If you’ve been involved as an issuer of securities in a private placement, you know the routine: Your lawyer has made sure that your form of stock purchase agreement, by which investors invest in your company in exchange for shares thereof, contains a number of representations and warranties made by the investor.
It is highly likely that one of those representations and warranties is that the investor is an “accredited investor”, meaning they meet one or more of the requirements set forth in Rule 501(a) of Regulation D, promulgated under the Securities Act of 1933. It is likely that the investor has even checked a box identifying the specific criteria under which they have qualified as an accredited investor.
You tell the investor that you are relying on that statement, and you memorialize that reliance in writing in the subscription agreement. You’ve got your representation and warranty and your exemption from registration, you accept the subscription agreement and issue the shares to a person or entity you now believe to be an accredited investor… but is your belief reasonable?
The Northern District of Indiana, in Supernova Systems, Inc. v. Great American Broadband, Inc., recently tackled the issue of whether the representation and warranty that a purchaser of securities is an “accredited investor” constitutes sufficient grounds for the issuer to “reasonably believe” that such purchaser is, in fact, an accredited investor.
In Supernova, the plaintiff-purchaser Supernova Systems, Inc. (“Supernova”) made a written representation and warranty to the defendant-issuer Great American Broadband, Inc. (“GAB”), that it was an accredited investor, when in fact, it was not.[1. The specific representation was that “(SuperNova) is an accredited investor as defined in Rule 501(a) of Regulation D, promulgated under the Securities Act.” It did not, however, require Supernova to indicate under which specific criteria it qualified as an accredited investor.] It had neither $5,000,000 in assets, nor did each of its owners qualify as accredited investors individually. The availability of the exemption from registration hinged on whether GAB “reasonably believed” that Supernova was an accredited investor.
Naturally, GAB pointed to Supernova’s representation. Supernova, on the other hand, argued that GAB needed more than just their representation, they needed “objective evidence” to rely upon.
The Court confirmed that Regulation D “contains no guidelines for determining what issuer measures are necessary to establish ‘reasonable belief,’” but found support for the proposition that “the reasonableness of an [issuer’s] reliance turns on the adequacy of its investigation.”
Ultimately, the Court would not let Supernova disavow its accredited investor representation in order to support its claims against GAB, and declared that, as a matter of law, GAB “reasonably believed” that Supernova was accredited, especially in the context of months-long negotiations involving extensive exchanges of information.
For our issuer-clients, the Supernova decision brings a sigh of relief, but it also should concern issuers who are conditioned to blindly accept accredited investor questionnaires completed by prospective investors. Are the accredited investor representations and warranties in your stock purchase agreements sufficient to support a reasonable belief? The answer may be “probably,” but it’s definitely worth a case-by-case analysis to be certain.
The obvious example is where a potential investor represents they are an accredited investor, but pays for lunch with food stamps and openly discusses their pending bankruptcy. At that point, you’re probably not being reasonable in accepting their representation that they are accredited investors.
The less obvious example is where a potential investor represents they are an accredited investor, but doesn’t indicate why. Perhaps they failed to complete the questionnaire, or they clearly marked a box that is inapplicable, such as when an entity-investor represents that they are accredited because they are an individual whose net worth is over $1,000,000. In those instances, is the issuer’s reliance on the incomplete or clearly inaccurate representation reasonable?
The Supernova case should serve as a red flag, highlighting the risks of not performing adequate due diligence on each of your investors by asking additional questions, verifying income or net worth and taking additional steps to justify your reliance on the investor’s statements.
The first step is making sure you have well-drafted representations and warranties that are clear and conspicuous, and identify not simply whether a potential investor is accredited, but why.