VERIFYING ACCREDITED INVESTOR STATUS
COASTLINE CAPITAL FUND MANAGEMENT
In order to invest in a private placement offering, the Sponsor needs to verify the status of an Investor. The SEC provides definitions for individuals and entities that are considered Accredited Investors. These definitions are described in Rule 501 of Regulation D. You can see the definitions here and here:
If the offering is issued under a Regulation D, Rule 506(b) exemption, it may accept a maximum of 100 Investors, 35 of which may be “sophisticated” but unaccredited Investors. The remaining 65 Investors must be accredited according to the SEC’s definitions. For the 506(b), the Sponsor relies on the Investor to self-identify as accredited or unaccredited. Typically, the Subscription Agreement (or a “Suitability Questionnaire”) will have a section that requires the potential investor to check the categories that describe their accredited or unaccredited but “sophisticated investor” status and what part of the definition they are using for this. The potential Investor is clearly and unambiguously indicating their status and signing their name to confirm it. If the potential Investor is accepted by the Sponsor, invests in the offering, becomes dissatisfied for some reason, this person should not be able to use their accredited or unaccredited status as a defense or source of complaint.
One of the drawbacks of the 506(b) offering is that the sponsor is not allowed to use general solicitation. He or she can only offer the securities to someone with whom he or she has a pre-existing relationship. The 506(c) offering changed that and allows general solicitation. However, the SEC required that only Accredited Investors could invest in a 506(c) offering AND the Sponsor had to take “reasonable steps” to verify the Investor’s status. “Reasonable steps” is a vague phrase and open to interpretation. Fortunately, the SEC provided “safe harbor” methods to prove accredited status. If a Sponsor can show evidence using one of these methods, he or she is deemed to have taken “reasonable steps” to determine an investor’s status. If a Sponsor doesn’t use a “safe harbor” method, he or she should be ready to articulate what “reasonable steps” were taken to verify an investor’s status. (An example would be a lengthy business relationship with the Sponsor and the potential Investor where the Sponsor had detailed knowledge of the Investor’s business, wealth, or income.)
Three Methods to Determine Accredited Investor Status
Third Party Verification – I list this one first even though the SEC lists it last because it’s the easiest one for the Sponsor and also for the Investor. For the Sponsor, it shifts the burden and risk to a 3rd party professional or verification service. For the Investor, he or she doesn’t need to disclose certain specifics about their income or net worth. The Investor can also use the same source to verify their status for different Private Placement Memorandums instead of navigating the different forms and requirements of each Sponsor.
With this method, a 3rd party verifies that the Investor is an Accredited Investor. The SEC specifically mentions broker dealers, registered investment advisors, attorneys, and certified public accountants. “Safe harbor” evidence is a letter written and signed by one of the above-mentioned professionals. The SEC does not get into specifics about what the letter needs to look like and does not have a general form for this purpose. It’s up to the professional to write the letter and the Sponsor to approve the letter.
As a Sponsor, I would want this letter to include the professional’s license number, state of issue, and statement certifying current and valid status. I would also want them to indicate the method with which they determined the investor’s accredited status (2nd and 3rd method, income and net worth).I don’t think that this letter needs to be fancy as long as it contains this information and is signed. I think it could also be a simple form that the professional fills out and signs. We have a simple form that an Investor can give to their professional of choice, which would take just a couple of minutes to complete. We feel that this can be a stumbling block for some Investors since their professional may not have the time or inclination to draft such a letter. A simple form makes it a lot easier for people to say “yes.” (Disclaimer: I am not an attorney and do not have experience dealing with the SEC on this issue. I’m sharing what we do and our interpretation and any reader is cautioned to seek his or her own legal counsel for advice.)
Another option is to use online 3rd party accredited investor companies. These will provide a letter for a fee. The advantage to the Investor is that he or she won’t have to engage one of their financial professionals to provide the verification letter. The burden, risk, and time can be transferred to the third party. The Investor may want to keep their involvement in the Private Placement Offering private. For the Sponsor, it makes things even easier since he or she merely accepts the letter as evidence.
A quick google search will come back with a lot of options. I don’t recommend any specific service but provide the following for information purposes only:
Income Test – For this and the third method, the Investor will need to provide two things: 1) Documentary evidence of income and 2) Signed statements to the Sponsor to verify income. Individuals need to show income that exceeded $200,000 (or $300,000 together with a spouse) in each of the two previous years and sign a statement indicating a reasonable expectation to earn the same in the current year.
The Investor can show W-2’s, 1099’s, and paystubs to satisfy the documentary part of the test.
The SEC does not provide any forms or templates for the statement part of the test. I’ve come up with a simple form that I believe satisfies this part of the test and makes it easier for Investors and Sponsors to comply. For our Offerings, we use this test if an Investor opts for the Income Test method.
Click here to download form.
Net Worth Test – For the Net Worth Test, the Investor will need to provide three things: 1) Documentary evidence in the form of bank statements, brokerage statements, 3rd party appraisals or BPOs, loan statements, and any other pertinent documents to calculate net worth, 2) A Credit Report from a reputable credit reporting company showing liabilities, and 3) A Signed Statement indicating that the Investor has no undisclosed liabilities. Individuals (with or without a spouse) need to show a net worth exceeding $1 million, excluding the value of the primary residence. (It gets a little tricky, though, if the home is underwater or if there was any mortgage debt incurred in the last 60 days. Both count against the Investor and decrease net worth. See the SEC’s website for more detailed info.)
Again, the SEC does not provide any forms or templates to help or guide Investors or Sponsors that wish to use this test to prove Accredited Investor status. I came up with a form that was inspired from the example that the SEC used on its own website. I added in the statement that the Investor disclosed all liabilities. I believe that this should be sufficient to satisfy the SEC for the “safe harbor” requirement of “reasonable steps.” For the Net Worth Test. Again, I am not a securities attorney so seek your own legal counsel. I’ve provided a copy of what we use for our Investors for your information only. Click here for a copy.