Hi, Tilden Moschetti here, syndication attorney with the Moschetti Law Group. I focus exclusively on Regulation D filings – that’s your 506(b) and your 506(c). I primarily produce private placement memorandums, operating agreements, subscription agreements, investor questionnaires, and make sure that syndicators are raising capital legally and in compliance with the SEC and local state jurisdictions. Today, we’re going to do a deep dive into one of the big sections and rules of Regulation D, and that is rule 506(b). I thought we’d take a deep look and really understand how it works.
Again, this is Tilden Moschetti, syndication attorney for the Moschetti Law Group. Today, we’re going to do a deep dive into rule 506(b). How are we going to do that? We are going to look at the code section itself, so that we can understand how it all works and interplays. We’ll talk about some of the nuances that are contained within that section. Most of our clients are either doing 506(b) or 506(c), probably 95% of my clients are on those two exceptions under Regulation D. So let’s take a look at 506(b).
This is the first part of 506(b):
§ 230.506 Exemption for limited offers and sales without regard to dollar amount of offering.
(b) Conditions to be met in offerings subject to limitation on manner of offering
(1) General conditions. To qualify for an exemption under this section, offers and sales must satisfy all the terms and conditions of §§ 230.501 and 230.502.
506(b) and subsection one talks about the general conditions. But let’s talk about the beginning first. Very clearly, it says 506(b), these are the conditions that must be met in offerings subject to the limitations. So let’s go through what those conditions are.
First up, general conditions subsection one. To qualify for this exemption – let’s back up just a little bit because this word “exemption”, what exactly do we mean by exemption? In general, all securities must be registered either with the state or with the SEC. However, there are some regulations which allow an exemption from that registration. Regulation D is a set of rules that are exempt offerings. And 506(b) is one of those exemptions. So that’s what we mean by that.
To qualify as an exemption under this section under 506(b), offers and sales must satisfy all of the terms and conditions of section 230.501 and 502. So automatically, we’re pointing to other rules, and it’s getting a little bit more complicated. Let’s try and ease it up. When we’re talking about 501, for the most part, we’re talking about who can invest. The big topic in 501 is accredited investors.
§ 230.501 Definitions and terms used in Regulation D.
(a) Accredited investor. Accredited investor shall mean any person who comes within any of the following categories, or who the issuer reasonably believes comes within any of the following categories, at the time of the sale of the securities to that person:…
(5) Any natural person whose individual net worth, or joint net worth with that person’s spouse or spousal equivalent, exceeds $1,000,000;
The other part of 501 talks about how advertising works and what’s prohibited under Rule 501 for 506(b) offerings. We’ll take a deeper dive into those in just a minute. But let’s also talk about what is in rule 502.
Rule 502 is more about what you need to say in order to meet and satisfy all the terms and conditions. Here we’re really talking about the PPM (private placement memorandum). Your private placement memorandum is there for a very specific purpose. It’s to convey information from you, the sponsor, over to your investors. I’m going to use the words sponsor, issuer, and syndicator interchangeably – they’re all the same thing. You’re the sponsor, the syndicator, the issuer. We’re all talking about you as that person.
So what needs to be a part of that PPM? Well, first off, there is some non-financial information. Some of that is obvious, right? You need to talk about what the investment kind of is, what are people giving their money for, and what are they getting out of it. But another major piece of the PPM that is non-financial information is your risks. So identification of those risks, disclosure of those risks, disclosures of any conflicts of interest that may exist between you the issuer and the investor. Those are all non-financial and must be disclosed in order to meet the requirements of 502, which is part of 506(b).
Number two, there must be some disclosure of financial statements. But what are they really looking for? You may be asking yourself, “But we just got started, we don’t have any financial statements.” And that’s okay, they still need you to make this disclosure. What they’re really looking for here is use of funds. How much money are we talking about? How is it going to be used by you as the sponsor? What is the investor likely to get from it? How is that going to work? For businesses that are already ongoing and raising capital, those companies can raise funds under 506(b), and what they would need to disclose in that case is financial statements that support what the investors are getting themselves into by investing with you.
Number three that needs to be disclosed is the opportunity to ask questions. So investors need to have an opportunity to ask you as a sponsor questions that they may have. Otherwise, it hasn’t really been this kind of open system of “let me explain everything about the investment to you.” We do not keep anything in our investments behind closed doors and do not let the investors know if it’s something that materially affects them. So they need that ability to ask those questions, and it’s required by 502 that they have that opportunity. In our PPM, we make it very clear that that opportunity is here, here’s the contact information, etc.
And number four on these is a biggie, and we’ll actually do another video on this later, but it is the limitations on resale. The SEC doesn’t want people just buying up these investments in order to create a secondary marketplace where they can be traded. These are private offerings, hence the name private placement memorandum or private placement. Because they’re not a public offering, it’s not being opened up to the public. And so we’re not trying to create a marketplace here. The SEC is very concerned that people will try and do an end run around the system, basically do a Reg D offering which is really in disguise a public offering. That is not allowed. And that is why there are these limitations on resale. A discussion of that must be within that PPM to satisfy the conditions of 502.
So this is rule 506(b), and specifically 501. Now, we have this other rule under 502(c), and this talks about the advertising. This portion here that we’re talking about, about advertising:
§ 230.502 General conditions to be met…
(c) Limitation on manner of offering. Except as provided in § 230.504(b)(1) or § 230.506(c), neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising, including, but not limited to, the following:
(1) Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and
(2) Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising;
So, what you are not allowed to do (except as provided by rule 504, which this is not – I know it says (b) there, this is 504(b) not 506(b), that’s a completely different thing. 504 offerings exist, but they are actually much more complicated and most people opt not to do them. Most people opt to do 506(b) and 506(c).) So except as provided by 504(b) and of course 506(c) which we’re not really talking about here but is the other big exception under Reg D, neither the issuer nor any person acting on its behalf may make this a general solicitation. This is the key phrase that’s oftentimes used – this isn’t a general solicitation, meaning that we cannot advertise and put it out into the public for people that you don’t know.
When you’re on the phone doing a consultation with me, I will most often say, “Do you have a significant relationship to all of your investors? Or do you have a significant business relationship with all of your investors?” This is why I’m asking that question. Because if you don’t have a significant relationship with those investors, you cannot find those investors because you don’t have this relationship with them. You have to advertise, right? And if you have to advertise, then we’re under rule 506(c), not 506(b).
They of course give us a definition of what they mean by advertising. Any advertisement, article, notice or other communication published in a newspaper, magazine, similar media broadcast over television, radio – why they didn’t mention internet, I don’t know. But internet definitely applies. You cannot be putting this on social media and saying “this is a great offering, come invest with us.” If you get caught with that, you are not in compliance with rule 506(b), and bad things will happen as a result of that.
And then it uses the often-used technique (it certainly was used a lot more pre-COVID days) of putting together a seminar or a meeting to discuss investments. You can’t put a seminar or some sort of live thing together in order to invite people in and then pitch them the offering. Now, you certainly can do a seminar or a meeting and have these people just generally invited and have people that you don’t know, but you cannot be pitching your specific offering to them. You should not be saying “well here’s an example” – I would not discuss whatever that particular offering is that’s a 506(b) offering, you should not discuss it at all at that meeting, if you choose to do that.
So that’s rule 506, 502(c). Let’s take a deep dive into rule 506(b)(2), and then we’re going to circle back to what the accredited investors portion of rule 501 is. Again, under 506(b)(2), there are specific conditions on what you must do.
§ 230.506 Exemption for limited offers and sales without regard to dollar amount of offering…
(b) Conditions to be met in offerings subject to limitation on manner of offering…
(2) Specific conditions –
(i) Limitation on number of purchasers. There are no more than, or the issuer reasonably believes that there are no more than, 35 purchasers of securities from the issuer in offerings under this section in any 90-calendar-day period.
So there is a limitation on the number of purchasers. Now, some of this is going to be surprising, so stay tuned. There is a limitation on the number of purchasers, there may be no more than 35 purchasers of securities from the issuer in the offering under this section in any 90-day period. Two interesting parts there: no more than 35 purchasers, and 90-day period.
Let’s first talk about the 90-day period, because here’s an interesting opportunity. If you have more than 35 investors who meet this definition, then they can invest, they just cannot invest within the same 90-day period. A regular Reg D offering is valid from that Form D filing for a period of one year. So you could do four different offerings during that period of time and pull in a lot more than 35. But it would have to be broken up so that you don’t have more than 35 purchasers within any 90-day period. So that’s interesting.
Now let’s talk about these 35 purchasers. You’re thinking to yourself, “Wait, I thought that I could only have 35 non-accredited investors in my 506(b) offering. I’ve got a lot more who are accredited investors, how on earth am I going to make this happen?” Hold on, not to worry.
This is rule 501(e):
(e) Calculation of number of purchasers. For purposes of calculating the number of purchasers under § § 230.506(b) and 230.506(b) only, the following shall apply:
(1) The following purchasers shall be excluded:
(i) Any relative, spouse or relative of the spouse of a purchaser who has the same primary residence as the purchaser;
(ii) Any trust or estate in which a purchaser and any of the persons related to him as specified in paragraph (e)(1)(i) or (e)(1)(iii) of this section collectively have more than 50 percent of the beneficial interest (excluding contingent interests);
(iii) Any corporation or other organization of which a purchaser and any of the persons related to him as specified in paragraph (e)(1)(i) or (e)(1)(ii) of this section collectively are beneficial owners of more than 50 percent of the equity securities (excluding directors’ qualifying shares) or equity interests; and
(iv) Any accredited investor.
So 501(e), and we’re going to skip right to the punchline here. Subsection four of rule 501(e) says that – well first, 501(e) says in subsection one, “the following purchasers shall be excluded.” And the punchline is one of those people, those people who are accredited investors, are excluded. They do not count for that 35.
So, not to worry, there’s actually a footnote in rule 506(b)(2) that points directly to this rule 501(e) so that there’s not any confusion. Under 501(e), you do not need to count as part of your 35 any accredited investors. There are actually some other interesting people who are not included as well.
So you have a husband and wife where the husband is a non-accredited investor, and he wants to invest in the property, no problem, he can come in, he’s a friend of yours, they can come in no problem. But the spouse would also like to invest – again, no problem under 501(e)(1)(i) because any relative of the spouse as long as they share the same primary residence as the purchaser shall not be counted. So you only need to count the one person rather than the two.
Also interesting is a trust or estate where there is collectively more than 50% of the beneficial interest. They do not need to count any of those other people that have a beneficial interest in the trust. And you can leave it to your children because that’s excluding contingent interests. So if you’re still living, the trust can leave that there too.
Also interesting is any corporation can also be an investor and so long as the beneficial owner owns more than 50%, even if that person is a non-accredited investor, that person won’t count – that one person, but the remainder of the people as long as they own less than 50%, they aren’t going to count. Interesting. And of course, the accredited investor is there.
So this is rule 506(b). Rule 506(b) probably represents maybe half of the people that we do private placement memorandums for. If you need some help with your syndication, be it for real estate, you’re an entrepreneur, you’re raising some capital for your business, or you’re putting together that new cryptocurrency hedge fund, give us a call. My name is Tilden Moschetti. I am a syndication attorney. Or visit us online at www.moschettilaw.com, or if you need help with your private placement memorandums, we’ve got you covered there too.