Key Distinctions Between SEC Rules 506(b) and 506(c)

In the world of selling securities, transactions and/or securities are either registered or exempt, or they are illegal.  In 1933, the U.S. adopted the Securities Act, which codified certain exempt transactions and securities.  The exemption that our firm most frequently uses is the “private offering” exemption.  Under this exemption, issuers (e.g., Companies raising money) are able to issue securities in a private offering without having to register the securities.  Subsequent to the adoption of the Securities Act, the SEC developed rules (e.g., Regulation D) that interpreted what a “private offering” meant. 

 

Rule 506(b) of Regulation D

The most common rule by which capital is raised for private companies in the United States is Rule 506(b), which states that that an issuer can raise unlimited amount of money from an unlimited number of accredited investors (and, in some circumstances, up to 35 non-accredited investors*), provided that the issuer and the promoters did not use “general solicitations” to find investors.  

Under this rule, promoters, officers, or directors of the issuer typically attempt to find investors through their personal network and introductions to prospective investors from people within their network.  

However, the promoters, officers, or directors of the issuer are not permitted to send out mass communications that aren’t specifically directed at prospective investors.  Likewise, they could not host a meeting or presentation open to the masses to attempt to pitch those attendees as investors.  These are a few examples of “general solicitations”, which are not permitted under Rule 506(b).

Additionally, accredited investors buying into a Rule 506(b) opportunity are permitted to self-verify their accredited status. This typically either acknowledging certain things about themselves to demonstrate their sophistication and accreditation, or completing an investor suitability questionnaire, wherein they certify that they are “accredited”.

506(b) very much represents the “old school” way of raising money.  As we all know, however, a lot has changed since 1933…

 

Rule 506(c) of Regulation D

With the omnipresence of the internet, social media, and instant and mass communication, Congress enacted securities laws that allow for some more modern methods to raise money.  One of those was 506(c), which allows issuers, promoters, officers and directors of issuers to use “general solicitations” to find investors and still qualify for the “private offering” exemption.  The issuer does, however, have to take some additional steps to assure that the investor is, in fact, accredited.   

Under Rule 506(c), companies have the freedom of general solicitation only if they accept money from accredited investors (the 35 non-accredited investors is not permitted under this rule). Additionally, companies raising funds under 506(c) must take what the SEC characterizes as “reasonable steps” to verify the accredited status of purchasers. Self-verification, allowed under 506(b), is not allowed under 506(c). 

Satisfying the “reasonable steps” standard for the SEC can be quite onerous for companies and business owners. Because of that and the high stakes involved with non-compliance, we often recommend outsourcing this service to a third-party provider, or requiring that the purchaser’s attorney or Certified Public Accountant provide an opinion letter verifying the purchaser’s accredited status.

 

Old School vs. New School

506(b) very much represents the “old school” way of raising capital.  That said, it still dominates the private offering landscape for amounts of money raised year-after-year.  To highlight the differences in use, issuers raising capital under 506(b) raised approximately 1.4 TRILLION dollars in 2019 compared to $210 Billion raised in the same year using 506(c).

But, sometimes, the promoters, officers, and directors of the issuer may have better ability to source investors via general solicitations than through their own network and, in those cases, it can be a viable option to pursue.   

 

*Pro tip: Doida Crow Legal often recommends companies selling securities under Rule 506(b) to steer clear of non-accredited investors anyway due to burdensome SEC disclosure requirements (e.g., audited financial statements).

 

Our Firm Can Help Determine the Optimal Method For Your Company

Doida Crow Legal focuses on the legal side of complex business transactions like fundraising, and we have a special place in our hearts for ambitious, spirited entrepreneurs looking to make a difference in their communities. Let’s talk soon.

 

 

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