Securities and Exchange Commission (“SEC”) rule amendments go live today that aim to simultaneously harmonize the exempt offering framework while reducing complexities faced by investors and businesses in complying with their obligations when accessing investment opportunities or capital. Here are our key takeaways for the 506(c) landscape:
- The new rules allow an issuer relying on Rule 506(c) to rely on its previously conducted “reasonable steps” verification of an investor during a subsequent securities sale for up to five years.
- It is unclear how these new rules affect platforms that host multiple issuers - while the spirit of the rule would lead to the conclusion that a platform can apply the five-year lookback across its investor base, the language of the rule does not appear to allow one issuer to rely on the reasonable steps verification undertaken by a different issuer (even if on the same platform).
- Compliance departments across platforms can reasonably come to different conclusions regarding their obligations under this new paradigm. A great deal is at stake as a platform that does not adequately comply with its 506(c) reasonable steps verification requirements could inadvertently cost an issuer its exemption from registration, which will have severe consequences.
Summary Changes - Non-506(c)
The primary changes made by the amendments include (i) simplifying the integration doctrine for determining when multiple offerings are considered to be a part of the same raise, (ii) enhancing an issuer’s ability to generally solicit for a raise prior to determining which exemption it will rely upon and (iii) increasing the maximum offering amounts under both Regulation CF ($5 million in a 12-month period) and Regulation A ($75 million in a 12-month period, including up to $22.5 million in secondary sales by affiliates of the issuer).
These amendments are all welcome changes that promise to increase access to private investment opportunities for both accredited and non-accredited investors while preserving the ability for the SEC to effectively protect investors. Issuers are increasingly availing themselves of close-in-time offerings, and the general integration framework provides much-needed clarity in enabling those issuers to comply with their regulatory obligations. In addition, by permitting issuers to gauge interest in an offering prior to determining an applicable exemption, issuers will be able to tailor their offering to better suit the investor base interested in investing. Finally, while Regulation CF and Regulation A remain relatively small in terms of dollars raised (~$1 billion raised in 2019 combined, compared with ~$1.5 trillion raised under Regulation D), they do remain the primary exemptions through which non-accredited investors are able to access private market securities. Increasing offering limits provides an elegant route to enhance opportunities for non-accredited investors while maintaining robust investor protections in the form of increased disclosure.
Rule 506(c) Verification Requirements
One of the most important amendments for our clients involves the new five-year look back for a reasonable steps accreditation verification and its somewhat ambiguous application to platforms. Rule 506(c) under Regulation D is a deviation from the traditional private placement exemption that requires issuers to raise capital only from investors with whom it (or its agent) maintains a pre-existing and substantive relationship. Rule 506(c) offerings broaden the reach of a potential raise by allowing the issuer to generally solicit and advertise an offering to the public while remaining exempt from the standard registration and disclosure requirements under the Securities Act of 1933. However, in exchange for this broader potential reach, the issuer is obligated to undertake reasonable steps to confirm that each investor participating in the offering is, in fact, an accredited investor.
In conjunction with the adoption of Rule 506(c), the SEC provided a list of non-exclusive list of verification methods issuers may use when seeking to satisfy the verification requirement with respect to natural person purchasers - these include reviewing tax documentation for the prior two years to confirm the investor meets the income test, reviewing bank and brokerage statements plus a credit report to confirm the investor meets the net worth test or obtaining a verification letter from an approved third-party evaluator attesting as to the investor’s accreditation status. The issuer is required to verify the investor’s accreditation status at the time of investment, and the verification rules require all documentation reviewed in making that determination to be dated within the previous 90 days.
In practice, these rules meant that an issuer would have to re-verify an investor making a new investment in the same company if the new investment was more than 90 days past the date of the last verification. This adds substantial friction to the investing process as it increases the cost of compliance and raises serious privacy concerns for investors forced to provide sensitive information to the same issuer. In addition, these re-verifications are arguably unnecessary from an investor protection perspective given the enhanced relationship with the investor after the first reasonable steps verification.
In light of these concerns, the SEC is adopting a new amendment that adds an additional item to the non-exclusive list of verification methods to satisfy the verification requirement for repeat investors.
Under the new rules, an issuer may rely on its previous “reasonable steps” verification of a particular investor so long as that investor provides the issuer with a written representation that they continue to qualify as an accredited investor and the issuer is not aware of information to the contrary. The written representation under this method of verification is acceptable so long as it is within five years from the date the person was previously verified as an accredited investor.
How Will These Changes Affect the Ecosystem?
This new rule clearly and substantially reduces the compliance burden for issuers interacting with the same investor base. By permitting a simple representation rather than a full re-verification, the new rule balances pragmatic compliance hurdles, investor privacy and investor protection. In addition, while 506(c) platforms are growing at a rapid rate, this promise to lower compliance hurdles going forward may incent more traditional 506(b) shops to explore the possibilities under this new offering framework.
An unanswered question under this new paradigm is how the new rule affects 506(c) platforms that host deals. These platforms maintain relationships with thousands of accredited investors, but oftentimes each deal involves a brand-new issuer.
Will the new issuer be permitted to leverage the reasonable steps accreditation verification completed on the same platform but for a different issuer?
The logical answer here under the spirit of the new rule is that the platform ought to be able to apply the five-year look-back for accreditation verifications across issuers. It is the platform that maintains a relationship with the investor base, and the issuer comes to the platform specifically to leverage that platform’s relationships. However, the language of the new rule speaks directly to the issuer, and it simply does not provide an avenue for one issuer to rely on the reasonable steps taken by a different issuer. This conflict between spirit of the rule change and the language formally adopted is one that must be navigated carefully by each platform’s compliance department.
Parallel Markets is built around the idea that technology can dramatically reduce the amount of time and friction involved in investor onboarding. Broadly speaking, these rules align with our overall vision to simplify the hurdles investors and issuers face in interacting with one another on the private markets.
There remain open questions regarding how the changes to Rule 506(c) filter through the ecosystem. We think compliance departments across our platform network can reasonably come to different conclusions about their obligations under this new paradigm. Parallel Markets is consulting experts in the field and eagerly awaiting SEC guidance clarifying these issues. To the extent you or your legal team would like to chat through the implications of these rule changes, please do not hesitate to reach out to us at firstname.lastname@example.org.