Tag Archives: rule 506(b) deals

Married Couples As Accredited Investors

When a married couple invests in an offering under Rule 506(b), Rule 506(c), or Tier 2 of Regulation A, we have to decide whether the couple is “accredited” within the meaning of 17 CFR §501(a). How can we conclude that a married couple is accredited?

A human being can be an accredited investor in only four ways:

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  • Method #1: If her net worth exceeds $1,000,000 (without taking into account her principal residence); or
  • Method #2: If her net worth with her spouse exceeds $1,000,000 (without taking into account their principal residence); or
  • Method #3: Her income exceeded $200,000 in each of the two most recent years and she has a reasonable expectation that her income will exceed $200,000 in the current year;
  • Method #4: Her joint income with her spouse exceeded $300,000 in each of the two most recent years and she has a reasonable expectation that their joint income will exceed $300,000 in the current year.

A few examples:

EXAMPLE 1: Husband’s net worth is $1,050,001 without a principal residence. Wife’s has a negative net worth of $50,000 (credit cards!). Their joint annual income is $150,000. Husband is accredited under Method #1 or Method #2. Wife is accredited under Method #2.

EXAMPLE 2: Husband’s net worth is $1,050,001 without a principal residence. Wife’s has a negative net worth of $500,000 (student loans!). Their joint annual income is $150,000. Husband is accredited under Method #1. Wife is not accredited.

EXAMPLE 3: Husband’s net worth is $850,000 and his income is $25,000. Wife’s has a negative net worth of $500,000 and income of $250,000. Husband is not accredited. Wife is accredited under Method #3.

Now, suppose Husband and Wife want to invest jointly in an offering under Rule 506(c), where all investors must be accredited.

They are allowed to invest jointly in Example 1, because both Husband and Wife are accredited. They are not allowed to invest jointly in Example 2 because Wife is not accredited, and they are not allowed to invest jointly in Example 3 because Husband is not accredited.

The point is that Husband and Wife may invest jointly only where both Husband and Wife are accredited individually. At the beginning, I asked “How can we conclude that a married couple is accredited?” The answer: There is no such thing as a married couple being accredited. Only individuals are accredited.

CAUTION: Suppose you are an issuer conducting a Rule 506(c) offering, relying on verification letters from accountants or other third parties. If a married couple wants to invest jointly, you should not rely on a letter saying the couple is accredited. Instead, the letter should say that Husband and Wife are both accredited individually.

Questions? Let me know.

What’s the Difference Between Rule 506(c) and Rule 506(b) in Crowdfunding?

Three and a half years into Title II Crowdfunding, I am asked this question a lot, sometimes by portals, sometimes by issuers.

A Chart, of Course

Three Important Differences

Verification

In a Rule 506(b) offering, the issuer may take the investor’s word that he, she, or it is accredited, unless the issuer has reason to believe the investor is lying.

In a Rule 506(c) offering, on the other hand, the issuer must take reasonable steps to verify that every investor is accredited. The SEC regulations allow an issuer to rely on primary documents from an investor like tax returns, brokerage statements, or W-2s, but they also allow the issuer to rely on a letter from the investor’s lawyer or accountant. In practice, that’s how verification is typically handled.

I strongly recommend that issuers do not verify investors themselves. Instead, they should use a third party like VerifyInvestor. If an issuer handles verification itself and makes a mistake, it’s possible that the entire offering could be disqualified. Conversely, once an issuer hands the task to VerifyInvestor, the issuer has, by definition, taken the “reasonable step” required by the SEC, and can sleep well at night.

Information

If all the investors are accredited, there is no difference between Rule 506(b) and Rule 506(c).

If there is even one non-accredited investor in a Rule 506(b) offering, on the other hand, the issuer must provide a lot more information, specifically most of the information that would be included in a Regulation A offering.

The technicalities are important to the lawyer, but to the issuer or the portal, the bottom line is that if non-accredited investors are included the offering will cost $5,000 – $7,500 more, and take a little longer to prepare.

Advertising

In a Rule 506(b) offering you can advertise only the brand. In a Rule 506(c) offering you can advertise the deal.

Ever watch the commercials for brokers and investment banks during a golf tournament? They feature an older guy and his very attractive wife, planning for a carefree and meaningful retirement. They message is:  we can help you achieve your dreams. But they don’t show any of the actual investments they recommend! They’re only advertising the brand.

That’s the model for a website offering investments under Rule 506(b). We can advertise the website – the brand – but we cannot show actual investments. The website attracts investors who sign up and go through a KYC (know your customer) process following SEC guidelines. We have the investor complete questionnaires, we speak with the investor on the phone a couple times, we learn about his or her experience and knowledge investing – we develop a relationship. Then, and only then, can we show the investor actual investments.

In contrast, a website offering investments under Rule 506(c) can show actual investments to everyone right away.

Which is Better?

If I own a jewelry store, I have two choices:

  • I can display jewelry in the front window where passersby can see it.
  • I can display a sign in the front window saying “Great jewelry inside. Must register to enter.”

That’s why I prefer Rule 506(c).

But I also acknowledge three benefits of Rule 506(b):

  • To include non-accredited investors, you must use Rule 506(b), or another kind of offering altogether.
  • If you use Rule 506(c), you might lose bona fide accredited investors who are unwilling to provide verification.
  • If you use Rule 506(b), which doesn’t require verification, you might get money from non-accredited investors who are willing to lie.

Switching Midstream

You can start an offering using Rule 506(b), then switch to Rule 506(c), as long as you haven’t accepted any non-accredited investors.

Conversely, once you’ve advertised a Rule 506(c) offering, you cannot go back and accept non-accredited investors, claiming you’re relying on Rule 506(b).

Questions? Let me know.

WHAT CAN I SHOW ON MY SITE, TO WHOM, AND WHEN?

The SEC no-action letters issued to FundersClub and AngelList early in 2013 created some confusion around the deal-specific information that can be shown to prospective investors. Let’s try to clear that up.

Rule 506(b) Deals

You cannot show your Rule 506(b) deals to just anyone browsing the Internet, because that would be “general solicitation and advertising,” which is permitted under Rule 506(c) but still prohibited under Rule 506(b). If you’re a real estate portal, you can say “We have great real estate deals on our site,” but you can’t say “Look at this multi-family rental project in Austin.”

Both FundersClub and AngelList hid their deals behind a firewall. A user couldn’t see the deals until he registered at the site and promised he was accredited. In the 2013 no-action letters the SEC approved this arrangement, sort of.

I say “sort of” for three reasons:

  • The two no-action letters weren’t actually about registering users. They were about whether FundersClub and AngelList had to register as broker-dealers. Nowhere do the no-action letters say “We agree that, because you hide your deals behind firewalls, you’re not engaged in prohibited general solicitation and advertising.”
  • The no-action letters were issued by the Division of Trading and Markets within the SEC, not the Division of Corporation Finance. Typically, the Division of Corporation Finance would deal with so-called “exempt offerings” (offerings that are exempt from the general registration requirements of the Securities Act of 1933), of which general solicitation is a part.
  • Most intriguingly, the no-action letters aren’t exactly consistent with prior SEC rulings dealing with the online solicitation of customers, specifically the IPONET rulings in 2000. Those rulings assumed that the person doing the online solicitation was a registered broker-dealer; by definition, FundersClub and AngelList were not broker-dealers.

As a result, we can’t be 100% certain that the SEC, if asked point blank, would approve those arrangements from the perspective of general solicitation and advertising.

Nevertheless, the no-action letters were issued and the Crowdfunding industry has adopted the FundersClub and AngelList model: if you’re doing Rule 506(b) deals, you put the actual deals behind a registration firewall.

Once an investor registers at your site he can see the deals, but he can’t invest in them. In a series of no-action letters issued long before the JOBS Act, the SEC established that once an investor has become a customer, he has to wait before investing – the so-called “cooling off period.”

Some sites today are using a 21 day cooling off period, presumably because Title III incorporates a 21 day cooling off period. But the Title III rule is irrelevant to Rule 506(b). Thirty days is probably better, although, again, the notion of a cooling off period comes from SEC rulings, not a statute.

One more twist: at the end of the cooling off period, your investor can invest only in new deals, not deals that were on the site when he registered.

Rule 506(c) Deals

Rule 506(c) is far simpler. If you are doing only Rule 506(c) deals, you can show anything to anyone anytime.

Using Rule 506(c), you can show every detail of every deal to every casual viewer, even before the viewer has registered at your site. If you think that’s a bad idea from a marketing perspective or because you’re trying to protect confidential information, no problem. You don’t have to show all the details on your home page, but you can.

You can also make users register before they can see deals, just like Rule 506(b). If you take that route, you can ask users whether they’re accredited when they register, as you would under Rule 506(b), but you don’t have to ask. You can let everyone see the deals, accredited and non-accredited alike.

If you ask whether users are accredited – because you think it’s a good idea from a marketing perspective – that doesn’t mean you have to stop non-accredited investors at the door. Non-accredited investors can see the deals, too. Maybe they’ll tell their accredited friends.

Suppose a user tells you she’s accredited when she registers. Can you take her word for it? At that point in the process, absolutely! We don’t want to spend money or time on verification yet, and we don’t want to create transactional friction where we don’t have to.

With Rule 506(c), there is only one critical moment: when your investor is ready to write a check. At that point you must verify that she’s accredited, not merely by asking her but by looking at her tax returns, or getting a letter from her lawyer, or, most likely, having her verified by a third party service like VerifyInvestors or Crowdentials.

There’s no cooling off period with Rule 506(c), either. Your investors can see all the deals and invest right away.

Have I mentioned before that Rule 506(c) is better for Crowdfunding?

Questions? Contact Mark Roderick at Flaster/Greenberg PC.

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