Rule 506(b) vs Rule 506(c)

Introduction

Rule 506 of  Regulation D promulgated under the Securities Act of 1933 (Securities Act) allows for the private placement of securities without the need for registration under the Securities Act. This exemption has two subcategories: Rule 506(b) and Rule 506(c). Although they both share the same purpose, they differ in several ways, and each has its own unique advantages and disadvantages. Rule 506 is a safe harbor under Section 4(a)(2) of the Securities Act. If issuers rely only on Section 4(a)(2), they must also comply with the various State securities laws applicable to the offering and sale of securities, but Rule 506 preempts state securities law (except that States may require notice filings and require fees to be paid). The vast majority of private offerings are conducted under Rule 506(b). Issuers who are (or who have affiliates who are) subject to “bad actor” disqualification, may not rely on Rule 506.

Rule 506(b)

Rule 506(b) is the original exemption under Rule 506 that has been in effect since 1982. It allows issuers to raise an unlimited amount of capital from an unlimited number of accredited investors, as well as up to 35 non-accredited investors. This makes it a popular choice for companies looking to raise capital from a wide range of investors. Please note that, while issuers are allowed to raise capital from up to 35 non-accredited investors, these investors are entitled to substantial information rights, so most issuers only allow accredited investors to invest. Additionally, for issuers who are funds, most investments the fund makes will require the fund to qualify as an accredited investor. If non-accredited investors are in the fund, the fund may be unable to make its investments. General solicitation is not allowed, and issuers can only offer and sell securities to investors with whom they have a “substantive pre-existing relationship” that would reasonably lead them to believe that the investor is a sophisticated investor.

Pros of Rule 506(b):

• Allows issuers to raise an unlimited amount of capital from an unlimited number of accredited investors, as well as up to 35 non-accredited investors (typically not recommended to allow non-accredited investors to invest).
• No need to register the offering with the SEC (although Form D is required).

Cons of Rule 506(b):

• Limited marketing opportunities due to the prohibition on general solicitation and advertising. Without an existing network of accredited investors, it may be difficult to find investors.
• Non-accredited investors are limited to 35 and are entitled to increased disclosure.

Rule 506(c)

Rule 506(c) was added in 2013. It allows issuers to raise an unlimited amount of capital from an unlimited number of accredited investors, as long as all investors have been verified as accredited by the issuer. This eliminates the need for non-accredited investors and allows issuers to use general solicitation and advertising to market the offering. However, issuers must take “reasonable steps” to verify that all investors are accredited.

The SEC leaves “reasonable steps” open to interpretation but also provides some safe harbors for issuers:

• the issuer can verify the investor meets the income threshold requirements by examining tax documents from the previous 2 calendar years and obtain a representation from the investor that they reasonably expect to meet the standard in the current year;
• the issuer can verify the investor meets the net worth requirements by examining (a) asset documents (such as bank and brokerage statements) and (b) a credit report, all dated within the past 90 days; or
• the issuer can obtain a third party verification letter from (a) an attorney, (b) a CPA, (c) a registered investment adviser or (d) a broker dealer stating that the investor is an accredited investor.

Pros of Rule 506(c):

• Allows issuers to raise an unlimited amount of capital from an unlimited number of accredited investors.
• No need to register the offering with the SEC (although Form D is required).
• Allows issuers to use general solicitation and advertising to market the offering.

Cons of Rule 506(c):

• Expensive and time-consuming to verify that all investors are accredited.
• Marketing securities offerings online are difficult.

Conclusion

Each has its own unique advantages and disadvantages, so it is important for companies to understand the differences and carefully consider which option may be best for their company. Additionally, there are many other exemptions that may be more suitable than Rule 506.

NOTE: In several places, the term “unlimited investors” was used. Please be aware that this is only looking at the offering through the context of the Securities Act. Other rules (such as 12(g) of the Exchange Act or Section 3(c)(1) of the Investment Company Act) may limit the number of investors or beneficial owners. As always, consult your own attorney and do not rely on the above as legal advice.