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Requirements of Rule 506(c): Reasonable Steps

This September, the Securities and Exchange Commission (“SEC”) modified Regulation D and created new Rule 506(c), allowing general solicitation and advertising by issuers of private funds pursuant to certain conditions. These conditions require, among other things, that issuers relying on Rule 506(c) take “reasonable steps” in order to verify: 1) that each investor is an “accredited investor;” and 2) that each person involved in the operation and distribution of the fund is not a “bad actor.” In this posting, the first of these requirements will be discussed, with the latter “bad actor” condition to receive further attention in next week’s posting.

To date, the SEC has not offered an exact definition for what it considers “reasonable steps” when determining whether each investor in a Rule 506(c) offering is accredited. Rather, the SEC stated in its final rules that whether steps taken are “reasonable” would be an “objective determination by the issuer in the context of the facts and circumstances of each purchaser and transaction.” In the past, issuers generally relied on investor representations made in the subscription agreement without independently verifying the financial status of the investor. Now, the SEC will expect the issuer to exercise greater diligence than before in ascertaining accredited investor status if the fund uses Rule 506(c) to promote its interests. To accomplish this, the SEC provided a non-exclusive list of methods that an issuer may follow to show that “reasonable steps” were taken to verify that the purchaser is an accredited investor. This includes:

  • 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; and
  • 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.

To provide some “real-world” context to these methods, the SEC gave the following examples that may be deemed sufficient for issuers targeting natural persons as potential investors:

  • When relying on income as the basis for establishing accreditation, the issuer may review IRS forms that report revenue for the previous two (2) years, and obtain a written confirmation from the purchaser representing that he or she expects to reach the same income level in the current year.
  • When relying on net worth, the issuer may review financial statements, brokerage statements, etc. from third parties in order to verify assets; a consumer report from at least one consumer reporting agency; and a written confirmation from the purchaser that all liabilities to make a net worth determination have been disclosed (information cannot be older than (3) three months).
  • The issuer obtains a written confirmation from a broker-dealer, a registered investment adviser, a licensed attorney or a CPA that such person has taken reasonable steps in the prior (3) three months to verify that the purchaser is an accredited investor.

When relying on Rule 506(c), issuers should take all necessary steps, non-exclusive to the steps above, to verify that the purchaser is indeed an accredited investor. Failure to do so may result in the loss of the Regulation D exemption and, potentially, the loss of the Securities Act Section 4(2) private placement exemption as well. For further information on this topic, or to read more about general solicitation and advertising under Rule 506(c), go here, or contact us at or (619) 298-2880.