Simple Verity

In this post I examine some of the issues with verifying accredited investor status (net worth or income) for purposes of a Reg D, Rule 506 offering.  The viewpoint I take is strictly a pragmatic one: how can the industry and regulators get a workable solution in place that gets the job done?

Note: this post addresses the new, higher standard for checking accredited investor status in cases of general solicitation or general advertising in Title II of the JOBS Act.  It is my understanding that in cases without general solicitation, the higher verification standard, and hence, the following post, will not apply.

1. Being “certain” is too hard, and overshoots the goal.

The gold standard for checking income is to verify against tax returns.  There are several problems, though, with requiring tax returns: it is intrusive, somewhat costly, and also fails in several cases (for example, when someone has a large Schedule C “paper loss” they might seem not to meet the threshold, despite having plenty of cash income).

There really is no gold standard for checking net assets, except an audit-type inquiry (verifying assets is somewhat easier, but verifying the absence of liabilities is impossible).  Other methods shy of an audit include an accountant’s letter or a self-provided balance sheet, all of which are intrusive and time-consuming (and, due to the uncertain value of illiquid assets like business holdings or partnership interests, hardly conclusive).

Besides, the verbatim text of the law doesn’t require being certain, or even mostly certain.  It merely requires that the issuer “take reasonable steps to verify.”  So we should set aside the “gold standard” methods and see what lesser steps can still give a “reasonable” assurance that the investor is accredited.

2. Just taking “reps & warranties” doesn’t achieve the goal.

However, you can’t just take the investor’s word for it with a perfunctory “check the box.”  Why not?  Two reasons, both based on the law itself.

First, the text clearly requires a higher standard.  The previous standard was that an issuer must have a “reasonable belief,” whereas the new standard (in cases of general solicitation) is that an issuer must “take reasonable steps.” If someone tells you “I am accredited,” and you have a general belief in their trustworthiness, you can today claim a “reasonable belief” even though you’ve taken no steps to verify that.  But, obviously, that mere belief is no longer sufficient, unless you take further steps.

Second, the clear intent of the Congress is a trade-off: loosen the strictures around advertising and general solicitation, but in return, tighten the requirement for accreditation.  And that makes sense; after all, permitting general solicitation but requiring only a rep & warranty about accreditation would be equivalent to dismissing the accreditation requirement wholesale with a wink and a nudge.

3. What characteristics would an ideal solution have?

You might think a perfect solution would never let a single unaccredited investor slip through the cracks, but I suggest that would be overkill.  Why?  Even if you think the accredited investor standard is meant primarily to protect “widows and orphans” (and there is reason to think not), it only applies to a particular exemption from registration.  Scammers are still free to push registered securities which may be risky or worthless onto unaccredited investors.  So, in an echo of the adage about running faster than a grizzly bear (don’t need to do it; only need to run faster than your hiking buddy), you need not “catch” every single unaccredited investor, only raise the bar enough to discourage issuers from pursuing unaccredited persons.

A succinct way to describe the ideal, therefore, is this: an ideal process for verification of accredited investor status need only be sensitive enough to make it uneconomical for issuers to target unaccredited investors.

A corollary is this: an ideal process for verification should never exclude a bona fide accredited investor.

A process that has these two characteristics should satisfy regulators (by creating an economic, as well as regulatory, disincentive for lawbreaking) and the industry (by ensuring that capital formation isn’t stopped).

4. What process fulfills these requirements?

My proposal is one of “reasonable escalation.”

(Full disclosure: my company, SimpleVerity, sells a service offering that is capable of the following.)

Begin with self-reporting and the assumption of truth: presume that an investor is accurately describing his income or net assets, and that we merely need some according external evidence.  Then, begin conducting progressively more intensive steps, only as needed.

If an issuer conducts some passive external verification which concurs with the self-report, we have success.  Such passive external verification might be a statistical model (based on e.g. zip code, profession, age, etc.) or it might be a personal data profile (based on e.g. land holdings, public records of stock holdings, etc.).  “Passive” here means that the lookup can be performed with only the directory information already provided by the investor.  Both of these types of verification are commercially available, and a record of having done either type of check with a concurring result would be a “reasonable step.”

Otherwise, if a passive external verification cannot be found to agree with the self-report, a second stage of escalation may occur.  In the second stage, the investor provides documentation, such as tax returns or a personal balance sheet, and if it concurs with the self-report, we have success.  Although this will involve more expense and hassle than a passive lookup, this documentary verification, too, can be streamlined and automated.

Finally, if neither passive verification nor documentary verification are successful, the door remains open for the issuer to conduct its own non-standard, individualized diligence.  Since this is the least streamlined and automated, it will be used most sparingly.  However, it need not be particularly burdensome if the investor’s status is easy to establish.

For example, let us imagine that the Sultan of Brunei offers to invest in a startup.  It is unlikely that he will have been established in the databases consulted by passive verification, and he may justifiably not want to be bothered with submitting a tax return.  In this case, the issuer may simply look in the annual list of the Forbes 400 in order to take a “reasonable step.”

(I also suggest that SEC should allow issuers to fall back on an “actual” standard in order to preserve their Reg D exemption in the absence of taking “reasonable steps.”  In other words, if you don’t take reasonable steps, but your investor turns out actually to be accredited, you are OK.)

5. How and how much?

How can such a regime of “reasonable escalation” be implemented, and how much would it cost?

First off, intermediaries should handle this for issuers.  Although the law places the burden on the issuer, verification will be something an issuer does perhaps once, ever, while it is will be a standard part of all Reg D, generally-solicited deals an intermediary conducts.

The intermediary would then either run its own process in-house, or contract out to a third party (like SimpleVerity).  The choice will probably depend upon the nature of the intermediary entity.  If the intermediary is a broker-dealer who is distributing shares to its network of clients with whom it has a deeper relationship (and hence financial knowledge), it will probably want to handle verification in-house.  If the intermediary is not a broker-dealer, it will probably want to contract out the verification.

For a third party verifier, the favored approach will probably be to use an API integration, whereby the intermediary first passively queries, and escalates the interaction as needed.

Regarding costs, Joseph Bartlett of Sullivan & Worcester speculated that verification could cost as much as $500 per investor.

That price point would have some pretty serious effects — for the worse — on who could use Reg D and how.  However, we believe the costs could be radically lower, by perhaps an order of magnitude, if a “reasonable escalation” standard is established, and once volume and competition are established.

6. Conclusion

SEC should strongly consider a “reasonable escalation” standard, and build in a safe harbor for verifications conducted in this manner.

SEC should not assume that the problem is intractable or will not yield to technology or business process; intermediaries should be free to choose methods and vendors to solve the problem.  SimpleVerity, among others, stand ready to provide this service.

Furthermore, and contrary to some public commentary to the contrary, SEC should extend the safe harbor to the entire offering’s exemption; that is, if every investor was verified as accredited according to the safe harbor, but one unaccredited investor slips through, that should not jeopardize an otherwise exempt offering.