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Bad actors
How to qualify investors when using general solicitation


ules added through the Jumpstart Our Business Startups Act eliminate the prohibition on using advertising and general solicitation to court investors to buy securities in certain unregistered offerings. While this has created possibilities, it has also imposed conditions. The Securities and Exchange Commission (SEC) requires companies that generally solicit investors to take “reasonable steps” to verify that all purchasers in the offering are accredited. But there’s no bright line test to verify accreditation, says Michael Lawhead, a shareholder at Stradling Yocca Carlson & Rauth. “Reasonable steps” are objective determinations made by the company in the context of each offering and each buyer. The SEC has, however, provided vague, but important, guidelines. Smart Business spoke with Lawhead about vetting investors. How should companies conduct due diligence on potential private investors? For an individual to be accredited, he or she must have an individual net worth, or joint net worth with spouse, of $1 million annually, excluding the value of the investor’s primary residence. The investor’s individual income must exceed $200,000 in each of the past two years, or $300,000 in the past two years with a spouse, and have a reasonable expectation of reaching that in the coming years. One way to verify income is to examine the two most recent years of IRS reported income, which can be obtained from the individual. Certification from the individual about future income is acceptable. T o verify net worth, look at bank statements, brokerage statements or similar documents that would show net worth for the past three months. Companies should

MICHAEL LAWHEAD Shareholder Stradling Yocca Carlson & Rauth (949) 725-4277 WEBSITE: Find Michael Lawhead’s profile at

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also acquire written representation from the individual that discloses his or her liabilities. A company could also obtain written confirmation from a registered broker/ dealer or other service provider who can verify the purchaser is accredited. A certification of accredited investor status can be obtained from an individual who invested in the company’s 506(b) offerings prior to this new rule being enacted. What constitutes reasonable steps? The SEC has laid out three factors companies should explore to qualify investors. One factor is the nature of the investor. Public information can be used to qualify investment companies, such as venture capital funds. Qualifying individual investors can be done by attaching a high minimum investment amount to the offering. A company could conclude that the buyer is accredited if he or she can pay it. Another factor is the type of information available. Public filings and information from reliable third parties can be used. The last factor is the nature of the offering. Investors gathered by third parties, such as placement agents, are likely to be accredited since the third party has screened them. What’s a ‘bad actor’? Essentially, a company will not be able to rely on Rule 506 if certain covered persons

purchasing securities have been subject to disqualifying events. Covered persons include the company making the offering, its predecessors, affiliates, shareholders invested at 20 percent or greater, directors and officers, and any person who has or will receive compensation in connection with the offering. The list of disqualifying events includes criminal convictions, court injunctions and restraining orders in connection with securities offerings. Companies are looking to law firms to develop questionnaires to investigate individuals. If using a placement agent, verify the agency has done due diligence. What happens if there’s an oversight in the verification process? A company won’t lose the benefit of the 506 safe harbor as long as it can demonstrate that it attempted a thorough investigation of potential investors. Not following the steps results in the loss of the safe harbor, but not the ability to conduct a private offering. General solicitation is not as easy as placing ads and waiting for money to roll in. The burden of complying with these rules is the responsibility of the company making the offering. An improperly conducted private offering could, among other things, give investors a right of rescission, which means they could take their money back. ●

© 2013 Smart Business Network Inc. Reprinted from the December 2013 issue of Smart Business Orange County.