What Is SEC Rule 506c?
Regulation D Rule 506c was enacted in 2012 and was created to allow businesses a way to raise capital from private investors without registration but to allow advertising and general solicitation. It was a major expansion of the Rules of Reg D (which were established in 1982), which, broadly speaking, provided entrepreneurs with the opportunity to raise capital privately from a large number of investors. It does this by allowing you to offer securities without having to register the offering with the Securities and Exchange Commission (SEC). Except, until rule 506 c, federal securities laws didn’t provide for advertising or solicitation without some form of registration.
Those issuing securities under Reg D must do so by following one of the rules within the regulation. Of these rules, Rule 506c offers some of the biggest advantages. However, it also has some drawbacks to consider before you move forward. In this article, we examine Rule 506c in detail to ensure you understand all of your obligations when creating an offer of securities under this rule. (See https://www.law.cornell.edu/cfr/text/17/230.506 for the full text of Rule 506c.)
Rule 506c is one of the two distinct exemptions offered to securities issuers under Rule 506 of Reg D. It allows you to offer restricted securities to an unlimited number of accredited investors (Rule 501). What’s more, an offering of securities made under Rule 506c allows you to raise as much capital as you need for your business venture.
The following are the basic criteria for Rule 506c offerings:
An issuer can raise an unlimited amount of money under Rule 506c.
You can sell your securities to an unlimited number of accredited investors. However, you cannot sell securities to non-accredited investors.
Advertising and solicitation of your securities are allowed as long as all of your investors are accredited. If you wish to work with non-accredited investors, you must make your offering under Reg D Rule 506b, but there you won’t be able to advertise or do a general solicitation.
The issuer must take steps to verify the status of an accredited investor that wishes to buy their securities. These steps include, but aren’t limited to, checking tax returns, examining credit reports, and conducting suitable due diligence that involves the collection of relevant documentation.
The issuer must ensure that investors receive all relevant information to allow them to make a reasonable decision (use a Private Placement Memorandum (PPM)). However, investors may require further documentation.
Prospective purchasers must be able to as questions of the issuer. If an issuer makes themselves unavailable, they may (and probably will) get accused of withholding important information, and the whole offering can fall apart.
The issue cannot withhold or exclude any important information from their offering. They must also make every effort to ensure the information they provide is accurate, up-to-date, and cannot mislead an investor. Failure to follow these rules can lead to prosecution at both the state and federal levels.
While this seems like a lot of criteria that you need to meet, Rule 506c offers several benefits that can make offering securities under it more desirable than offering registered securities.
The Benefits of Rule 506c
The most obvious benefit of Rule 506c comes from the lack of SEC registration required.
The Securities Act requires that all securities be registered with the SEC unless there is an appropriate exemption. Under Reg D, the newest of the exemptions is Rule 506 c. While a typical capital raise that doesn’t fall under an exemption requires registration, creating this registration is time-consuming and requires the company put itself under the watchful eye of the SEC. The slow process can make it more difficult for smaller companies to gain access to funding which is particularly damaging to companies that have an urgent need for capital so they can maintain rapid business growth, or in the case of real estate, do anything at all.
Rule 506c allows you to quickly access capital from suitable investors without tying you up in all of the paperwork that comes with a typical capital raise. It is also ideal for those who wish to syndicate their business ventures or raise money for real estate. The rule has no limits on the number of investors you can involve or the amount of money you raise. As a result, Rule 506 c offerings can allow you to collect small sums from a huge number of investors, which add up to a larger capital raise that enables your business venture.
We often see this in the real estate industry. By creating a syndicate under Rule 506c, an issuer can invite several investors to a development project that the investors would not be able to fund on their own. Each investor stands to gain if the project succeeds, with the issuer also gaining access to a larger knowledge pool and the funding they require.
Offerings of securities under Rule 506c usually cost less than public offerings. Again, this relates to the time saved on registration and other paperwork. More time saved means that an issuer’s employees can focus on other business tasks. It also means the issuer doesn’t have to dedicate as many resources to the completion of paperwork.
Finally, Rule 506c is sometimes preferred to Rule 506b because it offers issuers the chance to advertise to prospective investors. While this comes at the cost of working with non-accredited investors, the ability to advertise means you can appeal to a wider pool of potential investors and build your network.
The Drawbacks of Rule 506c
The lack of non-accredited investors is the most significant drawback of Rule 506 c. We’ll dig into what this means a little later, but it essentially cuts out approximately 95% of the potential investors you might attract to your offer of securities.
Rule 506 c also places limitations on the resale of the securities you offer. This may be a concern to investors if they need access to liquid capital but can’t sell the securities they purchased from you. Again, we’ll discuss this topic in more detail later in the article.
Rule 506 c also requires you to verify every accredited investor who wants to purchase your securities. The verification process adds time to the sale, though there are third-party companies that can complete the process on your behalf.
Filing Form D
Though the SEC does not require you to register your offer with them, it does ask you to notify them of your offering and its exempt status under Rule 506c. You do this using Form D, which is a fairly simple form that asks you for key details about the transaction. Using Form D, you’ll provide your name and address, along with the names and addresses of other key personnel who are part of the offer of securities.
You must file Form D within 15 days of making your first sale using the SEC’s Electronic Data Gathering, Analysis, and Retrieval (EDGAR) system. Form D is a necessity if you offer securities under Rule 506c. Thankfully, the process, including registering your business on the EDGAR system, takes no more than a couple of hours, and is done typically by syndication attorneys, though individuals can do it themselves too.
How Much Capital Can You Raise With A 506c Offering?
As mentioned, one of Rule 506(c)’s biggest advantages is that it allows you to raise an unlimited amount of capital. This means it differs from many of the other rules in Reg D. For example, Rule 504 of Reg D only allows you to raise up to $10 million.
However, having no limit on the amount of capital you raise does not mean you can ask for any amount of money. You must ensure that you offer securities at a reasonable price to ensure that investors can see the potential for returns. Furthermore, you need to define exactly what you’re going to do with the money you raise to ensure investors feel confident about your company.
For example, let’s say you want to syndicate a real estate development project using multiple accredited investors. You’ve decided to offer securities and your research shows you that the project should cost approximately $15 million. However, you decide to use your capital raise under Rule 506c to try and raise $25 million.
Rule 506(c) will not stop you from making an offer of securities with a total value of $25 million.
Still, you may find that asking for $10 million more than you need will worry many of your investors. In addition to potentially raising the price of your securities, asking for more money than you need could make investors think you’re irresponsible. Many will also feel wary about what you intend to do with the extra money and will not invest if you plan to simply stockpile the extra cash.
As such, “unlimited” does not mean there are no limits to how much money you can raise using Rule 506c. It simply means the SEC doesn’t impose a limit. You still have to consider your business, the nature of the offering, and what you’re going to do with the money so you can set a suitable limit for your offering.
Private Placement Memorandums Under Rule 506c
As part of your Rule 506c, you must create a Reg D Private Placement Memorandum (PPM) that you distribute to all potential investors. This document has some similarities to a business plan. You use a PPM to dig into the details about the opportunity you’re offering, as well as to provide information about your business and the relevant parties involved in the offer of securities.
A PPM is a completely fact-based document that should provide the information an investor needs to make an informed decision about the financial and business matters that the opportunity has. While a PPM can still serve a marketing purpose by demonstrating your professionalism, the language you use and the nature of the document differ markedly from a business plan. These differences mean you can’t just transplant your business plan into a PPM and call it a day. You have to take great care to ensure you’re offering factual information that does not mislead investors or misrepresent the opportunity you’re offering to them.
Accredited Investors And Third-Party Verification
Under Rule 506(c), you can only make your offering to accredited investors. This differs from Rule 506b, which allows you to offer securities to both accredited investors and up to 35 sophisticated non-investors. As mentioned, the trade-off here gets balanced out by Rule 506c allowing you to solicit investors.
The SEC chooses which investors carry the accredited status. As a general rule, an accredited investor will meet at least one of the following criteria:
The investor has a net worth of at least $1 million. This net worth can’t include the investor’s primary residence. However, they can share their net worth with their spouse.
An investor can be accredited if they earn at least $200,000 per year and can verify this income for the last two years. The investor may also have to show they expect to earn the same amount or more for the coming year. This figure rises to $300,000 if the investor has a joint income with a spouse.
The investor must have an adequate amount of knowledge to ensure they don’t need the same level of protection as non-accredited investors. This knowledge can come from their job, such as somebody who is a knowledgeable employee of a fund that deals in private securities. People who have SEC or state registration for their role are also likely to fall into the knowledgeable category.
Happily, you can include as many accredited investors in your securities offering as you like. The SEC places no limitations, which opens up the possibility of syndication or crowdfunding. In both cases, you rely on a large volume of investors to make small contributions that total up to the required whole. Syndications and crowdfunding allow both the issuer and their investors to access opportunities they might not otherwise have access to.
While manual verification is manageable for a small securities offering, it can become a major burden for a Rule 506c offering. The ability to include an unlimited number of accredited investors can lead to hundreds, or even thousands, of people buying your securities. Conducting this verification process on each person is time-consuming and requires a lot of repetitive work. What’s more, this work does not carry over to future offers of securities. For every new offering, you must complete the verification process again.
Thankfully, the SEC allows the use of third-party verification services to take most of the work off your plate. In addition to conducting the research for you, a third-party accreditation service provides you with a letter stating the accredited status of each investor in the deal. This letter allows you to take advantage of Rule 506c “safe harbor” status, which essentially means you’re not held responsible if the third party is incorrect about the investor’s status.
Of course, there are limitations in place for who the SEC classes as an appropriate third party for verification purposes. Any of the following can offer third-party verification:
A suitable attorney
Registered brokers and dealers
Certified public accountants
Registered investment advisors
If you a third-party verification service, the letter you receive should tell you which of the accreditation criteria the investor meets. The validator should also sign and date the letter to confirm that they conducted the review on your behalf.
Engaging one of these services requires the payment of upfront fees. However, they save significant amounts of time while ensuring that you’re not liable if an investor turns out to not have accredited status.
Securities Resale Limitations
Under Rule 144(a)(3) of the Securities Act, offers of securities conducted under Rule 506c are restricted. This means that somebody who buys your securities is not able to resell them freely. Instead, they must wait for you to register the securities if you choose to do so. Or, that can resell if they obtain an effective registration statement.
This issue is crucial because it affects the liquidity of the securities you offer. Use your PPM to inform investors that any securities they buy from you under a Rule 506c offer carry restrictions. Failure to do so could constitute withholding or misrepresenting important information, which may result in federal or state prosecution.
Advertising And Soliciting Under Rule 506c
The ability to advertise your offer of securities is one of the most important advantages of the Rule 506c offering. The rule allows you to use any marketing channel you wish to advertise your offer. You can also commission solicitors to act on your behalf to increase sales. It’s a good idea to discuss your use of solicitors in your PPM. Your solicitors are also considered covered persons under Bad Actor rules.
The SEC does levy conditions for this ability to advertise. The previously noted rule that all investors in a Rule 506c offering must be accredited directly applies here. So too do the verification steps that you take to confirm the accredited status of your investors. Failure to verify an investor’s accreditation could mean that your offering falls apart or that you’re unable to perform it under Rule 506c.
What Constitutes Advertising and Solicitation?
Influence is the keyword here.
The SEC generally focuses on the ability of your materials to influence an investor’s decision. For example, let’s assume you’ve distributed written materials to your potential investors. If these materials contain any information issuer information or a substantial analysis of the opportunity you’re presenting, they’re classed as general solicitation. If they only contain facts and figures that come from pre-existing and public sources, it’s likely that the materials can’t sway an investor’s opinions. As a result, those materials are likely not classed as general solicitation.
When it comes to advertising, influence obviously plays a role here. An advert of any type is designed to influence a consumer into buying a product. As such, any advert that you put out to the general public falls under the SEC’s definition of general advertising.
Thankfully, this is all allowed under Rule 506c as long as you only accept accredited investors that you’ve verified.
Bad Actor Rules Apply To Rule 506c
Rule 506c’s status as a safe harbor rule allows you to offer securities without registering them with the SEC. However, that safe harbor status disappears if one of the key members of the issuer’s team is a Bad Actor. Such members include the issuer, any of the issuer’s affiliates, directors, certain stockholders, and officers, plus any compensated solicitors.
The SEC refers to these individuals collectively as covered persons.
As the securities issuer, you’re responsible for ensuring that nobody involved in your offering is a Bad Actor. Again, failure to do so can lead to accusations of misleading or misrepresenting your offer of securities, resulting in prosecution.
The General Structure Of A Rule 506c Offer Of Securities
Some general steps that apply to almost all Rule 506(c) offerings:
Before you consider making an offer of securities, build an issuing team around yourself. Make sure that you conduct all appropriate due diligence to confirm nobody on the team is a Bad Actor.
Set your intended capital raise and decide what types of securities you’ll offer to investors.
Create your PPM to outline all of the facts related to the offering. If you do not have all of the details required to complete a PPM, you’re not ready to offer securities.
Assuming you can complete a PPM, consider hiring a solicitor to advertise your offer. You should also create a general marketing strategy to ensure you reach as many accredited investors as possible.
If an investor shows an interest in buying securities, validate them either manually or by using a third-party validator. Never skip this step. Make a reasonable effort to confirm that you’re selling to an accredited investor in every case.
Make your first securities sale.
Complete and submit Form D within 15 days of making your first sale.
Continue to sell securities until you achieve your intended capital raise.
Invest the money you receive according to the estimates in your PPM.
The SEC does not require ongoing reporting for a Rule 506c offering. As such, you’re under no obligation to provide the SEC with any more information after you’ve completed your Form D filing.
Is Rule 506c Right for You?
How do you know if an offer of securities under Rule 506c is right for you and your syndication? What about Reg D Rule 506b vs Rule 506c?
Generally speaking, if you want the freedom to advertise your offer and you’re happy to work only with accredited investors, Rule 506c is a good choice. The lack of limits on the amount of capital you can raise and the number of investors you can sell to also makes Rule 506c ideal for syndicates and crowdfunding activities. Rule 506c is also ideal for entrepreneurs and start-ups that don’t want to incur the costs that registering with the SEC requires.
Tilden Moschetti, Esq., is a highly sought-after syndication attorney with nearly two decades of experience. His clientele ranges from real estate developers and startups to established businesses and private equity funds. Tilden’s expertise in syndication law comes not only from his knowledge of syndication and securities law but from real, hands-on experience as an active syndicator himself in every real estate product type and nearly all markets in the US. His knowledge and experience set him apart and established him as the Reg D legal services leader.