Issuers should ensure that investors are not criminals

The JOBS Act requires that issuers wishing to engage in general solicitation take “reasonable steps” to verify the accredited investor status of purchasers. Rule 506(c) sets forth a principles-based method of verification which requires an objective determination by the issuer or its representatives that the steps taken are “reasonable” in the context of the particular facts and circumstances of each purchaser and transaction. But perhaps a question whether the investor is a felon should be added to the list.

A case decided in 2011 by California’s Court of Appeal, Second District, suggests that indeed it may be prudent for issuers to ensure that investors are not criminals. The plaintiff in this case intended to purchase units in a limited liability company, but was rejected after the mezzanine lender would not accept the plaintiff as a member due to his status as a former felon. The plaintiff subsequently sued the lender, alleging a violation of the Unruh Civil Rights Act. After a dismissal by a trial court, the case was appealed, resulting in a conclusion that  (1) status as a felon is not a personal characteristic similar to those enumerated in the statute; (2) criminal convictions raised legitimate questions about the honesty and trustworthiness of the plaintiff, and the lender had legitimate business reasons justifying its decision; and (3) the potential consequences of allowing the plaintiff’s claim would improperly involve the courts in second-guessing a lending institution‘s expertise in determining loan and investment criteria. As lenders are absolved from potential liability under the Act, issuers who unwittingly accept convicted felons as investors may be jeopardizing their funding.