that lifts the ban on general solicitation and advertising. The new regulation will require a firm to take reasonable steps to determine that an investor is accredited if it wants to engage in general advertisement or solicitation. It will be interesting to see if the SEC includes something on this issue.

Given the SEC’s huge rulemaking backlog, I doubt they will make a separate statement on same-sex marriages under securities law. The SEC could tuck something into the advertising rule since it is already in the works. Perhaps the SEC was waiting for the Windsor case to be decided.

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Image of the US Supreme Court by OZinOH

Same Sex Marriage and Accredited Investors

Compliance, the SEC and the Supreme Court

The US Supreme Court is likely to come out shortly with its ruling on same sex marriages. The ruling may have an impact on fundraising for private funds and other private placements.

One of the standards for private placements of securities is that the investors generally need to meet the definition of “accredited investors.” For individuals that means a (1) net worth, excluding the primary residence, of $1 million, or (2) annual income in excess of $200,000 in each of the two most recent years or joint income with a spouse in excess of $300,000.

That word “spouse” is the one being addressed by the Supreme Court.  Section 3 of the Defense of Marriage Act (DOMA) states that in determining the meaning of “any ruling, regulation, or interpretation of the various administrative bureaus and agencies of the United States,…the word ‘spouse’ refers only to a person of the opposite sex who is a husband or a wife.” (1 U.S.C. § 7 (1997)

William Carleton picked up on the wrinkle in Rule 506 that same-sex marriages were not treated equally for purposes of the accredited investor standard.

Here in my home state of Massachusetts, “spouse” is not limited to a man and a woman. In the landmark Goodridge decision that made same-sex marriage legal, the Massachusetts Supreme Judicial Court went through a laundry list of legal rights that couples enjoy once they are married. Those were rights not available not available to same-sex couples.

You can add the accredited investor standard to that big pile of legal rights.

The accredited investor concept was included in Regulation D “based on the presumption that accredited investors can fend for themselves without the protections afforded by registration.” I’m not sure how gender plays a role in determining the financial ability of a couple. But currently it does.

What happens if the Supreme Court strikes down the DOMA restriction? I assume the SEC will not do anything and let the term “spouse” sit in the definition. They have enough political landmines to deal with, I don’t see the SEC jumping out with a rulemaking embrace of same-sex marriage when it still has not yet removed the ban on general advertising or issued rules on crowdfunding.

That will leave it up to the issuers, the fund managers, the start-up companies, and their lawyers to wrestle with the definition of “spouse.” I expect a few intrepid offerings will get an extra investor or two. I expect many conservative issuers will wait for more guidance from the SEC.

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Steps to Determine if an Investor is Accredited

Private funds will be able to advertise and solicit for investor, provided all of the investors are “accredited investors.” The will dramatically change the way capital raising for private funds operates.

The drawback is the loss of 35 non-accredited investors in the fund. That exception has been eliminated. Funds will need to wait until the Securities and Exchange Commission issues the rules under Section 201 of the JOBS Act.

Part of those rules may be a mandated approach to determine if someone is an accredited investor.

“Such 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 SEC may take the opportunity to mandate an approach to validate an investor’s financial standing. As with most regulations, it could clear up uncertainty or create a paperwork headache (or both).

Will you need a copy of an investor’s W-2? A certified financial statement? Those are reasonable requests. However it would create much more personal information that would need to be safeguarded by the fund sponsor.

There is the possibility that the mandated approach would also address the requirements to determine if an investor is “qualified client” under the Investment Advisers Act or a “qualified purchaser” under the Investment Company Act.

We will have to wait and see what comes out of 100 F Street.

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Accredited Investors and the JOBS Act

The Jumpstart Our Business Startups Act repeals the SEC’s ban on general solicitation and advertising under Rule 506. That is the exemption from registration used by most private fund managers. Is this a good thing?

I didn’t like the ban, mostly because it was so broad. The SEC gave little guidance as to what was advertising in support of the company and what was advertisement in support of the sales of securities. I would have welcomed better guidance. Now it looks like private fund managers will be free to have late-night television ads, email campaigns, twitter accounts, and Facebook fan pages.

Section 201(a) gives the SEC 90 days to

“revise its rules issued in section 230.506 of title 17, Code of Federal Regulations, to provide that the prohibition against general solicitation or general advertising contained in section 230.502(c) of such title shall not apply to offers and sales of securities made pursuant to section 230.506, provided that all purchasers of the securities are accredited investors.”

At first, I thought the last proviso was extraneous. Rule 506 allows unlimited fundraising as long, but it’s limited to accredited investors. But that’s not right. Rule 506 allows up to 35 investors that are not accredited, as long as they are “sophisticated” – have sufficient “knowledge and experience in financial and business matters” to make them “capable of evaluating the merits and risks of the prospective investment”.

If a manager is going to advertise that it is fundraising, then it needs to ban those previously allowed 35, even if they are sophisticated. Money rules. You need $ 1 million, excluding your primary residence, or $200,000 in income, $300,000 income with your spouse. It doesn’t matter if you are sophisticated. Even though the Crowdfunding section of the JOBS Act is supposed to allow a broader range of capital sources, this part of the law cuts off access to non-accredited investors.

That means fund managers may have to cutoff  “friends and family” investors from the fund, unless they are accredited investors.

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The New Accredited Investor Standard

After thinking about it for almost year, the Securities and Exchange Commission has finalized the new definition of “accredited investor.” On January 25, 2011, the SEC proposed amendments to the accredited investor standards in the rules under the Securities Act of 1933 to implement the requirements of Section 413(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Section 413(a) of the Dodd-Frank Act required the SEC to adjust the accredited investor net worth standard that applies to natural persons individually, or jointly with their spouse, to “more than $1,000,000 . . . excluding the value of the primary residence.” Previously, this standard required a minimum net worth of more than $1,000,000, but permitted the primary residence to be included in calculating net worth. Under Section 413(a), the change to remove the value of the primary residence from the net worth calculation became effective upon enactment of the Dodd-Frank Act. This rule merely clarifies a few points.

Section 415 of Dodd-Frank requires the Comptroller General of the United States to conduct a “Study and Report on Accredited Investors” examining “the appropriate criteria for determining the financial thresholds or other criteria needed to qualify for accredited investor status and eligibility to invest in private funds.” The SEC lets us know that they may take a more thorough revision of the accredited investor standard after that report comes out in July 2013.

Under the rule, owning a home can only decrease your net worth. To the extent your mortgage debt is less than the fair market value of your house, you can’t include that equity in calculating net worth. To the extent your mortgage is in excess of the value of your house, the amount underwater is counted against net worth.

Just to really screw up things, the SEC requires certain mortgage refinancings to be counted against net worth. If the borrowing occurs in the 60 days preceding the purchase of securities in the exempt offering and is not in connection with the acquisition of the primary residence, the new increase in debt secured by the primary residence must be treated as a liability in the net worth calculation. This is intended to prevent manipulation of the net worth standard, by eliminating the ability of individuals to artificially inflate net worth under the new definition by borrowing against home equity shortly before participating in an exempt securities offering.

This new 60 day rule will be a pain in the neck. On the other hand, I saw some shady operators touting the ability to leverage up your home to get you over the threshold into accredited investor land. That scheme would seem to be targeted right at the vulnerable class of “house-poor”. Apparently state securities regulators were also concerned about advising investors to use equity in their home to purchase securities.

One of the other comments was that mortgage debt in excess of the home value should not count when the loan is non-recourse or the lender is prohibited by state law from collecting a shortfall after foreclosure. The SEC dismissed that idea as being too complicated and requiring a detailed legal analysis. They also counter with some data from a 2007 Federal Reserve Board Survey that suggests that the number of households nationwide that qualify as accredited investors is not affected by whether the net worth calculation includes or excludes the underwater portion of debt secured by the primary residence.

The rule ends up amending:

  • Rule 144(a)(3)(viii),
  • Rule 155(a),
  • Rule 215, and
  • Rule 501(a)(5) and 501(e)(1)(i) of Regulation D
  • Rule 500(a)(1)
  • Form D under the Securities Act;
  • Rule 17j-1(a)(8) under the Investment Company Act of 1940and
  • Rule 204A-1(e)(7) under the Investment Advisers Act of 1940

The rule is adopted with only a limited grandfather provision. The old accredited investor net worth test will apply to purchases of securities in accordance with a right to purchase such securities, only if

  1. the right was held by a person on July 20, 2010 (the day before the enactment of  Dodd-Frank)
  2. the person qualified as an accredited investor on the basis of net worth at the time the right was acquired and
  3. the person held securities of the same issuer, other than the right, on July 20, 2010.

Otherwise, the new rule goes into effect 60 days after it’s published in the Federal Register. That will the rule will be effective by the end of February 2012.

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