Rule 506b: Exempt Offerings & Investor Guidelines

Key Takeaways:

• Rule 506b allows issuers to raise an unlimited amount of capital without SEC registration, provided they limit sales to accredited investors and no more than 35 sophisticated but unaccredited investors.
• No advertising is allowed under Rule 506b, distinguishing it from Rule 506c, which permits general solicitation.
• Investor verification under Rule 506b is based on a reasonable belief standard, whereas Rule 506c requires strict verification for accredited investors.
• Form D filing is required after the first securities sale, listing basic company details.
• Differences with 506c include stricter investor accreditation, advertising allowances, and disclosure requirements for unaccredited investors.
• Legal considerations include the importance of adhering to securities laws, ensuring investors meet sophistication requirements, and avoiding fraudulent practices.
• State blue sky laws still apply, meaning issuers must comply with notice filings and other state regulations.
• Secondary transactions under Rule 506b may have resale restrictions that investors should be aware of.

Rule 506 b eliminates the need for people issuing securities to register if they meet certain qualifications. 

What is Rule 506 B?

Under rule 506 b, issuers of securities are exempt from the registration requirements of the Securities Act for unlimited size offerings. However, to qualify under this rule, the securities that are being offered can only be bought by accredited investors and no more than thirty-five unaccredited investors. These unaccredited investors must also meet certain requirements, such being an officer of the company that is offering the securities.

In addition, the issuer is not allowed to solicit the securities, and they must reasonably believe that the investors purchasing the securities are accredited or are unaccredited investors who meet sophistication requirements. 

Investor Sophistication Requirements

Under Rule 506b, while issuers can accept up to 35 non-accredited investors, these individuals must be considered "sophisticated." This means they should have enough knowledge and experience in financial and business matters to evaluate the investment risks. Companies often require these investors to:

• Have prior investment experience.
• Work with a financial advisor who can assist in making investment decisions.
• Have a sufficient net worth or income to absorb potential losses.

Because Rule 506b offerings do not require investor verification, companies must document their reasonable belief that unaccredited investors meet the sophistication standard. If an issuer fails to comply, they risk violating securities laws.

Advantages of Rule 506 B

There are a variety of advantages to qualifying under rule 506 b. In particular, this rule allows the inclusion of unaccredited investors in offerings. Securities issuers that use rule 506 c may lose accredited investors because of the need to provide verification. With rule 506 b, no verification is necessary. 

Limitations and Compliance Considerations

While Rule 506b provides an effective means of raising capital, issuers must be mindful of its limitations, such as:

• No General Solicitation: Issuers cannot publicly advertise their offering, including through websites, social media, or mass emails.
• Limited Number of Unaccredited Investors: No more than 35 unaccredited investors can participate, and they must meet sophistication requirements.
• Resale Restrictions: Securities sold under Rule 506b are "restricted securities," meaning investors generally cannot resell them without registration or another exemption.

Regulatory Compliance:

• State Compliance (Blue Sky Laws): Even though Rule 506b preempts most state laws, issuers still need to make "notice filings" in states where their investors reside.
• Avoiding Fraudulent Practices: Issuers should ensure they disclose all necessary information, particularly when dealing with unaccredited investors, to avoid legal scrutiny.

Information About Form D

Companies that qualify for rule 506 b are not required to report to the Securities Exchange Commission (SEC) and also will not need to register their securities. However, after their first securities have been sold, these companies are required to file Form D. This form is used to list basic information about the company:

• The addresses of the company's owners.
• Names of the company's owners.
• Names of the stock promoters. 

Understanding Form D Filing and State Regulations

Although Rule 506b offerings are exempt from SEC registration, issuers must file Form D electronically with the SEC within 15 days of the first securities sale. This filing:

• Provides basic company details, such as names of executives and the offering amount.
• Must be updated if any material changes occur, such as changes in investor composition.

State-Level Filings (Blue Sky Laws):

• While Rule 506b preempts most state securities laws, issuers must still submit a state notice filing in each jurisdiction where securities are sold.
• Each state has different requirements, fees, and deadlines, so issuers should consult legal counsel to ensure compliance.

Failing to file Form D or complete the required state notices can result in regulatory action or penalties.

What You Should Know Before Investing

It's important to do your due diligence before investing any of your money in a company that makes offerings under rule 506 b or c. In particular, you should contact the SEC to ask whether the company you are thinking about investing in has filed Form D. You should be wary of investing in a company that has not filed this form, as it may mean that they are not complying with the securities laws laid out by the federal government.

It's also a good idea to contact the securities regulator in your state to see if they can provide you any information about the company, including information about the owners. You should also ask your state's regulator if they have cleared the offering that you are thinking about purchasing. 

Secondary Market Considerations for Rule 506b Securities

Unlike publicly traded securities, Rule 506b securities are considered restricted, meaning they cannot be freely resold. Investors should be aware of:

• Holding Periods: Typically, restricted securities must be held for at least one year before resale unless an exemption applies.
• Resale Exemptions: Rule 144 under the Securities Act allows resale of restricted securities under certain conditions, such as holding periods and adequate public information about the issuer.
• Liquidity Issues: Since Rule 506b offerings are private placements, finding a buyer for resale can be challenging.

Investors considering these securities should have a long-term investment strategy and consult financial professionals before committing funds.

Difference Between Rule 506 B and 506 C

One of the biggest differences between 506 b and 506 c offerings is how the companies are allowed to sell securities. For example, advertising is strictly prohibited for 506 b offerings. However, if the company has an existing relationship with an investor, they are allowed to approach these investors about the offering. On the other hand, 506 c offerings can be advertised however the company wishes, and no investor relationship is required.

Only accredited investors are allowed to purchase 506 c offerings. 506 b offerings can include up to thirty-five unaccredited investors as long as they fulfill certain sophistication requirements. Companies that have more than 2000 investors, or more than 500 unaccredited investors, must report based on the rules of the Exchange Act. 

With 506 b offerings, companies will certify that an investor is accredited using a questionnaire. As you might imagine, this can pose a problem, as is there is nothing preventing an unaccredited investor from lying to the company about their certification. 506 c offerings have much stricter accreditation requirements. Companies making these offerings must be very careful to make sure that their investors are accredited. Self-certification is not allowed.

There are no limits to the size of offerings for either 506 b or 506 c companies. 506 c rules do not require disclosure.

With 506 b offerings, there is no requirement to disclose information as long as all of the investors are accredited. However, if the offering includes unaccredited investors, the company must provide the investors with a large amount of information about the offering. Both types of companies are required to file Form D, and this form must be filed in every state in which the company has an investor.

Neither 506 b nor 506 c companies require intermediaries when making offerings. However, if the companies choose to use an intermediary, this person must be registered as a broker-dealer or possess an exemption.

Comparing Rule 506b to Other Private Offering Exemptions

While Rule 506b and Rule 506c are both part of Regulation D, there are other private offering exemptions that companies may consider:

Each exemption serves different purposes, and issuers must carefully evaluate which one best suits their capital-raising needs.

Frequently Asked Questions:

1. What is the difference between accredited and sophisticated investors under Rule 506b?

Accredited investors meet income or net worth thresholds set by the SEC, while sophisticated investors have financial expertise but may not meet accredited investor criteria.

2. How long do I need to hold securities purchased under Rule 506b?

Most Rule 506b securities must be held for at least one year before resale unless an exemption, such as Rule 144, applies.

3. Can I advertise a Rule 506b offering?

No. General solicitation is prohibited under Rule 506b, meaning you cannot market the offering through public channels.

4. What happens if an issuer fails to file Form D?

Failure to file Form D can result in regulatory action, including fines or restrictions on future securities offerings.

5. Are there penalties for violating Rule 506b?

Yes. Violations of Rule 506b can lead to SEC enforcement actions, investor lawsuits, and loss of the offering exemption.

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