When Title II of the Jump Start our Business Startups (JOBS) Act took effect in September 2013, Rule 506 of Regulation D was split into 2 distinct exemptions, 506(b) and 506(c). 506(b) preserved the old Rule 506, but 506(c) changed the world of private investing.
For 80 years before the JOBS Act, a company wanting to offer and sell private securities was restricted to selling to their own network of family and friends, or through a broker or advisor to their established clients. This limit existed mainly because of the ban on general solicitation of a private security. If sold through a broker or advisor, a demonstrated, pre-existing relationship had to exist prior to the onset of the offering. This restriction is known as contemplation, and for the advisor or broker, the relationship must come first. A new offering may not be presented to a new relationship unless the offering were an “ongoing offering” such as a hedge fund or some REITs. Based on capital committed, Regulation D, Rule 506 is a widely utilized exemption to registration.
Under 506(c), the ban on general solicitation was removed from the regulation—and issuers could take their deals to the world of accredited investors seeking opportunities with a risk/reward profile that was different than what was previously available. There are at least five significant benefits to the issuer utilizing a Rule 506(c) exemption vs. Rule 506(b).
By far, the most significant advantage of an offering’s structure under the 506(c) exemption is the ability to generally solicit or market the offering. No pre-existing relationship requirement exists. This means that issuers can take their offering and publicly communicate the offerings and issuer’s attributes utilizing channels previously prohibited; including web, in a magazine, on a billboard, or most any other way they can imagine. This not only allows investors to show their current offer to the world, potentially resulting in an expedited completion of their raise, but it also creates a larger investor base for future deals the issuer may offer. With 506(b), a ban on general solicitation still exists and investors are still restricted to those inside a company’s close network or the intermediary’s existing client base.
Another difference between the 2 offerings is the prohibition of non-accredited investors into the investment. With 506(b), issuers may allow up to 35 non-accredited investors to invest in the deal, but even non-accredited investors need to be “sophisticated” and certain information about the offering is required to be provided to all investors. This becomes a problem as it allows for subjectivity to be introduced. The issuer may learn about an investor and think they are sophisticated and have “sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment”, while the SEC may later examine an investor and come to a different conclusion.
While issuers can allow non-accredited investors into a 506(b) exempt offering, both exemptions still require that accredited investors are verified. The difference is the requirement on what verification is required by the issuer. In a 506(b) exempt offering, investors may self-attest that they are accredited, and then the broker can have no basis to disbelieve the investor’s claim. In a 506(c) offering, the issuer is on the hook to take reasonable means to verify the accreditation status of the investor. One way to demonstrate reasonable means is to have the investor’s attorney, broker, advisor or CPA provide an accreditation letter on behalf of their client, and in a secondary verification, confirm that the professional is currently licensed. Accreditation is achieved by either proving the investor has a net worth of $1,000,000 not including primary residence; by proving that the investor has made $200,000 a year over the past 2 years, with a reasonable prediction to make that again this year; and, recently, the accreditation standard has been amended to allow certain licensed financial professionals to be considered accredited—and that discussion continues.
A fourth major difference between the two types of 506 offerings is the different type of documents required to be disclosed. This is where 506(c) becomes even more straightforward for an issuer to manage. In a 506(b) offering, the document disclosure requirements are similar to the information required in a registered offering. On the flip side, for a 506(c) offering, there are no document disclosure requirements because all investors must be accredited and theoretically should know the right questions to ask before they invest.
The last major difference is the waiting period before investing. In a 506(c) offering, there is no waiting period requirement. With a 506(b) offering, historically, issuers have to be able prove a relationship of a minimum of 30 days with an investor before they are allowed to know about the deal. The purpose of the 30-day waiting or “cooling off” period was for the broker-dealer to make sure the investor is suitable for the investment and is sophisticated enough to make the investment. This is also a time for the investor to learn about the issuer and educate themselves on private placement transactions. During this time period, there are suitability and sophistication investor attributes for the broker-dealer to gauge about the investor. This 30 day guideline was clarified with the SEC’s Citizen VC no action letter, where the quality of the relationship was determined to be more important than its duration.
As the world of private investing continues to evolve, 506(c) has emerged as a preferred means to raise private funds by mitigating the public solicitation concern that would invalidate the exemption for issuers.
For dealer managers and their syndicate members, removing that concern is significant because just one syndicate member that violates a non-solicitation requirement of a 506(b) offering invalidates the exemption for the whole offering—and poisons the well for all syndicate members and their investors. An increasing trend for many 506(b) offerings available for subscription is to convert them to a 506(c), removing one of the ongoing concerns for utilizing the 506(b) exemption.