An issuer raising capital under Rule 506(c) must take “reasonable steps” to verify that investors are accredited. Rule 506(c)(2)(ii) specifies several steps that will be deemed reasonable, like getting a letter from the investor’s accountant.
Looking to save money, some issuers are tempted to verify investors themselves rather than using a third-party service like VerifyInvestor. For most issuers I think that’s a bad idea.
Suppose a non-accredited investor gets into your deal by forging a letter from an accountant, whiting out the numbers on her tax return, or because someone in your office makes a mistake. The deal goes south, investors lose money, and a clever plaintiff’s lawyer learns about the non-accredited investor. “The offering was illegal!” he claims. “Investors get their money back!”
You say, “But the letter from the accountant!” The plaintiff’s lawyer says, “You should have called the accountant’s office!”
You say, “The numbers on the tax return were whited out!” The plaintiff’s lawyer says, “The new numbers are in a different font!”
You say, “Everyone makes mistakes!” The plaintiff’s lawyer says, “But this mistake wasn’t reasonable!”
What you have are (1) a big headache, and (2) a lawsuit that’s not getting thrown out on summary judgement. Sorry for all the exclamation points but that’s the tenor of litigation.
Now suppose you used a reputable third party to verify investors. The plaintiff’s lawyer, who is working on a contingency, writes his demand letter and you respond “Sorry, I used XYZ Corp., an industry leader in investor verification.” I suspect the plaintiff’s lawyer doesn’t take the case. I think there’s a very strong argument that by hiring XYZ Corp. you have automatically taken “reasonable steps.”
For $50 per investor or whatever it is, that seems to me about as close to a no-brainer as they come.
One, I said this is true for most issuers. A large issuer with lots of investors and an established, professionally-managed investor relationship department might be able to absorb the new responsibilities with proper training.
Two, Rule 506(c) is the only offering exemption that requires verification. In offerings conducted under Rule 506(b), Regulation A, and Reg CF, issuers are allowed to take investors at their word.
Three, suppose an issuer using Rule 506(c) does nothing to ensure that investors are accredited but they’re all accredited anyway. The issuer can still be sued successfully by that clever plaintiff’s lawyer. The obligation to take “reasonable steps” is independent of the requirement that all investors must be accredited.
Questions? Let me know.
2 thoughts on “Use A Third Party To Verify Investors Under Rule 506(c)”
That is called “soft fraud” — and things like the CF insurance policy available from companies like Assurely could protect the issuer against having to deal with that.
Now personally, I would go with “name and shame” the Investor as an actual fraud 😉
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