SIFMA Issues Guidance on Rule 506(c) Verification

On June 23, 2014, the Securities Industry and Financial Markets Association (“SIFMA”) issued a memorandum (the “Memorandum”) containing guidance for broker-dealers and investment advisers with respect to verifying the status of purchasers as accredited investors in connection with offerings made pursuant to Rule 506(c) (Reg D offerings utilizing general solicitation, as we have previously blogged about).

Pursuant to Rule 506(c), an issuer utilizing general solicitation for a Reg D offering must, among other things, take reasonable steps to verify that purchasers in the offering are accredited investors. The reasonable verification requirement is a separate condition from the condition that all purchasers in a Rule 506(c) offering must be accredited investors, and the requirement has generated significant commentary.

The Rule 506(c) adopting release provided four non-exclusive safe harbor methods that an issuer can utilize for such reasonable verification, two of which require the issuer to obtain detailed financial information from a purchaser. An issuer may also rely on the written confirmation of a purchaser’s accredited investor status issued by a registered broker-dealer or investment adviser, licensed attorney or certified public accountant. Any such third party must, however, take reasonable steps to verify the purchaser’s accredited investor status before providing written confirmation to the issuer.

To this end, the Memorandum provides two verification methods for broker-dealers and investment advisers to use in verifying natural persons as accredited investors that SIFMA believes satisfies the “reasonable verification” requirement.

One verification method (the “account balance method”) is essentially a determination by the broker-dealer or investment adviser of the purchaser’s net worth. For a broker-dealer or investment adviser to utilize the account balance method, a purchaser must have been a client of the broker-dealer or investment adviser for at least six months, must have (either individually or together with a spouse, if applicable) at least $2 million in cash and marketable securities in the purchaser’s account prior to making the investment in the Rule 506(c) offering, must make certain representations (pursuant to purchaser representations provided by SIFMA as part of the Memorandum) regarding, among other things, the purchaser’s indebtedness, and the broker-dealer or investment adviser must be unaware of any facts to indicate that the client is not an accredited investor.

The other method (the “investment amount method”) uses the purchaser’s investment amount as a proxy for the purchaser’s status as an accredited investor. For a broker-dealer or investment adviser to utilize the investment amount method, a purchaser must have been a client of the broker-dealer or investment adviser for at least six months, must invest, or unconditionally commit to fund, at least $250,000 in a Rule 506(c) offering, which commitment is callable in whole at any time, must make certain representations (pursuant to purchaser representations provided by SIFMA as part of the Memorandum) including, among other things, that the investment in the Rule 506(c) offering is less than 25% of the purchaser’s net worth (either individually or together with a spouse), and the broker-dealer or investment adviser must be unaware of any facts to indicate that the client is not an accredited investor and, in the case of a commitment, the broker-dealer or investment adviser has knowledge that the purchaser has fulfilled a call under a prior commitment.

The Memorandum also provides a method for broker-dealers and investment advisers to use in verifying legal entities (i.e., corporations, LLCs, etc.) as accredited investors. For a broker-dealer or investment adviser to utilize this method, a purchaser-entity must be named on the broker-dealer’s or investment adviser’s current list of clients that qualify as “institutional accounts” as defined in FINRA Rule 4512(c)(3)or as Qualified Institutional Buyers (which are required to have investible assets of at least $100 million), or the purchaser-entity must make an investment in the Rule 506(c) offering in excess of $5 million and must provide a written representation that it was not formed for the purpose of making that investment and that it has made at least one prior investment in securities (whether in a primary offering or in the secondary market).

If issuers begin to use Rule 506(c) offerings with increasing frequency, SIFMA’s guidance in the Memorandum may be an important guidepost for broker-dealers and investment advisers and other third parties (e.g., attorneys and accountants) in assisting issuers to comply with the “reasonable verification” requirement set forth in Rule 506(c). This guidance may also be useful to issuers and other market participants.

Take Care When Using Finders

With good reason, many securities lawyers, myself included, cringe when they hear that a business client has engaged a “consultant” or “finder” to help raise capital rather than a registered broker.  Under Section 15(a) of the Securities Exchange Act of 1934, as amended, with some limited exceptions, it is unlawful for any person to effect any transactions in, or induce or attempt to induce the purchase or sale of, any securities unless the person is registered as a broker or dealer under the Exchange Act or associated with a registered broker or dealer.  What activities will require a person to register?  Even the SEC admits in its guidance on registering as a broker or dealer that it is not always easy tell.  However, one clear indicator that a person is probably acting as a broker or dealer is the person’s receipt of transaction-based compensation, such as a percentage of invested capital.    

The SEC recently announced that it had charged William M. Stephens with soliciting investments for two related investment funds while not registered as a broker under the Exchange Act.  As described in the Cease-and-Desist Order, with respect to investors introduced by Mr. Stephens, Mr. Stephens was to be paid one percent of amounts investors committed to invest.  In addition, Mr. Stephens provided various investment materials to prospective investors, such as private placement memoranda and subscription documents.   

Why should a company raising capital care if a consultant or finder is acting as an unregistered broker?  The involvement of an unregistered broker could give investors a right of rescission, that is, the right to require the company to buy back the securities the investor purchased at the original purchase price.  Obviously, the consequences of having to repurchase a large number of securities could be catastrophic as they were for Neogenix Oncology, Inc.  As detailed in a surprisingly frank series of letters  from Neogenix’s management to shareholders and Neogenix’s SEC filings, Neogenix’s use of unregistered finders to secure investments gave rise to up to $31 million of potential rescission liabilities.  These potential liabilities, and their impact on Neogenix’s ability to raise additional capital, ultimately contributed to  Neogenix’s decision to file for bankruptcy.