On March 4, 2020, the Securities and Exchange Commission (“SEC”) announced the publication of a proposed rule (the “Proposed Rule”) containing a patchwork of rule amendments designed to harmonize, simplify, and improve the SEC’s exempt securities offering framework. The proposals are the most recent step in the SEC’s ongoing efforts to assess the capital raising framework as a whole and improve it for the benefit of investors, entrepreneurs, and more seasoned issuers. We previously discussed the SEC’s efforts in this regard in a 2019 Client Alert and subsequently submitted a comment letter to the SEC on isolated issues within its 2019 concept release.
The Proposed Rule issued in March, which had a comment deadline of June 1, 2020, and has largely been overshadowed by regulatory action in response to COVID-19, touches on a wide variety of issues in the SEC exempt offering framework, including:
- Offering integration, including establishing a general principle of integration and four non-exclusive safe harbors;
- General solicitation and offering communications;
- Harmonization of disclosure requirements;
- Offering and investment limits under Regulation A, Regulation Crowdfunding, and Rule 504 of Regulation D;
- Regulation Crowdfunding and Regulation A eligibility; and
- Bad Actor disqualification provisions.
While each of the above topics merits its own consideration for those interested, the focus of this Alert is on the Rule 506(c) verification requirements that are discussed in the Proposed Rule. Rule 506(c) of Regulation D was established in 2013 to implement Section 201(a) of the JOBS Act. Rule 506(c) provides an exemption without any limitation on offering amount pursuant to which offers may be made through general solicitation or general advertising, so long as the purchasers in the offering are limited to accredited investors and the issuer takes reasonable steps to verify their accredited investor status. Rule 506(b) and 506(c) are particularly important provisions of the exempt offering framework, as the SEC estimates that in 2019 approximately 57% of the $2.7 trillion raised in exempt offerings was raised using Rule 506. While some expected that the ability to use general solicitation and advertisement in Rule 506(c) offerings would perhaps result in that exemption surpassing the utilization rate of Rule 506(b), the SEC still estimates that more than 22x the capital was raised in Rule 506(b) offerings as in Rule 506(c) offerings during 2019.
It is this author’s opinion that the primary reason for the continued high utilization rate of Rule 506(b) over Rule 506(c) is due to the requirement in Rule 506(c) that issuers must take “reasonable steps to verify” that all investors in the offering are accredited investors. In the Proposed Rule, the SEC took steps intended to reassure the market that this verification requirement is not intended, in certain circumstances, to be significantly more burdensome than Rule 506(b)’s “reasonable belief” standard, including by expressly stating so. First, the SEC added an additional safe-harbor under Rule 506(c) where an issuer will be deemed to have taken reasonable steps to verify an investor’s status as an “accredited investor.” Under this new verification method, so long as the issuer previously took reasonable steps to verify an investor’s status as an “accredited investor” under Rule 506(c)(2)(ii) and the issuer is not aware of information to the contrary, the issuer can verify such status by simply obtaining a written representation from such person at the time of sale that he or she qualifies as an accredited investor. While this safe-harbor verification method may be useful in certain circumstances, it still requires that the issuer will have previously taken “steps to verify,” which is not helpful for reducing regulatory burden with respect to new investors solicited through general solicitation.
The second step the SEC took in the Proposed Rule release was reminding issuers and other market participants that Rule 506(c) provides a “principles-based method” for verification of accredited investor status, as well as a non-exclusive, non-mandatory list of verification methods for determining that a natural person who purchases securities in such an offering is an accredited investor. In other words, none of the delineated verification methods for natural persons are required. One of the methods is only required if the issuer wants to be deemed to have taken reasonable steps to verify a particular purchaser’s status as accredited. The SEC went on to state that the following factors are among those an issuer should consider when using the principles-based method of verification:
- The nature of the purchaser and the type of accredited investor that the purchaser claims to be;
- The amount and type of information that the issuer has about the purchaser; and
- The nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount.
In a footnote to these factors, the SEC cited language it had previously included in the Rule 506(c) adopting release (and which we cited in our 2019 comment letter to the SEC). That language states:
After consideration of the facts and circumstances of the purchaser and of the transaction, the more likely it appears that a purchaser qualifies as an accredited investor, the fewer steps the issuer would have to take to verify accredited investor status, and vice versa. For example, if the terms of the offering require a high minimum investment amount and a purchaser is able to meet those terms, then the likelihood of that purchaser satisfying the definition of accredited investor may be sufficiently high such that, absent any facts that indicate that the purchaser is not an accredited investor, it may be reasonable for the issuer to take fewer steps to verify or, in certain cases, no additional steps to verify accredited investor status other than to confirm that the purchaser’s cash investment is not being financed by a third party. (emphasis added).
While this non-binding language is helpful with respect to the SEC’s view on these matters, it does not have the utility to issuers and their counsel as a safe-harbor verification method based on minimum investment amount would have had (which is what we proposed in our comment letter). The SEC does solicit additional feedback in the Proposed Rule on the verification requirements in Rule 506(c), and it will be interesting to see if additional concrete steps are taken. Absent additional action from the SEC, it is unlikely that the SEC’s aforementioned steps in the Proposed Rule will increase the utilization rate of Rule 506(c) of Regulation D.
 The Federal Register version of the Proposed Rule can be accessed here (last accessed June 2, 2020).
 While Rule 506(b) (unlike 506(c)) does permit up to 35 purchasers that are non-accredited investors, it does not appear that this distinguishing characteristic is what makes Rule 506(b) so popular. For example, in the Proposed Rule, the SEC noted that it estimated that in 2019, among all Rule 506(b) offerings by issuers other than pooled investment funds, less than 5% of those offerings included non-accredited investors.
 Rule 506(b)(2)(i) requires that there must not be or the issuer must reasonably believe that there are not more than 35 purchasers of securities in the offering. In calculating the number of purchasers, any “accredited investor” is excluded from the purchaser count under Rule 506(b). See, 17 C.F.R. § 230.501(e). An “accredited investor” is any person who comes within, or who the issuer reasonably believes comes within, any of the delineated categories in Rule 501(a). It is worth noting that even if an issuer has taken no steps to establish a “reasonable belief” regarding accredited investor status under Rule 506(b), the exemption is not lost if the investor actually meets the definition of accredited investor at the time of sale.
Stuart M. Rigot is a member of the Capital Markets, Banking & Financial Institutions, and Mergers & Acquisitions practice groups of Wyrick Robbins. He regularly represents public and private companies in strategic combinations and financing transactions, with a particular emphasis on the financial services industry. Wyrick Robbins publishes Client Alerts periodically as a service to clients and friends. The purpose of this Client Alert is to provide general information, and it is not intended to provide, and should not be relied upon as, legal advice.