First there was Rule 506, under which investors could claim exemption to the requirement of registering securities.
Subsequently, in its July 10, 2013, meeting, the U.S. Securities and Exchange Commission (SEC) adopted the new Regulation D, Rule 506(c), authorized by the JOBS Act (Title II). Rule 506(c) went into effect on Sept. 23, 2013.
Now the old Rule 506 is known as Rule 506(b).
Which one applies to you – 506(b) or 506(c) – is the question. It can be confusing. This article is meant to explain the difference.
WHAT RULE 506(c) MEANS FOR YOU
Under the new rule, you can advertise private investment opportunities (securities offerings) to investors you don’t know under certain conditions. It is now legal to advertise a specific deal to private investors, provided you follow the new rules!
WHAT’S A SECURITY?
If you are using other people’s money for your real estate transactions, you are probably selling securities.
Securities include promissory notes or “investment contracts” between a manager or general partner and passive investors. Under the Securities Act of 1933, sales of securities must be registered (pre-approved as in a public offering) unless exempt. There are numerous exemptions (both federal and state) from registration.
By far, the most common exemption has been the Rule 506 private offering exemption. The SEC reported that as much as $898 billion may have been raised in Rule 506 offerings in 2012. Additionally, from 2009 to 2012, the average offering size was around $30 million. The median offering size was about $1.5 million.
THE OLD RULE 506(b)
The original rule was known as Rule 506, but will hereafter be known as Rule 506(b). It is still in effect. In general, under this rule an issuer of securities has a “safe harbor” exemption from registration. That means the issuer doesn’t have to obtain SEC pre-approval of the offering or need a license to sell its own securities, as long as it follows the rules for the exemption.
Rule 506(b) allows an issuer of its own securities to raise an unlimited amount of money from an unlimited number of Accredited Investors and up to 35 Sophisticated Investors.
However, the issuer cannot make any offers or sales of the securities by any means of general advertising or solicitation. To prove they didn’t solicit investors, issuers must be able to demonstrate a pre-existing relationship with an investor. The relationship must pre-date any offer to sell securities.
For issuers relying on Rule 506(b), the investors may self-certify that they are Accredited or Sophisticated. They do that by checking a box on a pre-qualification form provided by the issuer.
A Sophisticated Investor is one who, alone or with a purchaser representative, has such knowledge and experience in financial and business matters that he or she can evaluate the merits and risks of the prospective investment.
An Accredited Investor is:
- An individual (or couple) with a net worth of $1 million, excluding their primary residence, or
- An individual whose annual income exceeds $200,000 for the two most recent years (or $300,000 if married) and a reasonable expectation of the same for the current year.
THE PROBLEM WITH RULE 506(b)
Large funds ($10 million to $30 million) use registered investment advisers or the securities broker-dealer community to raise funds for their private offerings, based on their pre-existing relationships with investors.
This channel is not available for smaller funds. That is because investment advisers and broker-dealers typically won’t market securities offerings of less than $10 million. So the small issuer must develop direct relationships with prospective investors and sell securities on its own.
For these issuers, the pre-existing relationship and non-solicitation provisions or Rule 506(b) have been a source of great confusion. The provisions also have caused misinterpretation and been a significant impediment to their ability to fund their real estate transactions or businesses.
THE NEW RULE 506(c) SOLUTION
The new rule offers promotion opportunities for small issuers who want to raise $1 million to $10 million or more. Under the new Rule 506(c), issuers can advertise to anyone as long as they only accept Accredited Investors in their offerings and comply with the rest of the Rule 506(c) provisions.
However, in order to use the Rule 506(c) exemption, the issuer must be able to demonstrate that it took “reasonable steps” to ensure that all investors are Accredited at the time of the investment.
The SEC offered some non-exclusive methods to verify Accredited status for natural persons, which include such things as:
- Verifying income from the past two years’ tax returns and written assertions that the income is expected to continue;
- Verification of assets by reviewing statement balances from brokerage houses or banks, reviewing tax assessments/third-party appraisals of real estate holdings and verification of liabilities through an investor’s credit report; or
- Obtaining a written confirmation from a securities broker-dealer, registered investment adviser, licensed attorney or CPA, who attests to have taken reasonable steps to verify the investor’s Accredited status within the past 90 days and that the person is, in fact, Accredited; and there is an exemption for investors who previously invested with an issuer as an Accredited investor.
Under the Rule 506(c) exemption, Issuers can advertise on their own websites, as well as website platforms operated by others who generally pre-screen the viewers to restrict viewing of offering materials to Accredited Investors only.
NEW “BAD BOY” PROHIBITIONS FOR RULE 506 OFFERINGS
Concurrent with implementation of Rule 506(c), the SEC adopted a new Rule 506(d) that applies to all Rule 506 offerings.
Rule 506(d) disqualifies persons “who have been convicted of, or are subject to certain government court or administrative sanctions for, securities fraud or other violations of specified laws” (i.e., a cease and desist order, injunction, disciplinary order, etc.) issued by certain federal financial regulatory agencies or the postal service, from ever claiming a Rule 506 exemption.
For such events occurring prior to the effective date, mandatory disclosure to investors is required.
PROPOSED AMENDMENTS TO REGULATION D
The SEC has proposed some additional amendments to Regulation D that would apply to all Rule 506 offerings. These include:
- Additional Form D filing requirements (pre-sale, first sale and closing notices of securities).
- Filing of additional information about the issuer and marketing methods to be used.
- Additional legends and disclosures.
- Temporary submission of written ads/website content to the SEC prior to use.
These amendments have yet to be implemented, although some issuers of Rule 506(c) offerings are voluntarily complying with these requirements.
For now, here’s what you need to know:
There is a new Rule 506(c) that currently allows you to advertise securities offerings to anyone, even on your own website, providing you take “reasonable steps” to sell the securities only to Accredited Investors.
You will have to work with qualified securities counsel to ensure you understand and comply with the requirements under the new Rule 506(c) exemption.
Our clients tell us the bulk of their investors are Sophisticated, and many are investing via their self-directed IRAs.
The original Rule 506(b)—which prohibits advertising, requires demonstration of a pre-existing relationship before making offers and allows investors to self-certify their financial qualifications—will still be the rule of choice for issuers who want to include Sophisticated Investors in their offerings.
So for many issuers, it’s still business as usual.
We are happy to answer your questions in a free 30-minute consultation. To schedule a free teleconference, click here.