Reasonable Steps to Verify Accredited Investor Status

Joseph W. Bartlett, Special Counsel, McCarter & English, LLP

The following discussion fleshes out a checklist of 'safe harbors' when the issuer and its counsel are faced with a requirement that they take "reasonable steps to verify" accredited investor status. The pending SEC Regulations on the JOBS Act, Title II may list a safe harbor or two; but, if so, the same are not likely to be exclusive. Hence, my personal contribution.

The list is designed as guidance ("Guidance") for practitioners; it is not either a formal or informal legal opinion and it is a work-in-progress in the sense that it can and will be amended when, as and if we are educated by precedents … court decisions, No-Action letters, regulations and rules from a government agency, including State Securities Commissioners the SEC Staff and FINRA plus opinions from other commentators experienced in the sector. Pending such precedents, and in view of the apparent need, the hope (there is no guarantee, of course) is that the Guidance will attract enough of a consensus in the marketplace that it will protect those parties which adopt the same as the current canon against penalties for allegedly willful, reckless, grossly negligent, i.e., actionable, violations of the Securities laws. The idea is that, given adherence to the Guidance in the event of complaints based on the allegation that one of the investors in a 506(c) offering was not in in fact accredited, [1] the trier of fact will conclude that defendant issuer … compliant with one or more of the steps in the Guidance in fact acted reasonably,a test which is necessarily defined by common sense.

The underlying thesis of the Guidance vis-à-vis "reasonable steps" can be encapsulated in the slang phrase: "if it looks like a duck, walks like a duck and quacks like a duck … it's a duck." The premise is that there could be a number of safe harbors which meet that test. The absence of any one or more does not mean, according to the principle of conspicuous omission, that "reasonable steps" have not been taken; any one of the safe harbors (absent a red flag to the contrary, of course) is sufficient, as per the Guidance, to insulate the issuer from attack by a private or public accusers. And, the list itself is not exclusive; clearly, other fact situations can and will prove to be safe harbors based on the overriding principle that common sense controls when the qualifier "reasonable" is enshrined in the language of the statute or rule. Many roads, in short, lead to Rome. I expect that the list can be expanded sequentially since the critical objective is to reduce, to the extent possible, the frictional costs imposed on small business financings in aid of the objective of the JOBS Act … to foster job creation through such financings rather than to narrow the incidence of emerging growth companies successfully soliciting capital infusions.

The second premise is that, while self certification is not, of and by itself, a safe harbor in 506(c) (versus the universal practice of 506(b) offerings), investors claiming accredited status will initially be required to fill out a questionnaire. For purposes of the Guidance, the questionnaire is substantially more extensive than often seen in the "quiet 506" offerings. [2] A sample questionnaire, long version, is attached. As circumstance vary, the questions of course, can vary but one item is strongly recommended … namely that the questionnaire be headed by a reminder in capital letters (in order to attract attention of the investor) to the effect that filing a false statement with an agency of the Federal government is a crime under 18 U.S.C. 1001 and that the questionnaires will be maintained by the issuers in a file which is available for inspection by the appropriate Federal agency. The common sense idea, of course, is to impress upon any and all investors the seriousness of the answers they are asked to give.

Herewith a checklist of the safe harbors established by the Guidance, together with discussion accompanying each; the list assumes the investor has self-certified and filled out the questionnaire. The test is whether, as a matter of common sense, his or her word should be believed.

  1. Personal knowledge. If the investor candidate ("Candidate") is personally known to an individual who is affiliated with the issuer … a Board member, an employee or a member of the issuer's advisory team … and that personal knowledge is such that the issuer's affiliate can form a judgment based on knowledge and experience with and of the Candidate which extends to the Candidate's financial situation, Safe Harbor No. 1 is satisfied. It is not necessary that the knowledge be based on documentary evidence. The test again is one of common sense. Is the Candidate well known enough that common sense dictates acceptance of the self certification as written? Any number of items will enable the Candidate to pass the common sense test … that, for example, the Candidate's life style is such that failure to pass the test would be extraordinary. Based on common knowledge, if Warren Buffett is the Candidate, the inquiry need go no further.

  2. Size of the minimum investment. $25,000 should be more than enough to qualify under the common sense test.

  3. Prior experience in private investments. If, for example, the individual has been an investor in some number (3 or more) investments roughly equivalent to the instant case, the common sense test is satisfied.

  4. SEC Edgar filings on compensation. This is a "you can look it up" safe harbor.

  5. Other information available online (with minimum effort) … profiling the individual for, e.g., zip code: employer, employment history, education. If enough data falls into line, a safe harbor.

  6. References. The Guidance suggests that the questionnaire ask for references: who would have the type of personal knowledge that is discussed in Safe Harbor No. 1? The questionnaire then contains a clause, to be signed by the Candidate, expressly permitting the issuer and its affiliates to send an email query to one or more of the references for attestation purposes. The form of the query will be attached to the questionnaire and the email address of each reference for purposes of forwarding the query is to be provided by the Candidate, all in order to minimize expense.

  7. Processing by an agency supervised by the SEC. If a registered investment adviser or a broker-dealer has processed the "reasonable steps" inquiry, the issuer can rely on the word, if you will, of the processor. This is consistent with the SEC Staff's suggestion that SEC licensed organizations … broker dealers … will take the inquiry seriously.

  8. Professional attestation. Additional attestation resources will include lawyers and law firms; accounting firms; insurance brokers; certified financial planners; banks. The responses may, of course, be qualified but the fact that none are negative should be enough.

  9. Employer attestation, yes or no, on annual compensation.

  10. Investor volunteered information. Since no one size fits all, investors are encouraged to include any information, plus internet links, which constitute information which passes the common sense test for reasonableness … unless, of course, it is entirely insufficient.
  11. Super Platform information, sourced from Platform-affiliated brokers. See link to an article on Super Platforms

Investor Suitability Questionnaire

March 2013

[1] The practice of private organizations posting online opinions on legal issues is growing apace, presumably in response to the need of entrepreneurs raising or assisting in raising private capital for protection in fact situations where regulatory guidance from an understaffed and overburdened SEC is inadequate or non existent. See, for example, the K&L Gates legal opinion to AngelList, published on the AngelList site and attracting growing interest as the last word on several interpretative jump balls. As my former colleague, Ed Fleischman, once a member of the SEC, would say, the Agency often "regulates by opinion." See also the opinions of Skadden Arps and others which SecondMarket has collected and published on its website.

[2] "Quiet 506:: A Study In Irony,"

Joseph W. Bartlett, Special Counsel,

Full Biography

McCarter & English, LLP

McCarter & English, LLP is a firm of over 400 lawyers with offices in Boston, Hartford, Stamford, New York City, Newark, Philadelphia and Wilmington. In continuous business for more than 160 years, we are among the oldest and largest law firms in America.

Clients come first at McCarter & English. Their goals and priorities are what count. Our job is to listen to our clients, stay on top of the frequent changes that can affect their goals, and implement the strategies that will lead to success. Applying this approach effectively and consistently requires dedication and constant attention to many details. This client-centered philosophy has served our clients well and is responsible for our success and stability.

We are honored to be the chosen law firm of clients ranging from Fortune 100 companies to mid-market and emerging growth companies to individual people. When our clients do great things, we are pleased to get the assist.

Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances, and reflects personal views of the authors and not necessarily those of their firm or any of its clients. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from Joseph W. Bartlett. This work reflects the law at the time of writing.