Exemptions to SEC Registration Requirements: Developing a Deeper Understanding of Rule 506(b) Versus Rule 506(c)
Evidence suggests that often times issuers would rather bypass registration of their offerings with the Securities and Exchange Commission (SEC). Regulation D of the Securities Act contains several methods to avoid registration that come in the form of exemptions or safe harbors to registration. Regulation D was modified by the Jumpstart Our Business Startups Act (JOBS Act) which contained sweeping legislation to modernize federal securities laws. Title II of the JOBS Act went into effect in 2013, splitting the Rule 506 exemption of Regulation D into two different ones: Rule 506(b) which contained the exemption that existed prior to Title II of the JOBS Act taking effect and Rule 506(c) offering an alternative method of exemption as prescribed by Title II of the JOBS Act. Unlike earlier exemptions, Rule 506(c) of Regulation D permits general solicitation of private placement offerings, although only accredited investors are allowed to invest. This new rule serves as an alternative to Rule 506(b) which did not, and still does not, permit general solicitation. As you read about some of the differences outlined below, you may begin to understand why Rule 506(c) is the viable solution that so many investors and capital-raising companies have been seeking.
SEC Registration Exemptions Explained
Rule 506(b) of Regulation D was the most commonly used exemption to avoid registration of securities with the SEC. However, the disadvantage of Rule 506(b) and most of the other exemptions that existed prior to the JOBS Act was that they do not allow general public advertising, including print, TV, radio, social media, or traditional publicity. The prohibition on public advertisement of private placement offerings has meaningful restrictions. Effectively, it means that investors must have a substantive prior relationship with the issuer of a private placement offering. If the prospective investors simply read or hear about the opportunity, and then discuss it with the issuer, that would NOT qualify as a prior relationship. Instead, relationship duration and extent of familiarity are significant considerations for anyone wishing to utilize Rule 506(b). As a result, investors in private placement offerings who do not use Rule 506(c) need to rely on private networks of family, friends, colleagues, or other people they know personally. The advantage of Rule 506(b), however, is that you can trust people to tell you that they are accredited investors, and if necessary, you could accept up to 35 non-accredited investors (although in practice, this is usually not done due to the extra requirements imposed when non-accredited investors are involved).
When it comes to Rule 506(c), the advantages and restrictions are different. Along with the ability to advertise private placement offerings, unlike other commonly used exemptions, Rule 506(c) sets no upper limits on the amount of money a company may raise. To reap the benefits of Rule 506(c) however, an issuer must take "reasonable steps” to ensure that all investors are accredited investors.
The Importance of Accredited Investor Verification
General solicitation or advertising under Rule 506(c) improves a company’s access to capital while expanding investment opportunities for investors. While an investor may self-verify as an accredited investor under Rule 506(b), issuers or their advisers utilizing the new Rule 506(c) must verify all accredited investors by reviewing documentation, including bank statements, proof of net worth, tax returns, brokerage statements, or written statements from a licensed attorney, licensed broker, or certified accountant. Since many issuers and investors find this highly detailed and nuanced process rather confusing, third party verification services, like VerifyInvestor.com, help streamline the process to get verified as an accredited investor. Furthermore, business startups appreciate the investor verification services because performing the check internally is often difficult for companies. Some companies that have tried to do it internally have subsequently been investigated and penalized, with very punitive results, for failing to properly conduct the verification.