Rule 506(b) Securities Offerings: Leveraging 506(b) Placements,...

Rule 506(b) Securities Offerings: Leveraging 506(b)Placements, Comparison to Rule 506(c) OfferingsNavigating Rules for Solicitation and Accreditation Process for Non-Accredited Investors

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WEDNESDAY, AUGUST 24, 2016

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Today’s faculty features:

Matthew A. Cordell, Attorney, Ward and Smith, Raleigh, N.C.

Knox Proctor, Attorney, Ward and Smith, New Bern, N.C.

James F. Verdonik, Attorney, Ward and Smith, Raleigh, N.C.

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For CPE credits, attendees must participate until the end of the Q&A session andrespond to five prompts during the program plus a single verification code. In addition,you must confirm your participation by completing and submitting an AttendanceAffirmation/Evaluation after the webinar and include the final verification code on theAffirmation of Attendance portion of the form.

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SEC RULE 506: PRIMARY CAPITAL-RAISING TOOL

FACTORS TO CONSIDER WHEN CHOOSING RULE 506(b) OR RULE 506 (c)

© 2016 WARD AND SMITH, P.A.

Jim VerdonikWard and Smith, P.A.E: [email protected]: (919) 277-9188August 20164829-3477-9446

SEC RULE 506: PRIMARY CAPITAL-RAISING TOOL

FACTORS TO CONSIDER WHEN CHOOSING RULE 506(b) OR RULE 506 (c)

Summary

PART I Rule 506 Overview

PART II Summary of Rule 506 (b) and 506 (c) Similarities and Differences

PART III Accredited Investor Definition: Old and New

PART IV Rule 506 (b): How Do You Avoid Making a General Solicitation?PART IV Rule 506 (b): How Do You Avoid Making a General Solicitation?

PART V Rule 506 (c): What Are Reasonable Steps to Verify AccreditedInvestor Status?

6

PART I

RULE 506 CHOICES OVERVIEWRULE 506 CHOICES OVERVIEW

7

Rule 506 The Once and Future CapitalRaising Champion

• In the Capital Raising World, Rule 506 has Been theWorkhorse.

• Recent Changes to Rule 506 Are Making Rule 506 anEven More Useful Capital Raising Tool

• Changes Offer More Choices, Which Require MoreLegal Analysis

• Cannot Sleep Walk Through Rule 506 Offerings• Offerings to Non-Institutional Investors Create

Biggest Challenges

• In the Capital Raising World, Rule 506 has Been theWorkhorse.

• Recent Changes to Rule 506 Are Making Rule 506 anEven More Useful Capital Raising Tool

• Changes Offer More Choices, Which Require MoreLegal Analysis

• Cannot Sleep Walk Through Rule 506 Offerings• Offerings to Non-Institutional Investors Create

Biggest Challenges

8

Standards for 506 (b) vs 506 (c)

• For Rule 506 (b) avoiding a General Solicitationrequires that the Issuer or the Issuer's Agent had a"Prior Substantive Relationship" with Each Offereebefore the Offer.

• For Rule 506 (c) no "Prior Substantive Relationship"with Offerees is required, because GeneralSolicitations are Permitted, but the Issuer must take"reasonable steps to verify" the Accredited Investorstatus of each Purchaser before the Closing the Saleto that Purchaser.

• For Rule 506 (b) avoiding a General Solicitationrequires that the Issuer or the Issuer's Agent had a"Prior Substantive Relationship" with Each Offereebefore the Offer.

• For Rule 506 (c) no "Prior Substantive Relationship"with Offerees is required, because GeneralSolicitations are Permitted, but the Issuer must take"reasonable steps to verify" the Accredited Investorstatus of each Purchaser before the Closing the Saleto that Purchaser.

9

Primary Choice Rule 506 Offerings

The Second Half of this Presentation will:• Compare the "Prior Substantive Relationship"

requirement of Rule 506 (b) to the "ReasonableSteps to Verify" requirement of Rule 506 (c).

• Discuss How Continuing Past Practices in Rule 506 (b)Offerings may result in Issuers Conducting GeneralSolicitations that deprive the Issuer of the Exemptionfrom Registration.

The Second Half of this Presentation will:• Compare the "Prior Substantive Relationship"

requirement of Rule 506 (b) to the "ReasonableSteps to Verify" requirement of Rule 506 (c).

• Discuss How Continuing Past Practices in Rule 506 (b)Offerings may result in Issuers Conducting GeneralSolicitations that deprive the Issuer of the Exemptionfrom Registration.

10

SUMMARY OF RULE 506 (b) AND506 (c) SIMILARITIES AND

DIFFERENCES

PART II


E. Knox ProctorWard and Smith, P.A.E: [email protected]: (252) 672-5477August 20164834-3042-8214

SUMMARY OF RULE 506 (b) AND506 (c) SIMILARITIES AND

DIFFERENCES

Understanding Rule 506 Requires Understanding PriorProblems Regulation D Was Designed to Solve

• Section 4 (a) (2) "transactions by an issuer not involving any publicoffering."

• Because of Section 4 (a) (2)'s Lack of Detail, Lawyers were Reluctant toRender Legal Opinions that Offerings Qualified for the Exemption asOffering Issues Became More Complex due to:

- National Capital Raising System began to Replace Local Capital Raising Systems- Entrepreneurial Economy Relying Less on Commercial Bank Loans and More Reliant

on Selling Debt and Equity Securities• Regulation D tried to Answer Section 4 (a) (2)'s Unanswered Questions:

- How many investors?- How know Investors?- What types investors?- When does one offering end and a new offering begin?- Do all investors require the same disclosures?

• Section 4 (a) (2) "transactions by an issuer not involving any publicoffering."

• Because of Section 4 (a) (2)'s Lack of Detail, Lawyers were Reluctant toRender Legal Opinions that Offerings Qualified for the Exemption asOffering Issues Became More Complex due to:

- National Capital Raising System began to Replace Local Capital Raising Systems- Entrepreneurial Economy Relying Less on Commercial Bank Loans and More Reliant

on Selling Debt and Equity Securities• Regulation D tried to Answer Section 4 (a) (2)'s Unanswered Questions:

- How many investors?- How know Investors?- What types investors?- When does one offering end and a new offering begin?- Do all investors require the same disclosures?

12

Different Statutory Authority forDifferent Parts of Regulation D

• Section 3(b) authorizes SEC to createExemptions up to $5 Million.– Rule 504 has $1 Million Annual Maximum

(Proposed to increase to $5 Million).– Rule 505 has $5 Million Annual Maximum.

• Because Rule 506 has no Annual Maximum,Rule 506 was issued under Section 4 (a) (2).

• Section 3(b) authorizes SEC to createExemptions up to $5 Million.– Rule 504 has $1 Million Annual Maximum

(Proposed to increase to $5 Million).– Rule 505 has $5 Million Annual Maximum.

• Because Rule 506 has no Annual Maximum,Rule 506 was issued under Section 4 (a) (2).

13

Advantages of Rule 506 over Rules 504and 506

Rule 506 has Three Primary Advantages overRule 504 and Rule 505• Unlimited $$$$ Amount• Federal Preemption of State Registration Laws• Greater Liability Protection• The Private Funds Industry can use Rule 506,

but not Rules 504 or 505

Rule 506 has Three Primary Advantages overRule 504 and Rule 505• Unlimited $$$$ Amount• Federal Preemption of State Registration Laws• Greater Liability Protection• The Private Funds Industry can use Rule 506,

but not Rules 504 or 505

14

More Changes in Practice than inTheory

In Theory Rule 506 (b) is just old Rule 506 with the following Changes:• Bad Actor Restrictions• Checking the Box in Form D• Greater Emphasis on Timely Filing Form DIn Practice Rule 506 (b) is likely to Evolve on a Different Course than Old Rule506 because:• As Business People see others using Websites and Social Media to sell

securities, they may forget the Solicitation Restrictions of Rule 506 (b)• With Many Exemptions Permitting General Solicitations, the SEC is Likely

to More Closely Scrutinize Compliance with the No General SolicitationRequirements of Rule 506 (b)

• The Accredited Investor Verification Practices of Rule 506 (c) Offerings mayChange Industry Practices in Rule 506 (b) Offerings

In Theory Rule 506 (b) is just old Rule 506 with the following Changes:• Bad Actor Restrictions• Checking the Box in Form D• Greater Emphasis on Timely Filing Form DIn Practice Rule 506 (b) is likely to Evolve on a Different Course than Old Rule506 because:• As Business People see others using Websites and Social Media to sell

securities, they may forget the Solicitation Restrictions of Rule 506 (b)• With Many Exemptions Permitting General Solicitations, the SEC is Likely

to More Closely Scrutinize Compliance with the No General SolicitationRequirements of Rule 506 (b)

• The Accredited Investor Verification Practices of Rule 506 (c) Offerings mayChange Industry Practices in Rule 506 (b) Offerings

15

Primary Issues That Differ in Rules 506(b) and 506 (c)

• Rule 506 (b) Does Not Permit GeneralSolicitation (PART IV)

• Rule 506 (b) Permits 35 Non-AccreditedInvestors, But Different Disclosure Rules Applyto Non-Accredited Investors

• Rule 506 (c) Requires Issuer to takeReasonable Steps to Verify Accredited InvestorStatus (PART V)

• Rule 506 (b) Does Not Permit GeneralSolicitation (PART IV)

• Rule 506 (b) Permits 35 Non-AccreditedInvestors, But Different Disclosure Rules Applyto Non-Accredited Investors

• Rule 506 (c) Requires Issuer to takeReasonable Steps to Verify Accredited InvestorStatus (PART V)

16

Divisions Within Rule 506 (b) andWithin Rule 506 (c)

Because the SEC Distrusts Internet Offerings, Different Standardsare evolving For:• Rule 506 (b) Offerings Conducted on the Internet vs 506 (b)

Offerings Not Conducted on the Internet• 506 (c) Offerings Conducted on the Internet vs 506 (c)

Offerings Not Conducted on the InternetBecause Rule 506 itself does not distinguish between Internetofferings and other types of offerings, the different standardsare based on the different mechanics of the each type ofoffering, but absent future guidance the basic principles likelyapply to all types of offerings.

Because the SEC Distrusts Internet Offerings, Different Standardsare evolving For:• Rule 506 (b) Offerings Conducted on the Internet vs 506 (b)

Offerings Not Conducted on the Internet• 506 (c) Offerings Conducted on the Internet vs 506 (c)

Offerings Not Conducted on the InternetBecause Rule 506 itself does not distinguish between Internetofferings and other types of offerings, the different standardsare based on the different mechanics of the each type ofoffering, but absent future guidance the basic principles likelyapply to all types of offerings.

17

Primary Issues That Apply to BothRules 506 (b) and 506 (c)

• Same Issuers Can Use the Exemption• Both Require Filing Form D• Bad Actor Prohibition of Rule 506 (d)• State Registration Laws Are Preempted• Same Liability Criteria and Defenses• Same Issuers Can Use the Exemption• Affiliates and Other Re-Sellers Cannot Use the Exemption• Investors Receive Restricted Securities for Re-sale Purposes• No Special Exemption from Section 12 (g) Registration Rules• Accredited Investor Definitions Are the Same

• Same Issuers Can Use the Exemption• Both Require Filing Form D• Bad Actor Prohibition of Rule 506 (d)• State Registration Laws Are Preempted• Same Liability Criteria and Defenses• Same Issuers Can Use the Exemption• Affiliates and Other Re-Sellers Cannot Use the Exemption• Investors Receive Restricted Securities for Re-sale Purposes• No Special Exemption from Section 12 (g) Registration Rules• Accredited Investor Definitions Are the Same

18

Same Issuers Can Use BothExemptions

• The Nature of the Issuer Often Determines the Exemption YouChoose

• In Internet Based Rule 506 Offerings Platforms and LeadInvestors Often Organize Exempt Investment Companies toSell Securities and Reinvest in a Single Issuer

• The Nature of the Issuer Often Determines the Exemption YouChoose

• In Internet Based Rule 506 Offerings Platforms and LeadInvestors Often Organize Exempt Investment Companies toSell Securities and Reinvest in a Single Issuer

19

Rule 506 Rules 504 and505

Section 4 (a)(6) RegulationCrowdfunding

Regulation A StateCrowdfunding

PublicCompanies

Yes No No No No in manyStates

Most ExemptInvestmentCompanies

Yes No No, butchange is likely(FixCrowdfundingAct)

No No in manyStates

RegisteredInvestmentCompanies

Yes No No No No in manyStates

Private Funds Industry

• The "Private Funds" Industry uses Exceptionsfrom the Definition of "Investment Company"

- Section 3 (c) (1) for funds with 99 or Fewer Owners- Section 3 c) (7) for funds whose investors are all

"Qualified Purchasers"

• Neither of these exceptions apply if thePrivate Fund is making an Exempt PublicOffering (504 and 505),but do Apply to Rule506 Offerings

• The "Private Funds" Industry uses Exceptionsfrom the Definition of "Investment Company"

- Section 3 (c) (1) for funds with 99 or Fewer Owners- Section 3 c) (7) for funds whose investors are all

"Qualified Purchasers"

• Neither of these exceptions apply if thePrivate Fund is making an Exempt PublicOffering (504 and 505),but do Apply to Rule506 Offerings

20

SEC Form D

• Must Check Box to Indicate Whether OfferingUses Rule 506 (b) or Rule 506 (c)

• Cannot Check Both• Integration Issues• Must Identify Intermediaries Who

Compensate in Offering- Unregistered Brokers Issues- Bad Actor Issues

• Must Check Box to Indicate Whether OfferingUses Rule 506 (b) or Rule 506 (c)

• Cannot Check Both• Integration Issues• Must Identify Intermediaries Who

Compensate in Offering- Unregistered Brokers Issues- Bad Actor Issues

21

Bad Actor Issues

• Rule 506 (d) Prohibits Use of Rule 506 if Identified Classes ofPeople have Committed Bad Acts

• Two General Classes:- People and Entities Associated with Issuers ,

including Promoters and 20% Shareholders- Intermediaries and their Personnel

• Defense of the issuer establishes that it did not know and, inthe exercise of reasonable care, could not have known that adisqualification existed.

• Can Obtain Exemption from SEC Staff

• Rule 506 (d) Prohibits Use of Rule 506 if Identified Classes ofPeople have Committed Bad Acts

• Two General Classes:- People and Entities Associated with Issuers ,

including Promoters and 20% Shareholders- Intermediaries and their Personnel

• Defense of the issuer establishes that it did not know and, inthe exercise of reasonable care, could not have known that adisqualification existed.

• Can Obtain Exemption from SEC Staff

22

Bad Actor Issues(continued)

• Issuer is Not Disqualified from Using Exemption If- Issuer establishes that it did not know and, in the

exercise of reasonable care, could not have known that adisqualification existed.

- Issuer must, in light of the circumstances, make factualinquiry into whether any disqualifications exist.• The nature and scope of the factual inquiry will vary based on

the facts and circumstances concerning, among other things,the issuer and the other offering participants.

• SEC has indicated very low cost estimate for compliance,which drives evolving practices

• Issuer is Not Disqualified from Using Exemption If- Issuer establishes that it did not know and, in the

exercise of reasonable care, could not have known that adisqualification existed.

- Issuer must, in light of the circumstances, make factualinquiry into whether any disqualifications exist.• The nature and scope of the factual inquiry will vary based on

the facts and circumstances concerning, among other things,the issuer and the other offering participants.

• SEC has indicated very low cost estimate for compliance,which drives evolving practices

23

Practice Points (Bad Actors)

• The more Control Someone Exercises theGreater the Inquiry should be.

• Questionnaires are used for Most People• Background Check for Officers and Directors• Disciplinary Check for Brokers• Brokers Often Have Their Own Questionnaires• Multiple Brokers and Sub-Brokers Complicate• Promoters are Often Difficult to Identify

• The more Control Someone Exercises theGreater the Inquiry should be.

• Questionnaires are used for Most People• Background Check for Officers and Directors• Disciplinary Check for Brokers• Brokers Often Have Their Own Questionnaires• Multiple Brokers and Sub-Brokers Complicate• Promoters are Often Difficult to Identify

24

Bad Actor Issues(continued)

• Affects current offering, but new investors couldpreclude future capital raising:

- Get Representations from New Investors- Get Right to Buy Back from New Investors

• Similar Disqualification applies to mostexemptions from Registration, includingSection 4 (a) (6) Regulation Crowdfunding,Regulation A and State Crowdfunding

• Prior Bad Acts Raise Disclosure Issues

• Affects current offering, but new investors couldpreclude future capital raising:

- Get Representations from New Investors- Get Right to Buy Back from New Investors

• Similar Disqualification applies to mostexemptions from Registration, includingSection 4 (a) (6) Regulation Crowdfunding,Regulation A and State Crowdfunding

• Prior Bad Acts Raise Disclosure Issues

25

Liability Implications of Section 4(a) (2)vs. 3(a) or 3 (b)

• Section 3(a) and 3(b) Rule 504 and 505 Offerings are ExemptPUBLIC Offerings.

• Section 4(a) (2) and Rule 506 Offerings are Exempt PRIVATEOfferings.

• Gustafson v Alloyd US Supreme Court (1993) - Exempt PublicOfferings are Subject to Stricter Liability Rules than PrivateOfferings

• Section 302 (c) (1) (B) of JOBS Act Specifically Preserved Rule506(c) 's Status as a "Private" Offering Despite being Able toMake A General Solicitation

• Section 3(a) and 3(b) Rule 504 and 505 Offerings are ExemptPUBLIC Offerings.

• Section 4(a) (2) and Rule 506 Offerings are Exempt PRIVATEOfferings.

• Gustafson v Alloyd US Supreme Court (1993) - Exempt PublicOfferings are Subject to Stricter Liability Rules than PrivateOfferings

• Section 302 (c) (1) (B) of JOBS Act Specifically Preserved Rule506(c) 's Status as a "Private" Offering Despite being Able toMake A General Solicitation

26

Liability Issues (continued)• Section 12(a)(2) of 1933 Act Creates Liability only in Exempt

and Non-Exempt PUBLIC Offerings for Disclosure Violationsthat Involve Misstatements or Omissions that are :– Intentional or– Negligent

• Section 10 of 1934 Act Creates Liability for Section 4 (a) (2)and Rule 506 PRIVATE Offerings for Disclosure Violations thatthat Involve Misstatements or Omissions that are :– Intentional or– In Reckless Disregard of the Truth

• This Difference Affects the Due Diligence Defense

• Section 12(a)(2) of 1933 Act Creates Liability only in Exemptand Non-Exempt PUBLIC Offerings for Disclosure Violationsthat Involve Misstatements or Omissions that are :– Intentional or– Negligent

• Section 10 of 1934 Act Creates Liability for Section 4 (a) (2)and Rule 506 PRIVATE Offerings for Disclosure Violations thatthat Involve Misstatements or Omissions that are :– Intentional or– In Reckless Disregard of the Truth

• This Difference Affects the Due Diligence Defense

27

Federal Preemption of StateRegistration Laws

• As the National Capital-Raising System Developed,State Securities Registration Laws and AssociatedExemptions Became a Much Bigger Impediment

• 1996 Section 18 was amended to Make all SecuritiesSold in Rule 506 Offerings "Covered Securities"

• Pre-empted State Registration Laws for all Rule 506Offering Except Post-Closing Notice Filings and Fees

• Failure to Comply with Rule 506 Often Creates StateLaw Liabilities

• As the National Capital-Raising System Developed,State Securities Registration Laws and AssociatedExemptions Became a Much Bigger Impediment

• 1996 Section 18 was amended to Make all SecuritiesSold in Rule 506 Offerings "Covered Securities"

• Pre-empted State Registration Laws for all Rule 506Offering Except Post-Closing Notice Filings and Fees

• Failure to Comply with Rule 506 Often Creates StateLaw Liabilities

28

Non-Accredited Investors(Sophistication)

• Rule 506 (b) (2) (ii) seems to require greaterinvestigation of the Sophistication of Non-Accredited Investors

• General Solicitation Prohibition in Rule 502 (c)which applies to all Investors make thisDistinction somewhat Illusory

• Avoiding General Solicitation Often RequiresIssuers to Determine Investor SophisticationBefore Making Offers

• Rule 506 (b) (2) (ii) seems to require greaterinvestigation of the Sophistication of Non-Accredited Investors

• General Solicitation Prohibition in Rule 502 (c)which applies to all Investors make thisDistinction somewhat Illusory

• Avoiding General Solicitation Often RequiresIssuers to Determine Investor SophisticationBefore Making Offers

29

Disclosures to Non-AccreditedInvestors

• Rule 502 (b) Contains Specific Disclosures to Non-AccreditedInvestors:

- Financial Statements that vary by Offering Size- Non-Financial Information Equivalent to Part II of Form

1-A if Issuer is Eligible for Regulation A Offering or Part I ofApplicable Registration Statement• Can make less Disclosure to the extent the Omissions are not

Material to Understanding the Issuer, Its Business and theSecurities Being Offered

• Some Financial Statement Requirements are relaxed iiftheIssuer cannot produce the Financial Statements withoutUnreasonable Cost

• Rule 502 (b) Contains Specific Disclosures to Non-AccreditedInvestors:

- Financial Statements that vary by Offering Size- Non-Financial Information Equivalent to Part II of Form

1-A if Issuer is Eligible for Regulation A Offering or Part I ofApplicable Registration Statement• Can make less Disclosure to the extent the Omissions are not

Material to Understanding the Issuer, Its Business and theSecurities Being Offered

• Some Financial Statement Requirements are relaxed iiftheIssuer cannot produce the Financial Statements withoutUnreasonable Cost

30

ACCREDITED INVESTOR DEFINITION:OLD AND NEW

PART III


Matthew CordellWard and Smith, P.A.E: [email protected]: (919) 277-9177August 20164828-8143-3142

ACCREDITED INVESTOR DEFINITION:OLD AND NEW

Types of Accredited Investors

• Individuals• Entities Based on Legal Status• Entities Based on Assets• New Rules Under Consideration

• Individuals• Entities Based on Legal Status• Entities Based on Assets• New Rules Under Consideration

32

Accredited InvestorsWho Decides?

• Issuer• Platform or Other Intermediary• Future Investors• Securities Regulators When File Form D• Plaintiffs

• Issuer• Platform or Other Intermediary• Future Investors• Securities Regulators When File Form D• Plaintiffs

33

Accredited InvestorsWhat if Are Wrong?

• Section 12 (a) (1) Liability for Violating Section 5 of 1933 Act because HaveNo Federal Exemption from Registration

• Cannot rely on Section 4 (a) (2) exemption if conduct a general solicitation• Violate Section 12 (a) (2) of 1933 Act because fail to disclose that investors

have rescission rights• Violate state securities laws because state registration laws are not

preempted• Violate state disclosure requirements because fail to disclose rescission

rights• Liability is to all investors not just to the investors you fail to verify• Liability for failing to disclose rescission rights from an earlier offering can

cause cascading liability to investors in later offerings

• Section 12 (a) (1) Liability for Violating Section 5 of 1933 Act because HaveNo Federal Exemption from Registration

• Cannot rely on Section 4 (a) (2) exemption if conduct a general solicitation• Violate Section 12 (a) (2) of 1933 Act because fail to disclose that investors

have rescission rights• Violate state securities laws because state registration laws are not

preempted• Violate state disclosure requirements because fail to disclose rescission

rights• Liability is to all investors not just to the investors you fail to verify• Liability for failing to disclose rescission rights from an earlier offering can

cause cascading liability to investors in later offerings

34

Accredited InvestorsIndividuals

• Net Worth – Greater than $1 Million• Residences – Only count primary residence and mortgage in determining

net worth if the home is "underwater"• What is Primary Residence vs Vacation Home or r4ental Property Affects

Net Worth Calculation• Income - $200,000 each of past 2 years and expect $200,000 in year

investment is made• Spouses – Can choose to include spouse in the net worth test or the

income test, but the income test increases to $300,000 if include spouse'sincome in the income test

• Executive Officers, Directors and general partners are automaticallyaccredited investors without regard to income or net worth

• Net Worth – Greater than $1 Million• Residences – Only count primary residence and mortgage in determining

net worth if the home is "underwater"• What is Primary Residence vs Vacation Home or r4ental Property Affects

Net Worth Calculation• Income - $200,000 each of past 2 years and expect $200,000 in year

investment is made• Spouses – Can choose to include spouse in the net worth test or the

income test, but the income test increases to $300,000 if include spouse'sincome in the income test

• Executive Officers, Directors and general partners are automaticallyaccredited investors without regard to income or net worth

35

Accredited InvestorsEntities Based on Legal Status

The following types of Accredited Investors can be easily verifiedbased on their legal status:• Banks• S&Ls• Insurance Companies• Business Development Companies• Registered Investment Companies• SBICs• ERISA Employee Benefit Plans with specified institutional

trustees or $5 million of Total Assets or self-directed by anAccredited Investor

The following types of Accredited Investors can be easily verifiedbased on their legal status:• Banks• S&Ls• Insurance Companies• Business Development Companies• Registered Investment Companies• SBICs• ERISA Employee Benefit Plans with specified institutional

trustees or $5 million of Total Assets or self-directed by anAccredited Investor

36

Accredited Investor EntitiesBased on Assets and Other Criteria

The following Accredited Investors present verification issuesbeyond verifying their legal status:• Entities not formed for the purpose of the investment and

having more than $5 million of total assets:– Trusts if directed by a sophisticated person– 501 (c) (3) non-profits– Corporations and other entities

• Employee benefit plans with $5 million in assets• Any entity all of whose owners are Accredited Investors

The following Accredited Investors present verification issuesbeyond verifying their legal status:• Entities not formed for the purpose of the investment and

having more than $5 million of total assets:– Trusts if directed by a sophisticated person– 501 (c) (3) non-profits– Corporations and other entities

• Employee benefit plans with $5 million in assets• Any entity all of whose owners are Accredited Investors

37

December 2015 SEC Report SEC StaffRecommends Accredited Investor Changes

Section 2 (a) (15) gives the SEC Wide Authority todefine"Accredited Investor" to including any person who, onthe basis of such factors as:• Financial Sophistication• Net Worth• Knowledge and• Experience in financial matters,• Amount of assets under management

Section 2 (a) (15) gives the SEC Wide Authority todefine"Accredited Investor" to including any person who, onthe basis of such factors as:• Financial Sophistication• Net Worth• Knowledge and• Experience in financial matters,• Amount of assets under management

38

Multiple New Categories of AccreditedInvestors

• To Date All Accredited Investors have been Treated the Same• Equal Treatment of All Types of Accredited Investors Is Not

Required by any Statute.• Proposal Would Create Categories of Accredited Investors• Proposal Would Impose $$$ Limits on Investments by Some

Accredited Investors• This Borrows from Crowdfunding Concepts, including $$$$

Limits on what Some Accredited Investors Can Invest

• To Date All Accredited Investors have been Treated the Same• Equal Treatment of All Types of Accredited Investors Is Not

Required by any Statute.• Proposal Would Create Categories of Accredited Investors• Proposal Would Impose $$$ Limits on Investments by Some

Accredited Investors• This Borrows from Crowdfunding Concepts, including $$$$

Limits on what Some Accredited Investors Can Invest

39

New Categories of AccreditedInvestors (continued)

New Rules Under Consideration Would:• Add Categories Based on Sophistication and

Experience, including Number of prior similarInvestments and Affiliation with VC or similarInvestor

• Create Higher Financial Tests for Super-Accredited Investors Who Have No $$$ Limitsto How Much They Can Invest

New Rules Under Consideration Would:• Add Categories Based on Sophistication and

Experience, including Number of prior similarInvestments and Affiliation with VC or similarInvestor

• Create Higher Financial Tests for Super-Accredited Investors Who Have No $$$ Limitsto How Much They Can Invest

40

December 2015 SEC Report re Accredited InvestorChanges Recommended by SEC Staff

• Individuals who are Accredited Investors today would remain Accreditedinvestors, but would be limited to investing not more than 10% of Incomeor 10% of Net Worth, Unless Satisfy Other Criteria.

• 10% Limitation Would Require More Details About both Income and NetWorth

• Create new Income and Net Worth Tests for investments without the 10%limitation

(a) $500,000 income without spouse(b) $750,000 income with spouse(c) $2.5 Million Net Worth (without primary residence)

• Every four years adjust all financial thresholds for inflation going forward.

• Individuals who are Accredited Investors today would remain Accreditedinvestors, but would be limited to investing not more than 10% of Incomeor 10% of Net Worth, Unless Satisfy Other Criteria.

• 10% Limitation Would Require More Details About both Income and NetWorth

• Create new Income and Net Worth Tests for investments without the 10%limitation

(a) $500,000 income without spouse(b) $750,000 income with spouse(c) $2.5 Million Net Worth (without primary residence)

• Every four years adjust all financial thresholds for inflation going forward.

41

Other Proposed Changes

• Focus on Invested Assets Rather than NewAssets

• Open to all Types of Entities that Meet assetsCriteria (requested by Native American Tribes)

• Marriage Change: Permit Income and NetWorth of "spousal equivalents" to be Included

• Focus on Invested Assets Rather than NewAssets

• Open to all Types of Entities that Meet assetsCriteria (requested by Native American Tribes)

• Marriage Change: Permit Income and NetWorth of "spousal equivalents" to be Included

42

Increase in Numbers of IndividualAccredited Investors

Type of IndividualAccreditedInvestor

1983 2013 2013 if HadAdjusted 1983Tests for CPIMeasuredInflation

$200,000 AnnualIncome Test

440,000Households0.5% of AllHouseholds

8 MillionHouseholds6.6% of AllHouseholds

$490,0002.1 MillionHouseholds1.7% of AllHouseholds

$200,000 AnnualIncome Test

440,000Households0.5% of AllHouseholds

8 MillionHouseholds6.6% of AllHouseholds

$490,0002.1 MillionHouseholds1.7% of AllHouseholds

$300,000 AnnualIncome withSpouse

4 MillionHouseholds3.3 % of AllHouseholds

$1 Million NetWorth Test

1.4 MillionHouseholds1.7% of AllHouseholds



43

New Financial Thresholds forIndividuals

CURRENT RECOMMENDED BY SECSTAFF

Annual Income without10% Limit

$200,000 or $300,000with Spouse8 Million Households6.6% of All Households

N/A$200,000 or $300,000with Spouse8 Million Households6.6% of All Households

Annual Income with 10%limit

N/A $500,000 or $750,000with Spouse Equivalent2.1 Million Households1.7% of All Households

Net Worth without 10%Limit

$1 Million9.2 Million Households7.5% of All Households

$2.5 Million6.4 Million Households3.1% of All Households

Net Worth with 10% limit N/A $1 Million5.4 Million Households4.4% of All Households

44

RULE 506 (b): HOW DO YOU AVOIDMAKING A GENERAL SOLICITATION?

PART IV



RULE 506 (b): HOW DO YOU AVOIDMAKING A GENERAL SOLICITATION?

Primary General Solicitation Issues

• Determining whether an Offering is Exempt underRule 506 (b) Requires Answering Two Questions:

- Was an Offer Made?- Was an Offer Made to Someone the Issuer or

Its Agent Did not have a Prior Substantive Relationship?• Issuer must be prepared to Prove the Exemption

Exists• Must have the Exemption for Offers Even if No Sales

Occur (Although Damages in a Civil Action Dependon Sales)






46

Rule 506 (b) Prohibits GeneralSolicitations

• Rule 506 (b) Requires Issuers to Comply with Rule 502.• Rule 502 (c) Prohibits Offering or Selling securities by using

"any form of General Solicitation or General Advertising,"including:

- "Any advertisement, article, notice or other communicationpublished in any newspaper, magazine, or similar media orbroadcast over television or radio."

- Any seminar or meeting whose attendees have been invitedby any general solicitation or general advertising;

• Rule 506 (b) Requires Issuers to Comply with Rule 502.• Rule 502 (c) Prohibits Offering or Selling securities by using

"any form of General Solicitation or General Advertising,"including:

- "Any advertisement, article, notice or other communicationpublished in any newspaper, magazine, or similar media orbroadcast over television or radio."

- Any seminar or meeting whose attendees have been invitedby any general solicitation or general advertising;

47

Primary General Solicitation Issues











48

Rule 502 (c)Builds onPrior Section 4 (a) (2) Principles

SEC v Ralston Purina 346 U. S. 119 (1953) and Subsequent Interpretations• Does the Class of Persons Need to Be Protected by the Registration

Provisions of the Securities Act?• Issuer or Agent Must Have a Pre-Existing Relationship that Provides

Sufficient Information to Determine Whether the Investors Are Able to"Fend for Themselves"

• 2015 No-Action Letter and CDI's Describe Information Required for Rule506 Offerings

• Issuers Can Use Questionnaires to Obtain the Necessary Information• Questionnaire Limited to Determining Accredited Investor Status May Not

Be Sufficient, Because Ability to Fend for Self Depends on More ThanFinancial Resources

SEC v Ralston Purina 346 U. S. 119 (1953) and Subsequent Interpretations• Does the Class of Persons Need to Be Protected by the Registration

Provisions of the Securities Act?• Issuer or Agent Must Have a Pre-Existing Relationship that Provides

Sufficient Information to Determine Whether the Investors Are Able to"Fend for Themselves"

• 2015 No-Action Letter and CDI's Describe Information Required for Rule506 Offerings

• Issuers Can Use Questionnaires to Obtain the Necessary Information• Questionnaire Limited to Determining Accredited Investor Status May Not

Be Sufficient, Because Ability to Fend for Self Depends on More ThanFinancial Resources

49

General Solicitation

Three Categories of General Solicitation Issuesfor Rule 506:• Internet – Many SEC Concerns Requires

Issuers or Platform Operators to Focus onDetails both relationship Details and Timing

• In-Person – Expect Some Greater Restrictions• Other Media – Expect Fewer Changes Because

of Long History

Three Categories of General Solicitation Issuesfor Rule 506:• Internet – Many SEC Concerns Requires

Issuers or Platform Operators to Focus onDetails both relationship Details and Timing

• In-Person – Expect Some Greater Restrictions• Other Media – Expect Fewer Changes Because

of Long History

50

General Solicitation Not Limited toPaid Advertising

General Solicitation or Advertising Can Include:• Press Releases• Free Public Relations Articles• Organized Telephone Solicitations

General Solicitation or Advertising Can Include:• Press Releases• Free Public Relations Articles• Organized Telephone Solicitations

51

The Real World Still Exists

• Internet Competition is Decreasing the Cost of OtherMedia

• Many Investors Like to Invest Locally and Local Mediais Inexpensive

• Person to Person is Still How Most People ConductBusiness

• Creating a Personal Connection is Still the Best SalesTool, But Personal Communications can be GeneralSolicitations

• Internet Competition is Decreasing the Cost of OtherMedia

• Many Investors Like to Invest Locally and Local Mediais Inexpensive

• Person to Person is Still How Most People ConductBusiness

• Creating a Personal Connection is Still the Best SalesTool, But Personal Communications can be GeneralSolicitations

52

General Solicitations(continued)

• General Solicitation includes Using Media andWord of Mouth to Drive People toPresentations

• Sign in Window is General Solicitation• Mass Mailing to Customers is General

Solicitation, But Is It an Offer?

• General Solicitation includes Using Media andWord of Mouth to Drive People toPresentations

• Sign in Window is General Solicitation• Mass Mailing to Customers is General

Solicitation, But Is It an Offer?

53

Rule 506 (b)'s Either or Choice IsIllusory

• Rule 506 (b) (ii): "Each purchaser who is notan accredited investor . . . has such knowledgeand experience in financial and businessmatters that he is capable of evaluating themerits and risks. . .."

• Seems to give ability to sell to AccreditedInvestors without Regard to Ability to Fend forThemselves.

• Rule 506 (b) (ii): "Each purchaser who is notan accredited investor . . . has such knowledgeand experience in financial and businessmatters that he is capable of evaluating themerits and risks. . .."

• Seems to give ability to sell to AccreditedInvestors without Regard to Ability to Fend forThemselves.

54

General Solicitation Depends on Factors Other ThanInvestor's Financial Resources

• CDI 256.18 (2009) indicates that an offering that is restricted to AccreditedInvestors Can Still be a General Solicitation.

• Most Subscription Agreements Require All Investors to Represent they:"have such knowledge and experience in financial and business mattersthat [they are] capable of evaluating the merits and risks. . .."

• Issue to Avoid General Solicitation is Whether this Representation isSufficient to Establish a Pre-Existing Substantive Relationship.

• Many Offerings Assume it is Sufficient, but is the Investor's RepresentationReally Sufficient?

• Problem: Ability to Fend for Self is Difficult to Determine for Many Non-Institutional Investors.

• CDI 256.18 (2009) indicates that an offering that is restricted to AccreditedInvestors Can Still be a General Solicitation.

• Most Subscription Agreements Require All Investors to Represent they:"have such knowledge and experience in financial and business mattersthat [they are] capable of evaluating the merits and risks. . .."

• Issue to Avoid General Solicitation is Whether this Representation isSufficient to Establish a Pre-Existing Substantive Relationship.

• Many Offerings Assume it is Sufficient, but is the Investor's RepresentationReally Sufficient?

• Problem: Ability to Fend for Self is Difficult to Determine for Many Non-Institutional Investors.

55

Prior Substantive Relationship AvoidGeneral Solicitation

• SEC CDI's in August 2015 Clarify what areGood Practices for All Offerings:

• Substantive: Is the Quality of the RelationshipSufficient to Determine the Investor's Abilityto Fend For Self?

• Timing : Does the Substantive RelationshipPre-Date the Offer

• SEC CDI's in August 2015 Clarify what areGood Practices for All Offerings:

• Substantive: Is the Quality of the RelationshipSufficient to Determine the Investor's Abilityto Fend For Self?

• Timing : Does the Substantive RelationshipPre-Date the Offer

56

Who Can Establish Prior SubstantiveRelationships?

• Angel Investor in an Angel Network Can Refer Other Investors(CDI 256.27)

• Registered Broker Dealers (CDI 256.28)• Registered Investment Advisers (CDI 256.28)• Facts and Circumstances Test for Other People• Website Operator Who Uses Appropriate Procedures (Citizen

VC No-Action Letter 2015)• Difficult for Issuers Establish Substantive Relationship During

the Offering Unlike Rule 506 (c)'s Reasonable Steps to VerifyAccredited Investor Status

• Angel Investor in an Angel Network Can Refer Other Investors(CDI 256.27)

• Registered Broker Dealers (CDI 256.28)• Registered Investment Advisers (CDI 256.28)• Facts and Circumstances Test for Other People• Website Operator Who Uses Appropriate Procedures (Citizen

VC No-Action Letter 2015)• Difficult for Issuers Establish Substantive Relationship During

the Offering Unlike Rule 506 (c)'s Reasonable Steps to VerifyAccredited Investor Status

57

Venture Capital Conferences (PrimarySEC No-Action Letter)

• Michigan Growth Capital No Action Letter (1995)- Granted to the Symposium Organizer (Not ot an Issuer)- Specifically Disclaims Ability of Presenting Companies to Rely on the Letter• Letter Represents:- Excludes Issuers "In Registration"- Publicized by "targeted mailings to known accredited investors, limited

generic advertising in Venture Journal and by word of mouth from priorattendees."

- No sales commissions- Prohibit circulation of Private Placement Memoranda- Organizer does not arrange prior contacts between presenters and

attendees- Presentations do not include specific financing details

• Michigan Growth Capital No Action Letter (1995)- Granted to the Symposium Organizer (Not ot an Issuer)- Specifically Disclaims Ability of Presenting Companies to Rely on the Letter• Letter Represents:- Excludes Issuers "In Registration"- Publicized by "targeted mailings to known accredited investors, limited

generic advertising in Venture Journal and by word of mouth from priorattendees."

- No sales commissions- Prohibit circulation of Private Placement Memoranda- Organizer does not arrange prior contacts between presenters and

attendees- Presentations do not include specific financing details

58

Venture Capital Conferences and PastPractices

SEC Has Turned a Blind Eye to Dozens of Annual Venture Capital Conferencesand Demo Days:• Primarily Because the Very Sophisticated Audience Makes it Easier to

Determine Ability to Fend for Self• Weakest Link in Chain: Not Everyone is Equally Sophisticated• Businesses Had No Other Choices to Raise Capital• This SEC Policy For Rule 506 (b) Offerings May Change Now That Rule 506

(c) and Other Exemptions Permit General Solicitations and Advertising.• CDI 256.33 (August 2015) Recommends Considering using Rule 506 (c)

where the Issuer or Persons Acting on Behalf of the Issuer Use a GeneralSolicitation to Invite People to a Presentation where an Offer is Made.

SEC Has Turned a Blind Eye to Dozens of Annual Venture Capital Conferencesand Demo Days:• Primarily Because the Very Sophisticated Audience Makes it Easier to

Determine Ability to Fend for Self• Weakest Link in Chain: Not Everyone is Equally Sophisticated• Businesses Had No Other Choices to Raise Capital• This SEC Policy For Rule 506 (b) Offerings May Change Now That Rule 506

(c) and Other Exemptions Permit General Solicitations and Advertising.• CDI 256.33 (August 2015) Recommends Considering using Rule 506 (c)

where the Issuer or Persons Acting on Behalf of the Issuer Use a GeneralSolicitation to Invite People to a Presentation where an Offer is Made.

59

Venture Capital ConferencesPrimary Issues

CDI 256.33 August 2015Demo Day to VC Conference Two Issues:• Does the Presentation Constitute an

Offer?• Is the Presentation a General

Solicitation?• Facts and Circumstances Test

CDI 256.33 August 2015Demo Day to VC Conference Two Issues:• Does the Presentation Constitute an

Offer?• Is the Presentation a General

Solicitation?• Facts and Circumstances Test

60

Venture Capital ConferencesAnd General Solicitations

Whether a VC Conference Constitutes a GeneralSolicitation Depends on:• Does the Issuer or the Organizer Have a Pre-

Existing Substantive Relationship with allAttendees?

• If Not, Were the Attendees ContactedThrough an Informal Personal Networkdescribed in CDI 256.27?

Whether a VC Conference Constitutes a GeneralSolicitation Depends on:• Does the Issuer or the Organizer Have a Pre-

Existing Substantive Relationship with allAttendees?

• If Not, Were the Attendees ContactedThrough an Informal Personal Networkdescribed in CDI 256.27?

61

Offers Are Important for Rule 506 (b),but not Rule 506 (c)

• The Prohibition on General Solicitation Appliesto both Offers and Sales.

• Section 2 (a) (3)The term “offer to sell”, “offerfor sale”, or “offer” shall include every attemptor offer to dispose of, or solicitation of an offerto buy, a security or interest in a security, forvalue." Therefore, Simply Omitting Price OrOther Terms Is Not Sufficient to Avoid Makingan Offer.

• The Prohibition on General Solicitation Appliesto both Offers and Sales.

• Section 2 (a) (3)The term “offer to sell”, “offerfor sale”, or “offer” shall include every attemptor offer to dispose of, or solicitation of an offerto buy, a security or interest in a security, forvalue." Therefore, Simply Omitting Price OrOther Terms Is Not Sufficient to Avoid Makingan Offer.

62

Offers at Venture Capital Conferences

• Whether the Presentation is an Offer Dependson whether only general "BusinessInformation" is Discussed

• Are Announcements from Stage that theIssuer Will Meet with Investors at a SpecifiedTime and Location Where Offers are UsuallyMade a General Solicitation

• Whether the Presentation is an Offer Dependson whether only general "BusinessInformation" is Discussed

• Are Announcements from Stage that theIssuer Will Meet with Investors at a SpecifiedTime and Location Where Offers are UsuallyMade a General Solicitation

63

Factual Business Information

• CDI 256.24 August 2015• Only "Offers" Violate the General Solicitation Rule• Factual Business Information is not an Offer if it

"does not condition the public mind or arouseinterest in the offering."

• See Gun Jumping Issues, where Timing, Media andOther Issues Affect the Analysis

• Rule 135 Can be used as a Guide

• CDI 256.24 August 2015• Only "Offers" Violate the General Solicitation Rule• Factual Business Information is not an Offer if it

"does not condition the public mind or arouseinterest in the offering."

• See Gun Jumping Issues, where Timing, Media andOther Issues Affect the Analysis

• Rule 135 Can be used as a Guide

64

Factual Business Information(continued)

• Facts and Circumstances Test Designed not to Interfere with Business'Ordinary Operations. Including Product Sales

• OK if Limited to Information a Customer or Vendor would Want to Know:- Description of Business- Financial Condition- Products- Services

• Not OK if Include Information Related to Investment Decisions:- Predictions- Projections- Forecasts- Valuation Opinions

• Facts and Circumstances Test Designed not to Interfere with Business'Ordinary Operations. Including Product Sales

• OK if Limited to Information a Customer or Vendor would Want to Know:- Description of Business- Financial Condition- Products- Services

• Not OK if Include Information Related to Investment Decisions:- Predictions- Projections- Forecasts- Valuation Opinions

65

Website Operator Is Making a GeneralSolicitation

• Every Website Operator is Making a GeneralSolicitation (CDI 256.23 August 2017)

• Primary Rule 506 (b) Issue is:- Is the Purpose to Attract People to Use

the Website?- Is the purpose to Sell Particular Offerings

listed on the Website?

• Every Website Operator is Making a GeneralSolicitation (CDI 256.23 August 2017)

• Primary Rule 506 (b) Issue is:- Is the Purpose to Attract People to Use

the Website?- Is the purpose to Sell Particular Offerings

listed on the Website?

66

Purpose of Statements

Purpose Usually Depends on Two Factors:• If Information About Particular Offerings is on the Home Page

or Other Open Access Part of the Website, a GeneralSolicitation is Being made.

• To Avoid a General Solicitation, the Information about aParticular Offering:

- Must be limited to Restricted Access Parts of theWebsite,

- Website Operator's Procedures Ensure Access only toInvestors for whom the Website Operator Has Satisfied the Pre-Existing Substantive Relationship Test.

Purpose Usually Depends on Two Factors:• If Information About Particular Offerings is on the Home Page

or Other Open Access Part of the Website, a GeneralSolicitation is Being made.

• To Avoid a General Solicitation, the Information about aParticular Offering:

- Must be limited to Restricted Access Parts of theWebsite,

- Website Operator's Procedures Ensure Access only toInvestors for whom the Website Operator Has Satisfied the Pre-Existing Substantive Relationship Test.

67

Timing of Pre-Existing SubstantiveRelationship

• Substantive Relationship Does Not Have toPre-Date the Investor Coming to the Website

• Website Procedures Can Create theSubstantive Relationship

• Determine Whether a SubstantiveRelationship Is Pre-Existing Based on Whenthe Investor First Receives Access toInformation that Constitutes and Offer (CDI256.29)

• Substantive Relationship Does Not Have toPre-Date the Investor Coming to the Website

• Website Procedures Can Create theSubstantive Relationship

• Determine Whether a SubstantiveRelationship Is Pre-Existing Based on Whenthe Investor First Receives Access toInformation that Constitutes and Offer (CDI256.29)

68

Evolution of Website IssuesLamp Technologies

Lamp Technologies (1997) no action Letter EmphasizedControlled Access to Accredited Investors and a Waiting Period• Lamp was a Software Developer that Operated a Website that

Listed Offerings by Private Funds• Used a Generic Questionnaire to form a Reasonable Basis to

Believe Subscribers Are Accredited Investors• Subscriber pays Monthly Fee for Password Access to Fund

Offerings• Subscriber Agrees Will Not Invest for Thirty Days• Subscriber Agrees Not to Disclose Offerings to OthersFocused on Knowledge of Investor's Financial Resources

Lamp Technologies (1997) no action Letter EmphasizedControlled Access to Accredited Investors and a Waiting Period• Lamp was a Software Developer that Operated a Website that

Listed Offerings by Private Funds• Used a Generic Questionnaire to form a Reasonable Basis to

Believe Subscribers Are Accredited Investors• Subscriber pays Monthly Fee for Password Access to Fund

Offerings• Subscriber Agrees Will Not Invest for Thirty Days• Subscriber Agrees Not to Disclose Offerings to OthersFocused on Knowledge of Investor's Financial Resources

69

Evolution of Website IssuesCitizen VC

Citizen VC (2015) No-Action Letter Changes Emphasis Away froma Waiting Period to Relationship that Provides RelevantInformation about the Investor's Experience and Goals• Online Venture Capital Fund Organizes SPVs Managed by an Affiliate to

Invest in Specific Businesses (Not Blind Pools)• Rule 506 (b) Offerings Sell SPV Interests• Conducts General Solicitation to Attract Investors to its Website• Home Page Promotes the Concept on Online Venture Capital, But Does

Not Promote Investment in a Specific Issuer• Investor Registers as a Member of the Website by Completing a Generic

Accredited Investor Questionnaire• Access to Specific Offerings Is Denied Until Website Operator Completes

the "Relationship Establishment" Process

Citizen VC (2015) No-Action Letter Changes Emphasis Away froma Waiting Period to Relationship that Provides RelevantInformation about the Investor's Experience and Goals• Online Venture Capital Fund Organizes SPVs Managed by an Affiliate to

Invest in Specific Businesses (Not Blind Pools)• Rule 506 (b) Offerings Sell SPV Interests• Conducts General Solicitation to Attract Investors to its Website• Home Page Promotes the Concept on Online Venture Capital, But Does

Not Promote Investment in a Specific Issuer• Investor Registers as a Member of the Website by Completing a Generic

Accredited Investor Questionnaire• Access to Specific Offerings Is Denied Until Website Operator Completes

the "Relationship Establishment" Process

70

Citizen VC Relationship EstablishmentProcess

After Registration and Accredited InvestorQuestionnaire Website Operator Contacts Investorto Discuss:

- Prior Investment Experience- Sophistication- Investment Goals- Investment Strategies- Financial Suitability- Risk Awareness

After Registration and Accredited InvestorQuestionnaire Website Operator Contacts Investorto Discuss:

- Prior Investment Experience- Sophistication- Investment Goals- Investment Strategies- Financial Suitability- Risk Awareness

71

Citizen VC Relationship EstablishmentProcess (continued)

• Send Introductory email to Investor• Answer Questions About the Website, the

Website Operator and Potential Investments• Access a Third Party Credit Report to Confirm

the Investor's identity and Credit History• Encourage Ongoing Interaction between he

Investor and the Website operator.• Imposed a $50,000 Minimum Investment

• Send Introductory email to Investor• Answer Questions About the Website, the

Website Operator and Potential Investments• Access a Third Party Credit Report to Confirm

the Investor's identity and Credit History• Encourage Ongoing Interaction between he

Investor and the Website operator.• Imposed a $50,000 Minimum Investment

72

Citizen VC (continued)

Quality of the Relationship Creates a Pre-ExistingSubstantive Relationship that is More Important thanRelationship Length:• Have Sufficient Information to Evaluate and Actually

Does Evaluate:- Sophistication- Financial Circumstances- Ability to Understand Risks and the Securities

Being Offered

Quality of the Relationship Creates a Pre-ExistingSubstantive Relationship that is More Important thanRelationship Length:• Have Sufficient Information to Evaluate and Actually

Does Evaluate:- Sophistication- Financial Circumstances- Ability to Understand Risks and the Securities

Being Offered

73

RULE 506 (c): WHAT AREREASONABLE STEPS TO VERIFY

ACCREDITED INVESTOR STATUS?

PART V



RULE 506 (c): WHAT AREREASONABLE STEPS TO VERIFY

ACCREDITED INVESTOR STATUS?

Rule 506 (b) Accredited InvestorRequirement in Rule 501 (a):

• Accredited Investors do not Counttoward Rule 506 (b)'s 35 Purchasers Limit

• Is an Accredited Investor• OR• Issuer has Reasonable Belief is an

Accredited Investor

• Accredited Investors do not Counttoward Rule 506 (b)'s 35 Purchasers Limit

• Is an Accredited Investor• OR• Issuer has Reasonable Belief is an

Accredited Investor

75

Rule 506 (b) AllowsSelf-Certification

• Issuer can accept self-certification ofAccredited Investor status by investors, unlessthe issuer knows or has reason to know thatself-certification is wrong.

• Courts often side with Issuers when Non-Accredited Investors sue alleging the issuershould have known to avoid rewardinginvestors who make misrepresentations

• Issuer can accept self-certification ofAccredited Investor status by investors, unlessthe issuer knows or has reason to know thatself-certification is wrong.

• Courts often side with Issuers when Non-Accredited Investors sue alleging the issuershould have known to avoid rewardinginvestors who make misrepresentations

76

Rule 506 (c) Test

For Rule 506 (c), Issuers must satisfy the Rule506 (b) TestANDMust take "reasonable steps" to verifyAccredited Investor Status.The Issuer loses the Exemption from even if theinvestor actually is accredited. Being lucky is nota defense.

For Rule 506 (c), Issuers must satisfy the Rule506 (b) TestANDMust take "reasonable steps" to verifyAccredited Investor Status.The Issuer loses the Exemption from even if theinvestor actually is accredited. Being lucky is nota defense.

77

Safe Harbor for Individual Investors

Relies on Reviewing Investor's Financial Documents:• Income – non-exclusive list includes Form W-2, Form 1099, Schedule K-1

to Form 1065, and Form 1040 for two most recent years andrepresentations about current year.

• Net Worth Documentation for Assets: bank statements, brokeragestatements and other statements of securities holdings, certificates ofdeposit, tax assessments, and appraisal reports issued by independentthird parties; and

• Net Worth Documentation for Liabilities: a consumer report from at leastone of the nationwide consumer reporting agencies; and

• Written statement from investor that all liabilities have been disclosed.

Relies on Reviewing Investor's Financial Documents:• Income – non-exclusive list includes Form W-2, Form 1099, Schedule K-1

to Form 1065, and Form 1040 for two most recent years andrepresentations about current year.

• Net Worth Documentation for Assets: bank statements, brokeragestatements and other statements of securities holdings, certificates ofdeposit, tax assessments, and appraisal reports issued by independentthird parties; and

• Net Worth Documentation for Liabilities: a consumer report from at leastone of the nationwide consumer reporting agencies; and

• Written statement from investor that all liabilities have been disclosed.

78

Safe Harbor for Individuals (cont.)

• Timing: Must be dated within three months before the investment date• Named Persons can provide written statements that they have taken

reasonable steps to verify Accredited Investor status within the prior threemonths (Note This Is Broader than Reviewing Safe Harbor Documents):– A registered broker-dealer– A investment adviser registered with the SEC (not states)– A licensed attorney in good standing in all jurisdictions where licensed– A certified public accountant registered and in good standing under

the laws of their residence or principal office• Must have a reasonable basis to rely on others not named in the Safe

Harbor.• Platforms use Sub-Contractors for Verification

• Timing: Must be dated within three months before the investment date• Named Persons can provide written statements that they have taken

reasonable steps to verify Accredited Investor status within the prior threemonths (Note This Is Broader than Reviewing Safe Harbor Documents):– A registered broker-dealer– A investment adviser registered with the SEC (not states)– A licensed attorney in good standing in all jurisdictions where licensed– A certified public accountant registered and in good standing under

the laws of their residence or principal office• Must have a reasonable basis to rely on others not named in the Safe

Harbor.• Platforms use Sub-Contractors for Verification

79

"Reasonable Steps" to Verify Outsidethe Safe Harbor

WHY? Is Most Important Question for Understanding Reasonable Steps."An issuer that solicits new investors through a website available to the general public,through a widely disseminated email or social media solicitation, or through printmedia, such as a newspaper, will likely be obligated to take greater measures to verifyaccredited investor status than an issuer that solicits new investors from a database ofpre-screened accredited investors created and maintained by a reliable third party."• 506 (b) Offerings:

– Issuer usually has contacts and knowledge of Investors other than the self-certification

OR– Registered Broker or Other Intermediary has contacts and knowledge of

Investors other than the self-certification• In Rule 506(c) Offerings on Internet, often no one has information about investors

other than the self-certification.• There is no reasonable basis for believing self-certifications by Unknown Investors

WHY? Is Most Important Question for Understanding Reasonable Steps."An issuer that solicits new investors through a website available to the general public,through a widely disseminated email or social media solicitation, or through printmedia, such as a newspaper, will likely be obligated to take greater measures to verifyaccredited investor status than an issuer that solicits new investors from a database ofpre-screened accredited investors created and maintained by a reliable third party."• 506 (b) Offerings:

– Issuer usually has contacts and knowledge of Investors other than the self-certification

OR– Registered Broker or Other Intermediary has contacts and knowledge of

Investors other than the self-certification• In Rule 506(c) Offerings on Internet, often no one has information about investors

other than the self-certification.• There is no reasonable basis for believing self-certifications by Unknown Investors

80

Something More than Self-Certification

• How much more is required is a facts and circumstances test.• Examples in SEC Release No. 33-9415 (July 10, 2013)

– the nature of the purchaser and the type of accreditedinvestor that the purchaser claims to be;

– the amount and type of information that the issuer hasabout the purchaser;

– the nature of the offering, such as the manner in which thepurchaser was solicited to participate in the offering

– the terms of the offering, such as a minimum investmentamount.

• How much more is required is a facts and circumstances test.• Examples in SEC Release No. 33-9415 (July 10, 2013)

– the nature of the purchaser and the type of accreditedinvestor that the purchaser claims to be;

– the amount and type of information that the issuer hasabout the purchaser;

– the nature of the offering, such as the manner in which thepurchaser was solicited to participate in the offering

– the terms of the offering, such as a minimum investmentamount.

81

Interpreting Facts and Circumstances• "After consideration of the facts and circumstances of the purchaser and

of the transaction, the more likely it appears that a purchaser qualifies asan accredited investor, the fewer steps the issuer would have to take toverify accredited investor status, and vice versa." SEC Release No. 33-9415(July 10, 2013)

• High Minimum Investment Amount• Publicly available information about the investor, including in government

filings (E. g proxy statement information)• Knowledge of Prior Investment Transactions• Issuers must prove they have an exemption. Create written record of the

reasonable steps taken to verify Accredited Investor status and why thesteps were reasonable.

• "After consideration of the facts and circumstances of the purchaser andof the transaction, the more likely it appears that a purchaser qualifies asan accredited investor, the fewer steps the issuer would have to take toverify accredited investor status, and vice versa." SEC Release No. 33-9415(July 10, 2013)

• High Minimum Investment Amount• Publicly available information about the investor, including in government

filings (E. g proxy statement information)• Knowledge of Prior Investment Transactions• Issuers must prove they have an exemption. Create written record of the

reasonable steps taken to verify Accredited Investor status and why thesteps were reasonable.

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Which Is More Difficult?506 (b) or 506 (c)

Issuers Who Choose Rule 506 (b) to Avoid Taking Reasonable Steps to VerifyAccredited Investor Status may have more difficulty Establishing a "PriorSubstantive Relationship," because:• Additional steps beyond Self-Certification by the Investor is required to avoid a

general solicitation• Rule 506 (b)'s test involve subjective information about Investors whereas Rule

506 (c) focuses on financial information• Obtaining Information is insufficient for Rule 506 (b), because the Issuer must use

the Information to appropriately evaluate the circumstances of prospectiveOfferees

• Many Issuers may be incapable of analyzing the subjective information, which issimilar in some ways to a broker-dealer's suitability analysis

• Much of the Information required to establish a Prior Existing Relationship wouldbe useful in taking Reasonable Steps to Verify Accredited Investor Status

Issuers Who Choose Rule 506 (b) to Avoid Taking Reasonable Steps to VerifyAccredited Investor Status may have more difficulty Establishing a "PriorSubstantive Relationship," because:• Additional steps beyond Self-Certification by the Investor is required to avoid a

general solicitation• Rule 506 (b)'s test involve subjective information about Investors whereas Rule

506 (c) focuses on financial information• Obtaining Information is insufficient for Rule 506 (b), because the Issuer must use

the Information to appropriately evaluate the circumstances of prospectiveOfferees

• Many Issuers may be incapable of analyzing the subjective information, which issimilar in some ways to a broker-dealer's suitability analysis

• Much of the Information required to establish a Prior Existing Relationship wouldbe useful in taking Reasonable Steps to Verify Accredited Investor Status

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Which Is More Difficult? (continued)

• Timing Favors Rule 506 (c) Over Rule 506 (b):- With Rule 506 (c), can take Reasonable steps to Verify

After Make the Offer and Before the Sale- With Rule 506 (b), the Issuer or Agent must establish

the Substantive Relationship Before the Offer (CDI 256.29 and256.30)• Numbers of Investors Favor Rule 506 (c) Over Rule 506 (b):

- With Rule 506 (c), must only take reasonable steps foractual Purchasers

- With Rule 506 (b), Must Have Prior SubstantiveRelationship with all Offerees and Purchasers

• Timing Favors Rule 506 (c) Over Rule 506 (b):- With Rule 506 (c), can take Reasonable steps to Verify

After Make the Offer and Before the Sale- With Rule 506 (b), the Issuer or Agent must establish

the Substantive Relationship Before the Offer (CDI 256.29 and256.30)• Numbers of Investors Favor Rule 506 (c) Over Rule 506 (b):

- With Rule 506 (c), must only take reasonable steps foractual Purchasers

- With Rule 506 (b), Must Have Prior SubstantiveRelationship with all Offerees and Purchasers

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