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 sources 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.
Under Rule 506 b, issuers of securities are exempt from the registration requirements of the Securities Act for unlimited size offerings. However, to qualify under this rule, the securities that are being offered can only be bought by accredited investors and no more than thirty-five unaccredited investors. These unaccredited investors must also meet certain requirements, such being an officer of the company that is offering the securities. In addition, the issuer is not allowed to solicit the securities, and they must reasonably believe that the investors purchasing the securities are accredited or are unaccredited investors who meet sophistication requirements.
Advantages of Rule 506 B
There are a variety of advantages to qualifying under rule 506 b. In particular, this rule allows the inclusion of unaccredited investors in offerings. Securities issuers that use rule 506 c may lose accredited investors because of the need to provide verification. With rule 506 b, no verification is necessary.
Information About Form D
Companies that qualify for rule 506 b are not required to report to the Securities Exchange Commission (SEC) and also will not need to register their securities. However, after their first securities have been sold, these companies are required to file Form D. This form is used to list basic information about the company:
• The addresses of the company’s owners.
• Names of the company’s owners.
• Names of the stock promoters.
What You Should Know Before Investing
It’s important to do your due diligence before investing any of your money in a company that makes offerings under rule 506 b or c. In particular, you should contact the SEC to ask whether the company you are thinking about investing in has filed Form D. You should be wary of investing in a company that has not filed this form, as it may mean that they are not complying with the securities laws laid out by the federal government. It’s also a good idea to contact the securities regulator in your state to see if they can provide you any information about the company, including information about the owners. You should also ask your state’s regulator if they have cleared the offering that you are thinking about purchasing.
Difference between Rule 506 B and 506 C
One of the biggest differences between 506 b and 506 c offerings is how the companies are allowed to sell securities. For example, advertising is strictly prohibited for 506 b offerings. However, if the company has an existing relationship with an investor, they are allowed to approach these investors about the offering. On the other hand, 506 c offerings can be advertised however the company wishes, and no investor relationship is required. Only accredited investors are allowed to purchase 506 c offerings. 506 b offerings can include up to thirty-five unaccredited investors as long as they fulfill certain sophistication requirements. Companies that have more than 2000 investors, or more than 500 unaccredited investors, must report based on the rules of the Exchange Act.
With 506 b offerings, companies will certify that an investor is accredited using a questionnaire. As you might imagine, this can pose a problem, as is there is nothing preventing an unaccredited investor from lying to the company about their certification. 506 c offerings have much stricter accreditation requirements. Companies making these offerings must be very careful to make sure that their investors are accredited. Self-certification is not allowed. There are no limits to the size of offerings for either 506 b or 506 c companies. 506 c rules do not require disclosure. With 506 b offerings, there is no requirement to disclose information as long as all of the investors are accredited. However, if the offering includes unaccredited investors, the company must provide the investors with a large amount of information about the offering. Both types of companies are required to file Form D, and this form must be filed in every state in which the company has an investor. Neither 506b nor 506c companies require intermediaries when making offerings. However, if the companies choose to use an intermediary, this person must be registered as a broker-dealer or possess an exemption.
Rule 506(b) Offerings – Regulation D Offerings
Section 4(a)(2) of the Securities Act of 1933, as amended (the “Securities Act”) exempts from SEC registration, transactions by an issuer not involving a public offering. Rule 506(b) of Regulation D of the Securities Act provides a “safe harbor” under Section 4(a)(2). Rule 506(b) sets forth standards that a company can use to meet the requirements of the Section 4(a)(2) exemption. Under Rule 506(b), an issuer may raise an unlimited amount of money. Additionally, the issuer can sell securities to an unlimited number of accredited investors and up to 35 non-accredited investors if certain disclosures are provided.
General Requirements of Rule 506(b) Offerings
An offering under Rule 506(b) has the following requirements:
• no general solicitation or advertising may be used to sell the securities
• the securities may not be sold to more than 35 non-accredited investors and all non-accredited investors, either alone or with a purchaser representative, must meet the legal standard of having sufficient knowledge and experience in financial and business matters to be capable of evaluating the merits and risks of the prospective investment
Rule 506(b) Offerings to Non-Accredited Investors
If non-accredited investors are purchasing in the Rule 506 (b) offering, the issuer must provide non-accredited investors with disclosure documents that generally contain the same type of information as provided in registered offerings, and provide the financial statement information specified in Rule 506. These financial statements may need to be certified or audited by an accountant. A company using Rule 506(b) for its offering is not required to provide specified disclosure documents to accredited investors, but, if it does provide information to accredited investors, it must also make this information available to the non-accredited investors as well. Additionally, the company’s management should be available to answer questions from prospective purchasers who are non-accredited investors.
Bad Actor Disqualification in Rule 506(b) Offerings
As a result of Rule 506(d) bad actor disqualification, an offering is disqualified from relying on Rule 506(b) of Regulation D if the issuer or any other person covered by Rule 506(d) has a relevant criminal conviction, regulatory or court order or other disqualifying event that occurred on or after September 23, 2013. Under Rule 506(e), for disqualifying events that occurred before September 23, 2013, issuers may still rely on Rule 506, but will have to comply with the disclosure provisions of Rule 506(e) discussed below.
Covered Persons
Understanding the categories of persons that are covered by Rule 506(d) is important because issuers are required to conduct a factual inquiry to determine whether any covered person has had a disqualifying event, and the existence of such an event will either disqualify the offering from reliance on Rule 506 or will have to be disclosed to investors.
“Covered persons” include:
• the issuer, including its predecessors and affiliated issuers
• directors, general partners, and managing members of the issuer
• executive officers of the issuer, and other officers of the issuers that participate in the offering
• 20 percent beneficial owners of the issuer, calculated on the basis of total voting power
• promoters connected to the issuer
• for pooled investment fund issuers, the fund’s investment manager and its principals
• persons compensated for soliciting investors, including their directors, general partners and managing members
Disqualifying Events
Disqualifying events in Rule 506(b) Offerings include:
• Certain criminal convictions
• Certain court injunctions and restraining orders
• Final orders of certain state and federal regulators
• Certain SEC disciplinary orders
• Certain SEC cease-and-desist orders
• SEC stop orders and orders suspending the Regulation A exemption
• Suspension or expulsion from membership in a self-regulatory organization (SRO), such as FINRA, or from association with an SRO member
• U.S. Postal Service false representation orders
Many disqualifying events include a look-back period (for example, a court injunction that was issued within the last five years or a regulatory order that was issued within the last ten years). The look-back period is measured from the date of the disqualifying event—in the example, the issuance of the injunction or regulatory order—and not the date of the underlying conduct that led to the disqualifying event.
Reasonable Care Exception
The rule provides an exception from disqualification when the issuer is able to demonstrate that it did not know and, in the exercise of reasonable care, could not have known that a covered person with a disqualifying event participated in the offering. The steps an issuer should take to exercise reasonable care will vary according to particular facts and circumstances. The instruction to the rule states that an issuer will not be able to establish that it has exercised reasonable care unless it has made, in light of the circumstances, factual inquiry into whether any disqualification exists.
Waivers
The final rule provides for the ability to seek waivers from disqualification by the Commission. There are a number of circumstances that could, depending upon the specific facts, be relevant to the evaluation of a waiver request. Rule 506(d)(2) of Regulation D provides another way for issuers to request a waiver of disqualification. Disqualification will not arise if, before the relevant sale is made in reliance on Rule 506, the court or regulatory authority that entered the relevant order, judgment or decree advises in writing—whether in the relevant judgment, order or decree or separately to the Commission or its staff—that disqualification under Rule 506 should not arise as a consequence of such order, judgment or decree.
Disclosure of Pre-Existing Events
Disqualification will not arise as a result of disqualifying events that occurred before September 23, 2013, the effective date of the rule amendments. Matters that existed before the effective date of the rule and would otherwise be disqualifying are, however, required to be disclosed in writing to investors. Issuers must furnish this written description to purchasers a reasonable time before the Rule 506 sale. Rule 506 is unavailable to an issuer that fails to provide the required disclosure, unless the issuer is able to demonstrate that it did not know and, in the exercise of reasonable care, could not have known that a disqualifying event was required to be disclosed.
Tradability and Re-sales in Rule 506(b) Offerings
A Purchaser in a Rule 506(b) Offering receives “Restricted Securities”. Rule 144(a)(3) identifies what offerings produce restricted securities. After these offerings, investors can only resell their securities into the market by using an effective registration statement under the Securities Act or an exemption from registration for the resale, such as Rule 144. Rule 144 permits the resale of restricted securities if a number of conditions are met, including holding the securities for six months or one year, depending on whether the issuer has been filing reports under the Securities Exchange Act of 1934. Rule 144 may limit the amount of securities that can be sold at one time and may restrict the manner of sale, depending on whether the security holder is an affiliate. An affiliate of a company is a person that, directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, the company. Rule 506(b) is only available for offers and sales by an issuer of securities to initial purchasers and is not available to any affiliate of the issuer or to any person for resales of the securities.
Form D Requirements
A company conducting a Rule 506(b) Offering must file a Form D with the SEC within 15 days after the first sale of securities in the offering.
Dos and Don’ts of Conducting a Rule 506(b) Offering
When raising capital, a company must comply with securities laws. As previously discussed, all offerings of securities must either be registered with the SEC or exempt from such registration. Rule 506(b) is the most commonly used securities exemption for private companies. Even after complying with the basics of this exemption, there are many nuanced requirements that, if missed, can jeopardize qualifying under the exemption. Failure to comply with Rule 506(b) can subject an issuer and its officers and directors to various penalties. The SEC and state regulators can institute investigations and administrative and civil actions, enter various orders, and impose significant monetary penalties, and can transmit evidence to the U.S. Attorney General, who can bring criminal proceedings. In addition, violating securities registration requirements entitles the purchasers to rescission rights under federal and state laws. This blog post compiles some of the best practices for conducting a 506(b) offering in a bullet-pointed list for easy reference. Remember that you shouldn’t engage in any securities offerings without retaining a lawyer experienced in such areas, so the below pointers are not meant to be, or take the place of, legal advice.
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