Unlike Rule 506(b), Rule 506(c) permits general solicitation and advertisement and permits companies to be in compliance with the private placement exemption so long as all investors in the offering are accredited and the companies take reasonable steps to verify the investors are in fact accredited. Such steps may include reviewing Form W-2s, tax returns and other information. Relying on representations in a subscription agreement alone may be insufficient. Many companies require potential investors to complete an investor questionnaire prior to making an investment in the companies’ securities, which questionnaire contains questions aimed at ensuring such investors satisfy the definition of being accredited investors. Such questionnaire may also be insufficient by itself to satisfy the verification requirement under the Rule. Companies are permitted, however, to take into account their relationship and knowledge of potential investors, as well.
Rule 501 of Regulation D sets forth the requirements of what constitutes an accredited investor. Generally, individuals qualify as accredited investors if their individual net worth or joint net worth with their spouse exceeds $1 million (excluding the value of such individual’s primary residence), or if such individual’s income exceeds $200,000 in each of the two most recent years or income with such individual’s spouse exceeds $300,000 in each of those years, and the individual has a reasonable expectation of reaching the same income level in the current year.
Bad Actor Disqualification
Even if companies would otherwise satisfy the requirements under Rule 506 and be eligible for one of the exemptions from registration there under, companies are disqualified from using such exemptions if they fall into the bad actor disqualification pursuant to Rule 506(d). Rule 506(d) disqualifies an issuer if the issuer, any director or executive officer of the issuer, any beneficial owner of 20% or more of the issuer’s outstanding voting equity securities or certain others has engaged in one of many specified acts set forth in the Rule. Such acts include having been convicted of a felony or misdemeanor within certain specified time frames in connection with the purchase or sale of any security, making false filings with the SEC and similar acts.
Form D and Blue Sky Laws
If companies comply with either exemption offered under Rule 506(b) or Rule 506(c) and are therefore exempt from the registration requirements under the 1933 Act and not disqualified pursuant to the bad actor disqualification under Rule 506(d), the companies do not need to register their offering of securities with the SEC. They are, however, still required to make a notice filing on Form D within 15 days of the first sale of securities. A Form D is a short public filing alerting the SEC that an offering and sale of securities has been made pursuant to an exemption from registration. In addition, companies should ensure that they have satisfied all applicable state securities laws, often referred to as blue sky laws, with respect to their offerings. Oftentimes, states will not require separate state filings to be made after a Form D is filed with the SEC, but will require a copy of the Form D or electronic notice of the offering be provided to the applicable state.
Due to the registration exemptions offered by Rule 506, companies can successfully raise a significant amount of money through private placements without having to endure the costly and time-consuming process of registering their offerings. In the last two years, regulations set by the Security and Exchange Commission (SEC) have undergone several changes. These changes were the result of the 2012 Jumpstart Our Business Startups Act. The JOBS Act, as it is more commonly known, was intended, in part, “to reduce barrier to capital formation, particularly for smaller companies.” In other words, the JOBS Act is meant to help companies attract investors more easily through the establishment of Rule 506(c), and a push to regulate equity crowd funding. Prior to the JOBS Act, companies were exempt from registering their transactions, as long as there was no public offering involved. One of the conditions was that the company was not allowed to use “general solicitation to market the securities.” Essentially, companies weren’t allowed to advertise or use crowd funding to attract investors. You can think of 506(c) offerings and crowd funding as cousins. Both aim to make it easier for companies to tap into a diverse network of investors, and both harness the potential of new technologies to raise capital quickly and cheaply. But, there are some crucial differences between the two. A basic guideline is that, in most cases, a 506(c) offering has fewer restrictions than crowd funding, except when it comes to who can invest, where the rules are stricter for a 506(c).
Who can invest?
This is the one area where crowd funding offers a more flexible opportunity to cast a wide net. 506(c) offerings must be made only by accredited investors, whereas crowd funding ventures are free to accept backing from non-accredited investors as well. On top of that, Rule 506(c) investors must be verified as accredited investors. Companies can use a third party service, such as Verify Investor, or take the risk of performing the accreditation in house. The trouble is that investors are often reluctant to provide sensitive financial information about themselves to a company they’re agreeing to back, so going with a third party service is often the quickest and easiest way to get past the verification hurdle.
How much capital can you raise?
This is where crowd funding most significant limitation comes in. While 506(c) offerings have no limit on their potential capital raise, crowd funders are restricted to a yearly cap of $1 million. While this often works for musicians, authors, and some businesses, it may not be useful for a business that needs a lot of capital up front in order to get going.
Is advertising allowed?
Here’s something that might surprise you: while 506(c) offerings are marketed and advertised freely now, the rules overseeing crowd funding solicitation are much more restrictive. General advertising is severely limited, and primary disclosure has to occur on an established “funding portal,” meaning one of the crowd funding websites we’ve all seen on our social media feeds.
What is legal now?
506(c) is legal now; crowd funding is kind of legal. The SEC has yet to put forth final recommendations, and only 11 states so far have legalized equity crowd funding for businesses. Even so, those states do not allow the use of social media to attract investors, since the internet is obviously not restricted to state lines. Although there is a suggested framework in place, equity crowd funding (unless it’s through Rule 506(c) to accredited investors) is largely not yet legal.
What is right for your company?
A range of factors come into play when deciding whether to go with 506(c) offerings or crowd funding.
• The size and scope of your company: Is $1M enough for you, or do you need more than that to get started? If you need more money up front, you should go with the 506(c) offerings. If your financial needs are less at the beginning, consider crowd funding.
• You product or service and its audience: Remember, your audience also includes your potential investors. Are they likely to have the financial security to be accredited? If so, go with 506(c). If you’re looking for a wider variety of investors, crowd funding may be more appealing.
• Your timeline: Do you need capital now, which would require you to use Rule 506(c), or can you wait as money trickles in?
• Legality: Remember that crowd funding still involves some legal pitfalls regarding how much can be invested. Accredited investors have a sense of the risk they are taking when they invest, whereas small amount investors on a crowd funding site may not. Consider the potential for backlash in your plan going forward, and remember to play it safe and consult your securities attorney.
The JOBS Act, Regulation D, and Rule 506(c)
The Jumpstart Our Business Startups (JOBS) Act was signed into law by President Obama on April 5, 2012. The law mandated certain changes to Rule 506 of SEC Regulation D designed to spur capital formation for growing innovators. The required Regulation D reforms took effect on September 23, 2013, after being finalized by the SEC this summer. This policy overview is not intended to, and does not, constitute legal counsel – issuers should consult their own legal teams before considering an offering and should not rely on this overview when considering such an offering.
Prior to the passage of the JOBS Act, Rule 506 of SEC Regulation D allowed issuers to raise an unlimited amount of capital through a private offering to an unlimited number of accredited investors and up to 35 non-accredited investors. The SEC defines an accredited investor as one with a net worth over $1 million (excluding the investor’s primary residence) or more than $200,000 in annual income ($300,000 for couples). Companies were prohibited from using general solicitation or general advertising to market their securities. The pre-JOBS version of Rule 506 has been maintained in its entirety as Rule 506(b). Issuers wishing to conduct a private offering to a mix of accredited investors and up to 35 non-accredited investors may still do so, provided that they do not use general solicitation to advertise the offering. The JOBS Act directed the SEC to lift the ban on general solicitation for offerings conducted under Rule 506, provided that issuers A.) sell securities only to accredited investors and B.) take reasonable steps to verify that all purchasers in an offering are accredited. The SEC finalized these reforms at its open meeting in July by creating a new Rule 506(c) that allows general solicitation in offerings to accredited investors. The finalized rules took effect on September 23.
As specified in the statute, issuers conducting Rule 506(c) offerings can now advertise to the general public, subject to certain conditions. This is a significant change from Rule 506(b), which prohibits general solicitation entirely. Though there are no specified limits on the reach of general solicitation under Rule 506(c), only accredited investors are permitted to purchase in an offering. The issuer must also take reasonable steps to verify that each investor in the offering is accredited. Other relevant SEC requirements or legal provisions may also apply. The SEC amended Form D, which is filed in conjunction with Rule 506 offerings, to add a checkbox for issuers to indicate whether they are relying on the new Rule 506(c) exemption and conducting general solicitation. New Rule 506(c): General Solicitation in Regulation D Offerings On August 29, the SEC in effect created an entirely new type of offering not subject to registration under the Securities Act of 1933. The SEC voted to propose amendments to Regulation D under the Securities Act to add new Rule 506(c). Rule 506(c) offerings would technically be private placements, made only to “accredited” investors, but they could be advertised widely on television, in newspapers, and most importantly over the internet. The JOBS Act of 2012 required the SEC to remove the prohibition on “general solicitation or general advertising,” which has been part of Regulation D since that regulation was adopted in 1982, so long as the purchasers in an offering were all accredited.
The way the SEC is proposing to effect this legislative mandate means that there will be two different types of offering under Regulation D’s Rule 506:
• Rule 506(b) offerings, which cannot use general solicitation but in which non-accredited investors can participate so long as they are provided with extensive information about the issuer of the securities, usually in the form of a private placement memorandum or PPM; and
• Rule 506(c) offerings, which can use general solicitation, but must be sold to accredited investors only, in which the market will let investors dictate the type of information that they need in order to make informed investment decisions.
The JOBS Act directed the SEC to lift the prohibition on general solicitation provided that all purchasers of the securities were accredited investors and the issuer took “reasonable steps to verify” that the purchasers were accredited, “using such methods as determined by the Commission.” The SEC declined to specify even a non-exclusive list of such methods, on the grounds that this would inhibit flexibility in the markets. Instead, the SEC is proposing that issuers be responsible for an objective determination of an investor’s accredited status based on a facts and circumstances analysis that would take into account factors such as the nature of the purchase, the type of accreditation that a purchaser claims, the manner of the offering and the terms of the offering (including minimum investment amount). The SEC believes that this approach would give issuers the ability to use a variety of different approaches depending on their circumstances. 1 Accredited investors include, in general, people with a net worth (excluding their residence) of $1 million, income of $200,000 a year (or $300,000 with their spouse), officers and directors of the issuer and various institutions that have more than $5 million in assets. Proponents of Rule 506(c) offerings believe that they will increase transparency, make it easier for small companies to raise capital and decrease companies’ administrative costs. Opponents argue that Regulation D was already a successful capital-raising mechanism (a recent study by the SEC showed a vibrant Regulation D market raising up to a trillion dollars in over 15,000 offerings a year, mostly in offering sizes under $1 million).
They also worry that, in the words of Commissioner Aguilar, removal of the prohibition on general solicitation would be “a boon to boiler room operators, Ponzi schemers, bucket shops, and garden variety fraudsters, by enabling them to cast a wider net, and making securities law enforcement much more difficult.” Rule 506(c) will present opportunities and threats. Contacting a broader range of investors will become easier, and thus more offerings can be made. This will combine with the opportunities already presented by the internet to present investment opportunities on a more cost-effective basis, without using an extensive PPM. More intermediaries (who must be registered broker-dealers) may enter the market. But, as the SEC points out in its Proposing Release: . . . eliminating the prohibition against general solicitation could make it easier for promoters of fraudulent schemes to reach potential investors through public solicitation and other methods not previously allowed. This could result in an increase in the level of due diligence conducted by investors in assessing proposed Rule 506(c) offerings and, in the event of fraud, would likely lead to costly lawsuits . . . The increased opportunity for fraud may mean that companies will need to do more to establish their legitimacy and intermediaries will seek to provide meaningful due diligence to distinguish themselves from their competitors. Moreover, liability under the securities laws for misstatements, both for issuers and their intermediaries, has not changed. The SEC has established a short 30-day period for the public to comment on the proposed rules. After that, the SEC will adopt final rules and establish an “effective date” for new Rule 506(c). Rule 506(c) offerings will only be legal after that effective date. The following table compares the principal attributes of traditional placements under Rule 506, new Rule 506(c) offerings and offerings made under Rule 506(c)’s cousin, crowd funding. The SEC has not yet proposed its rules for crowd funding, so additional restrictions are likely.
Benefits of 506(C) Offerings In General
The new Rule 506(c) gives businesses greater flexibility in raising capital by permitting businesses to publicly advertise an offering to a large number of people in a very cost-effective manner. Under Rule 506(c), businesses are permitted to use social media, and use other advertising and soliciting techniques to solicit investments from large numbers of investors to raise money so long as the business does not commit fraud in doing so and limits investors to “accredited investors”. Businesses also have greater freedom in making disclosures to investors, provided that the disclosures do not contain false or misleading information. Financial statements produced by the business for investors do not need to be reviewed or audited by an independent accountant. There is no limit to the amount of capital that can be raised. One of the few limitations to 506(c) offerings is that the business may only sell to accredited investors for whom the business has taken reasonable steps to verify their accredited status prior to sale. A new business can use a third party service to verify the status of investors, or the business can perform this work on its own.
Benefits Of 506(C) Offerings over Crowd funding
The SEC has recently issued regulations for equity crowd funding, another new type of capital raising method in which a large number of investors are solicited to invest small amounts of money for a new startup. Despite the arguably greater popularity of equity crowd funding, 506(c) offerings may still offer benefits that equity crowd funding cannot. Whereas an unlimited amount of capital can be raised through a 506(c) offering, equity crowd founders can only raise limited amounts of funds per year. This means that equity crowd funding is more likely to be a better option for artists and those who do not need a significant amount of capital, whereas a 506(c) offering may be more appropriate for other types of businesses. The annual costs of complying with the equity crowd funding rules and regulations each year are also far higher than compliance costs for 506(c) offerings.
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