The following is a guest post written by Samuel E. Whitley, a valued WealthForge partner and managing partner at Whitley LLP Attorneys at Law.
In order to raise capital, the Securities Act of 1933 requires that the offering be registered (i.e., a public offering) or exempt. Rule 506 is the most common exemption that companies use to raise capital. Rule 506 is part of Regulation D, which the Securities and Exchange Commission (“SEC”) promulgated in 1982. The SEC recently concluded that 95% of Regulation D offerings were conducted in reliance upon Rule 506.
Traditionally, Rule 506 offerings had to be conducted without general solicitation or general advertising. This made it difficult for companies that did not have a large existing network of potential investors to raise capital.
However, as part of the Jumpstarting Our Business Startups Act (“JOBS Act”), Congress directed the SEC to amend Rule 506 to permit general solicitation and general advertising. As a result, in July 2013, the SEC promulgated the new version of Rule 506, which actually permits companies to use either approach: the “old” method (no general solicitation and general advertising) and the “new” method (general solicitation and advertising permitted). The old method is set forth in Rule 506(b), and the new method is set forth as Rule 506(c). Both variations of the rule permit a company to raise an unlimited amount of capital.
This article is intended to compare and contrast Rule 506(b) and Rule 506(c) and point out the opportunities and pitfalls that may be presented to an issuer undertaking a private placement based on the new rules.
Accredited Investor Criteria
In amending Rule 506, the SEC left in place the criteria for determining whether a person is an “accredited investor.” For an individual, a person is an accredited investor if (1) he has total income of $200,000 (or $300,000 in joint income with his spouse) for the past two years, with a reasonable expectation of reaching the same level this year, or (2) he has a net worth (assets minus liabilities) of $1,000,000, excluding the value of his principal residence.
“Old” Rule 506 (Rule 506(b)) vs. “New” Rule 506 (Rule 506(c))
In a Rule 506(b) offering, an issuer cannot use general solicitation or general advertising to sell the securities offered in the placement. This prohibition has been interpreted to mean that the issuer (through its officers, directors, and/or brokers) must have a pre-existing, substantive relationship with the investor. Rule 506(b) permits up to 35 non-accredited investors to invest in the offering; however, if non-accredited investors invest, then they must be provided with an offering memorandum (often referred to as a private placement memorandum, or “PPM”) that meets certain disclosure requirements, including the provision of financial statements. An offering is not required for accredited investor-only offerings. Investors are allowed to “self-certify” themselves as accredited investors by signing a statement that they meet the applicable standards, as long as the issuer does not have knowledge otherwise.
Rule 506(c), on the other hand, permits issuers to advertise their offering freely (subject to anti-fraud rules) so long as only accredited investors invest. The rationale behind Congress’ directive to the SEC (which led to the creation of Rule 506(c)) is that an investor cannot be harmed by general solicitation or general advertising if they do not invest in the offering. However, in order to rely upon Rule 506(c), issuers must take reasonable steps to verify the investor’s accredited status – self-certification is not enough. Specifically, the issuer must either review the investor’s tax forms, bank or brokerage statements, and/or credit report in order to meet the Rule 506(c) reasonable method requirement. If an investor is unwilling to provide this information to an issuer, then the issuer may rely upon a written confirmation from a broker-dealer, SEC-registered investment adviser, certified public accountant, or attorney that the person meets the accredited investor criteria.
Opportunities and Pitfalls
Rule 506(c) has created some opportunities for issuers to raise capital but there are some disadvantages associated with it. As a result, a Rule 506(c) offering may not be for everyone. Below are some of the common advantages and disadvantages that we have seen in both offering types:
- Rule 506(c) works best for companies that do not already have a robust network of investors. Because they do not have this network, they must advertise in order to raise capital. Rule 506(c) was created precisely in order to facilitate this type of capital-raising.
- If an issuer and its management already have a robust investor network, or plan on raising capital from a small circle of investors, then Rule 506(b) (pre-existing relationship with no general solicitation or advertising) works fine.
- The verification process for Rule 506(c) offerings is cumbersome. Many investors who say they are accredited do not have the documentation to prove it, and even if they do, they may not want to provide it. Investors may obtain a written confirmation from certain intermediaries, but it may be hard to obtain. Financial advisors do not want assets being held “away” and may decline to provide the confirmation. For those investors that provide the information directly, there is always the risk that something will go awry. For instance, one of our issuer clients had a situation where an investor had filed a joint tax return with his spouse. His income for one year satisfied the $200,000 individual income requirement, but not the $300,000 joint income requirement. His joint income met the $300,000 requirement for the second year and was not in issue. There was no way to qualify this investor as accredited based upon his individual income since he had filed jointly with his spouse. In addition, there was no way to average the years together because the rule states that the investor must meet the income requirement for each of the prior two years. As a result, the issuer ended up having to qualify the investor based upon his net worth, which required obtaining a copy of a brokerage statement from the investor and pulling a credit report.
- Companies with a large retail customer base are well-positioned to take advantage of Rule 506(c). Although not all of your customers will be accredited investors, some of them may be, and so there is no harm in informing your customers that you are undertaking an offering and providing them with a PPM if they express interest.
- The main factor in determining whether to conduct the offering under Rule 506(b) or Rule 506(c) is how you will approach potential investors. If you already know the investors, then Rule 506(b) is preferable. If you are planning to permit access to the PPM via a password-protected Web site, then Rule 506(b) can be used, although there are a few caveats. If you are wanting to use broad means to reaching investors (advertisements in various media, pay per click ads, etc.), then the offering should be conducted via Rule 506(c).
There are many factors that determine the structure of an offering and what offering exemption should be used. For that reason, it is important that you consult with a knowledgeable securities attorney or a registered broker dealer like WealthForge.
Disclaimer: WealthForge provides this information to our clients and other friends for educational purposes only. It should not be construed or relied upon as legal advice.