The first accredited investor laws were implemented in the U.S. by the Securities and Exchange Commission (SEC) on September 23rd, 2013, although the initial push came from above in April of the previous year when President Obama signed the Jumpstart Our Business Startups (JOBS) Act. At the time, companies were required to register securities with the SEC before selling shares to investors. This made capital raising a costly and time-consuming process involving extensive regulatory filings
The idea behind the JOBS Act was to allow companies more versatility when seeking funding, by easing the burdensome requirements around reporting and disclosure intended to protect common retail investors. Since accredited investors have a much higher risk-taking capability and are usually experienced investors, they do not receive the same level of protection by the government as retail investors, who don’t always know the risks of what they’re getting into.
Regulatory authorities like the SEC need to strike a balance between protecting individuals investors while at the same time promoting investment and entrepreneurial activities, which are inherently risky.
Introducing the category of “accredited investors” was the U.S.’s attempt to take a more balanced approach in this regard.
What are the requirements for accredited investors?
In Rule 501 of Regulation D, the SEC defines an accredited investor as a person who meets one of the following requirements:
Has an individual annual income exceeding $200,000 or joint income exceeding $300,000 for the previous two years and can reasonably expect to earn the same or more in the current year
Has an individual net worth, or joint net worth with a spouse, exceeding $1 million (excluding the value of a primary residence)
Is a director, executive officer, or general partner of the issuer of the unregistered securities
Business entities such as banks, investment companies, and business development companies also qualify as accredited investors if they have a net worth of over $5 million, or are comprised of equity owners who are accredited investors. However, a company may not form for the express purpose of acquiring the securities offered.
Registered brokers, investment advisors, and (as of recently) individuals who can demonstrate high-level expertise in the area of unregistered securities may also qualify as accredited investors.
Although the requirements for accredited investors vary by country, they are typically similar to those defined by the SEC in the U.S. which served as a model for countries implementing equivalent laws. There are currently around 40 jurisdictions with accredited investor equivalents, variously called “classified investors” (Israel), “professional investors” (Hong Kong), “sophisticated investors” (Australia), “qualified investors” (Brazil), and “professional clients” (the EU), and combinations thereof.
Despite connotations of the term “accredited”, there is actually no official process for individuals and business entities to apply for accredited investor status. Rather, it is the responsibility of the company to take “reasonable steps” to verify that an investor is accredited. If a company does not conduct due diligence in this regard — even for a single investor — the results can put the whole offering at risk.
How do you verify accredited investor status?
Before the JOBS Act, companies could conduct offerings under Rule 506(b) of Regulation D which allowed them to take investors at their word concerning income and net worth, without having to verifying this information. The rule made capital raising easier from the perspective of compliance, but there was a significant downside: Rule 506(b) also prohibited companies from general solicitation and advertising in their efforts to court investors.
The intention was to protect unwary individual investors from going all-in with high-risk ventures, but the result was that capital became much harder to access because companies were not able to approach investors or advertise their offering.
The purpose of the JOBS Act was to create more sensible laws surrounding disclosure and registration of capital formation, in order to create easier access to capital for startups and other high-risk ventures. Effective as of September 23, 2013, Rule 506(c) of Regulation D allowed companies to drastically widen their visibility to potential investors through direct solicitation and advertising through various media platforms.
Naturally, there was a drawback. In exchange for greater visibility, companies were required to take “reasonable steps” to verify accredited status for all investors in offerings conducted under Rule 506(c).
According to SEC guidelines, there are two general methods for verifying accredited investor status that qualify as “reasonable steps”.
The first and more flexible “principles-based” method allows companies to make their own “reasonable determination” that a purchaser meets accredited investor requirements. Rule 506(c) sets forth a number of factors to be considered when employing this method:
The nature of the purchaser and the type of accredited investor that the purchaser claims to be
The amount and type of information that the issuer has about the purchaser
The nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount
The principles-based method puts a level of trust in issuers of unregistered securities, but if it turns out that your judgment was not in fact reasonable, the results can be dire. You can permanently lose the Rule 506(c) exemption, which effectively puts you in the same position companies were in before the JOBS Act.
The SEC also outlines a second, “safe harbor” method for companies who desire more certainty that a purchaser meets accredited investor standards. The safe harbor method is not required, but it is nonetheless recommended by many securities lawyers. There are four non-exclusive means of pursuing the safe harbor method:
- Verification based on income by reviewing relevant tax documentation such as Form W-2, Form 1099, Schedule K-1 of Form 1065, and Form 1040
- Verification of net worth by reviewing and comparing documents dated within the last three months, such as credit reports, bank statements, brokerage statements, tax assessments, and certificates of deposit
- Written confirmation from a registered broker-dealer, an SEC-registered investment advisor, a licensed attorney, or certified public accountant starting that they have taken reasonable steps within the last three months to verify the purchaser’s accredited investor status
- Verification of accredited investor status of persons who invested in the issuer’s Rule 506(b) offering before September 23, 2013 when Rule 506(c) went into effect
Needless to say, proper verification of accredited investors is an issue that companies seeking to raise capital should take seriously. The risk of verifying even one investor improperly can be disastrous for a business venture and result in losing the Rule 506(c) exemption altogether. In that event, the only recourse is to raise capital under Rule 506(b) through private networks without the exposure afforded by solicitation and advertising.
What is the cost of verifying accredited investors?
Performing accredited investor checks can get a bit complicated without some form of outside assistance, especially if you have a regular need to verify investors. Time is a major cost.
For example, consider the time you would need to spend liaising with investors to obtain the relevant documentation and, in some cases, having those documents translated. Or suppose an investor chooses to verify their status by proving net worth — unless they have a single bank account and no liabilities, the process can become complex and time-consuming.
An additional concern arises from the fact that regulatory authorities like the SEC are vague about what constitutes a “comprehensive” investor check. There is no central place where the SEC specifies exactly what this entails, and there is even a good deal of confusion among securities attorneys.
If you have a regular need to perform accredited investor checks, and if you don’t want to mess it up, there is every reason to work with a dedicated and dependable service provider that specializes in compliance.
Luckily, verifying investors with a service provider is not expensive — around $60 per check. But the true value is the time your team will save by automating the process and the security of working with a trusted partner.
Accredited investor laws were established to protect the common investor, who isn’t always aware of the high risks involved in certain investment opportunities.
The purpose was not to exclude middle-class investors or create an elite investment group, although there is a misconception surrounding this point. While exclusion was the practical effect for some time (with only 3% of Americans meeting the requirements to be considered an accredited investor), just last year a bill was passed in the U.S. expanding the definition to include persons who can demonstrate sufficient education or expertise. The result? A new field of accredited investors has opened up.
Whatever the case, proper verification of accredited investors remains a crucial step in raising capital or for companies who need to conduct regular investor checks. Dealers in unregistered securities should consider the various methods available to them in their jurisdiction with care. The costs of non-compliance are too great, especially when there are affordable safe harbor solutions to ensure best practice standards and eliminate the risks involved in navigating the myriad regulations of securities law.