The Compliance and Disclosure Interpretations (C&DIs) on Verification of Accredited Investor Status

In 2007, the Securities and Exchange Commission (SEC) published Compliance and Disclosure Interpretations (C&DIs) on the Securities Act rules affecting prospective investors in private placement offerings. Although these guidance documents are non-binding, they usually serve as a reliable source of legal clarification. It is good to review from time to time and to keep apprised of the latest C&DIs that are released. For example, many private placement investors have questions about both the income and net worth tests required in Regulation D of the Securities Act, and this supplemental guidance spells out what investors should do in specific situations.

Under the Securities Act, Regulation D requires investors to be accredited in certain circumstances. For example, Rule 506(c) of Regulation D allows for general solicitation of private placement offerings while requiring investors in these offerings to be accredited investors. Rule 501 of Regulation D defines the term “accredited investor” and defines income and net worth tests that investors should meet in order to become accredited investors.

To pass the income test for accredited investor status, an investor must be “a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.” This means that for each of the past two years, as well as the current year, a natural person must consider their individual income and, if married, their joint income with their spouse.

In the event the individual’s marital status changes, they must meet the individual income test during the unmarried year(s) and the joint income test during the married year(s). When it comes to proof of income, it may come from tax returns, W-2, K-1, 1099, and other government documents. In addition, if annual income was not reported in U.S. dollars, then an individual or a couple may use the average exchange rate for that year or the exchange rate in effect on the last day of that year. It’s important to know that the C&DIs also provide insight on specific tax documents and how they apply to an individual or couple.

The Net Worth Test for Accredited Investors

To fulfill the net worth test as an accredited investor, an individual needs a net worth over $1 million, either alone or together with a spouse, including all liabilities, exceeding the value of their primary residence, as well as those incurred on the primary residence within the last 60 days. However, an individual or a couple may not count the value of this residence toward their net worth to obtain accredited investor status.

An individual or a couple may use a consumer credit report as evidence of their liabilities. Evidence of assets may include bank statements, certificates of deposit, tax assessments and appraisal reports, as well as brokerage statements and other statements of securities holdings. It is important to note that documentation generally should NOT exceed the 90-day time limit. Furthermore, to include company assets, an investor must show the value of ownership of that company which may require evidence of the company's value or assets.

Key C&DIs Excerpts for Investors Seeking Accreditation Status

We believe the following excerpts will prove to be of great value to prospective investors and educate them about the income, net worth, and marital concerns that we discussed in this blog post. You may review the Q&A section below with additional details:

“Question: may a natural person satisfy the test for the requisite three-year period by satisfying either the individual income test or the joint income test in each of the three years and neither of the tests in all three years?

“Answer: If the person has had the same marital status for all three years, then no. A natural person must satisfy Rule 501(a)(6) based on that person’s satisfying the $200,000 individual income test for all three years or the $300,000 joint income test with that person’s spouse for all three years. If a person has been married for some but not all of the three years, however, he or she may satisfy the rule on the basis of the joint income test for the years during which the person was married and on the basis of the individual income test for the other years.

“Question: If a purchaser's annual income is not reported in U.S. dollars, what exchange rate should an issuer use to determine whether the purchaser's income meets the income test for qualifying as an accredited investor?

“Answer: The issuer may use either the exchange rate that is in effect on the last day of the year for which income is being determined or the average exchange rate for that year.

“Question: Rule 506(c)(2)(ii)(A) sets forth a non-exclusive method of verifying that a purchaser is an accredited investor by, among other things, reviewing any Internal Revenue Service form that reports the purchaser's income for the "two most recent years." If such an Internal Revenue Service form is not yet available for the recently completed year (e.g., 2013), can the issuer still rely on this verification method by reviewing the Internal Revenue Service forms for the two prior years that are available?

“Answer: No, the verification safe harbor provided in Rule 506(c)(2)(ii)(A) would not be available under these circumstances. We believe, however, that an issuer could reasonably conclude that a purchaser is an accredited investor and satisfy the verification requirement of Rule 506(c) under the principles-based verification method by:

• Reviewing the Internal Revenue Service forms that report income for the two years preceding the recently completed year; and

• Obtaining written representations from the purchaser that (i) an Internal Revenue Service form that reports the purchaser's income for the recently completed year is not available, (ii) specify the amount of income the purchaser received for the recently completed year and that such amount reached the level needed to qualify as an accredited investor, and (iii) the purchaser has a reasonable expectation of reaching the requisite income level for the current year.

“Where the issuer has reason to question the purchaser's claim to be an accredited investor after reviewing these documents, it must take additional verification measures in order to establish that it has taken reasonable steps to verify that the purchaser is an accredited investor. For example, if, based on this review, the purchaser's income for the most recently completed year barely exceeded the threshold required, the foregoing procedures might not constitute sufficient verification and more diligence might be necessary.”

Using Due Diligence to Verify Accredited Investor Status

Rule 506(c) of Regulation D expands capital-raising and investment opportunities for many, and capital raisers must take “reasonable steps” to verify a person’s accredited investor status. As a third party, VerifyInvestor.com facilitates this process for both accredited investors and capital raisers.

To benefit from all the advantages of accredited investor status and legally conduct a Rule 506(c) offering, sign up for VerifyInvestor.com’s accredited investor verification service today.