Understanding the Consequences of Non-Compliance with Rule 506(c) Accredited Investor Verification
VerifyInvestor.com
For any startup or new business, raising capital is essential. But that doesn’t mean it’s easy. It’s no secret that raising capital poses the biggest concern for small businesses and startups and is one of the most difficult aspects of getting any business off the ground.
Federal and state securities laws can complicate capital raising significantly for companies raising money through the offer and sale of securities. For example, while securities law exemptions like Rule 506(c) allow an issuer to offer and sell securities without having to register with the Securities and Exchange Commission (SEC), as we will discuss more fully below, there are serious consequences for noncompliance.
The Securities Laws and Capital Raise
Our examination of the consequences of Rule 506(c) noncompliance starts with the general rule that under the Securities Act of 1933 (“Securities Act”) unless an exemption exists, all public offerings of securities must be registered with the SEC.
Registration with the SEC can be cumbersome, difficult, expensive, and complicated — especially for smaller companies or startups. To ease this burden somewhat, after the passage of the Jumpstart Our Business Startups Act (JOBS Act) in 2012, the law was amended to carve out several exemptions from registration. The main exemptions, found in Rules 504, 505, Rule 506(b), and Rule 506(c), are in Regulation D (“Reg. D”) of the Securities Act. For this discussion, we will focus only on the Rule 506(c) exemption.
The Rule 506(c) Exemption.
Marketing
Rule 506(c) allows issuers to advertise and market their securities offerings to raise capital so long as:
Only accredited investors participate in the offering, and
The issuer takes “reasonable steps” to verify the accredited investor status of each investor, and
All other rules and regulations are complied with.
Central to the Rule 506(c) exemption is the definition of “accredited investor.” The definition has changed over time and continues to evolve, but essentially, the SEC’s definition of "accredited investor” focuses on financial status as an indicator of investor sophistication and ability to withstand investment losses.
Reasonable Steps
The exemption also requires issuers using the exemption to actively take “reasonable steps” to verify the accredited status of every single participant in the offering. While the SEC has not mandated specific steps, contending that it all depends on the facts and circumstances of each case, luckily, the law allows issuers to use third-party verification services. This can make the process more economical, reliable, and far less burdensome than trying to tackle it in-house. There are several ways investors can prove accredited status, but one way is by obtaining an accredited investor certificate.
While the law may not delineate exactly what steps an issuer must take to meet the law’s requirements, it is abundantly clear that to qualify for the Rule 506(c) exemption, issuers must “take reasonable steps to” verify the accredited status of every single investor who is participating in the 506(c) offering. The failure to verify the status of even one investor (as we will see below) can be fatal to the offering and can result in enforcement proceedings.
Advantages of Raising Capital with Rule 506(c)
The primary advantage issuers gain by using the 506(c) exemption is that they don’t have to register their securities with the SEC. This saves significant time and money. Another advantage is that an issuer can advertise a 506(c) offering, thereby reaching more investors. Further, so long as all of the law’s requirements are met, issuers can (theoretically) raise unlimited capital using this exemption.
Rule 506(c) Limitations
As with anything, Rule 506(c) has its limitations. In this instance, the main drawback is that for every single offering, issuers must actively take “reasonable steps” to verify that every single participant in a Rule 506(c) offering is an “accredited investor.” Importantly, verifying an investor for one Rule 506(c) offering will not cover that same investor for another offering. Every single time an issuer presents a 506(c) offering, the accredited investor status of every single investor must be verified for that offering.
This can be done manually — a long and cumbersome process — or it can be conducted by a third-party verification service. Verification services can save issuers time and money. Plus, reliable, safe, and secure third-party verification services offer peace of mind, as issuers can rest assured that their offering will fully comply with all securities laws.
The importance of complying with the law’s requirements as to verifying every single investor in a 506(c) offering cannot be understated. Below, we examine just one example of what can happen when an issuer inadvertently or otherwise fails to verify the accredited investor status of every single investor in a 506(c) offering.
The Consequences Rule 506(c) Non-compliance: SEC v. PIC Renegade Properties
A very good example of just how critical it is for issuers to fully comply with Rule 506(c)’s specifications is illustrated by SEC v. PIC Renegade Properties, LLC (“PIC”). In 2022, the SEC issued a cease-and-desist order against PIC for conducting the offer and sale of unregistered securities. Without admitting or denying the allegations, PIC ultimately entered into a settlement agreement with the SEC in which PIC agreed to pay $400,000 in penalties to resolve the violations.
At the time of the action, PIC was the general partner of a real estate fund. During the relevant time period, PIC raised over $54 million on behalf of the fund, through general solicitation on a website. The purpose of the capital raise was to acquire and renovate single-family homes for sale or rental. PIC filed a Form D with the SEC to indicate that it was relying on Reg. D’s Rule 506(c) exemption for the capital raise. However, according to the SEC, the exemption didn’t apply because the company failed to verify the accredited status of all investors. According to the SEC, PIC failed to verify the accredited investor status of more than two dozen investors and sold securities to four (4) non-accredited investors, one of which was a trust.
According to the SEC, among other things, PIC failed to take reasonable steps to verify all investors in that it:
had investors sign a form agreeing that they were accredited, and then simply relied on the investors checking a box indicating why they were accredited,
accepted investments even after receiving documents indicating that the investor(s) did not meet the required accreditation standards,
failed to consider the financial status of approximately 15 entity investors (companies, trusts, pension plans, and non-profit organizations), which had different accreditation criteria than individuals,
failed to obtain sufficient information to properly identify entities for the purposes of verifying accreditation, and
failed to provide proper training for its employees and failed to adopt written policies and procedures for verifying investors.
As a direct result of PIC’s failure to verify the accredited status of all investors, the company sold securities to at least four (4) unaccredited investors.
Finally, the SEC noted that in this case, the fund investments were risky and illiquid — making it all the more important that investors be accredited to prove that they were able to withstand the potentially significant losses.
As noted above, the company was fined $400,000 in civil penalties for its transgressions.
Verifying Investors is Critical.
As the PIC Renegade Properties, LLC case illustrates, it is critical for issuers to verify the accredited investor status of every single investor in a Rule 506(c) offering.
Accredited investor status protects both issuers and investors. Because private investments are typically expensive and high-risk investments, ensuring the accredited status of all investors means that both sides of the opportunity (i.e., investors and issuers) are protected by knowing that the investor has the financial means to withstand the risk of investment. Further, verifying investors is crucial because the law limits certain investment opportunities to accredited investors only. Thus, by verifying the accredited investor status of all investors, issuers can avoid compliance issues and enforcement actions from the SEC.
Rule 506(c) of Reg. D requires issuers to “take reasonable steps’ to verify the accredited investor status of each investor as a tradeoff for being able to advertise their 506(c) offering. Failing to comply with the Rule fully can have serious consequences. The 506(c) exemption tries to strike a balance between protecting investors and opening up capital raise opportunities for issuers by allowing them to advertise their securities. But the law’s mandates are strict. To qualify for the exemption, issuers must take reasonable steps to verify the accredited investor status of every single investor. VerifyInvestor.com makes verifying accredited investors easy, cost-effective, secure, and reliable. Our accredited investor verification services, (we also offer qualified purchaser and qualified client verification, along with AML/KYC), are always code-compliant and confidential. We help companies fully and easily comply with their legal obligations to verify accredited investors.