Rule 506(b) vs Rule 506(c): What’s the Difference?

In privately held companies, capital raising can be quite a challenge. But, did you know that you can raise funds without even registering your company with the Securities and Exchange Commission (SEC)? Well, Regulation D of the Securities Act of 1933 provides a means to raise capital without having to register with the SEC. Rule 506(b) and Rule 506(c) of Regulation D are used to structure offerings of securities to accredited investors. Probably you might be wondering what the difference is between Rule 506(b) and Rule 506(c). This article will provide you with a brief overview of the two rules.

Rule 506(b) and Rule 506(c)

Rule 506(b) and Rule 506(c) are both part of Regulation D. Under the rules, companies can sell their securities to accredited investors in a non-public offering. As long as the securities are sold privately, and the company does not have a public market for its shares, it is exempted from registration with the SEC. Although the rules are similar, there are a few things that distinguish them.

Understanding Regulation D

Before we dive into the rules, you should have some basic understanding of Regulation D. Regulation D is a set of rules that are designed to provide companies with a means of raising private capital without having to register their securities with the SEC. The rules offer “safe harbor” if certain requirements are met. In other words, if a company follows the specific provisions of Regulation D, it is exempt from having to register its securities with the SEC. As a result, companies can raise capital without having to file any disclosures with the SEC.

What is Rule 506(b)?

Rule 506(b) allows you to raise an unlimited amount of money from accredited investors. While up to 35 non-accredited investors are allowed to invest. However, any means of general solicitation or advertising of the offerings is prohibited. In this regard, the company might be required to disclose a prior relationship with the investor before this offering. While it is essential to note that verification of information provided in the offering materials is not required. Therefore, before the company can offer to sell its securities pursuant to Rule 506(b), it must take reasonable steps to verify that all investors are accredited.

Pros and Cons of Rule 506(b)

Although Rule 506(b) is considered as a great tool, this is not always the case. While the offering rules are flexible, they can be difficult to understand and apply. Here are a few of the main advantages and disadvantages of Rule 506(b).

Pros

• Up to 35 non-accredited investors are allowed under Rule 506(b). This might be a good number considering the fact that it is a private offering.
• No verification of information is required for accredited investors. As a result, companies can raise capital easily, without having to take time to verify the information provided by investors.
• The offering under Rule 506(b) is not regulated by the state blue-sky laws. It is therefore very flexible in terms of state securities regulations.

Cons

• General solicitation and advertising are not permitted under Rule 506(b). The company cannot distribute offering materials that are publicly available.
• Prior relationship is required for selling securities under Rule 506(b). So, if a company does not have a prior relationship with the investor, then it cannot offer its securities.

What should be included in form D?

While registration with the SEC is not required for capital raising under Rule 506(b), companies are still required to follow certain requirements. After the first security is sold, the company must file a Form D. This form is an SEC filing that must be filed by the company in order to exempt its securities offering under Regulation D. The following are the basic requirements that must be included in this form:

• Locations of the company’s owners.
• Names of the business’s owners.
• Stock promoters’ names

Exemptions to Rule 506(b)

Now that we have discussed the basic requirements for offering securities under Rule 506(b), let us discuss some of the common Rule 506(b) exemption. Here are a few of them:

• Unlimited value of the securities – Rule 506(b) allows an unlimited value of securities to be sold without having to register with the SEC. It gives issuers the flexibility to sell any number of securities in a private offering.
• The requirements of the purchaser – An issuer has the option to sell its securities to an unlimited number of accredited investors. However, non-accredited investors are restricted to 35.
• No disclosure requirements – As long as all information provided in the offering materials is true and correct, no disclosures are required. It gives companies the flexibility to present offerings in any way they want.
• Verification is not mandatory – Prior to offering securities, an issuer is not required to verify information provided by investors. As a result, it can take less time and effort to raise capital.
• No registration – Securities will not be registered with the SEC when offered under Rule 506(b). It can therefore help companies in avoiding the costs associated with SEC filings and disclosures.

What is Rule 506(c)?

Similar to Rule 506(b), Rule 506(c) of Regulation D provides companies with a way to raise capital privately without having to register their securities. However, there are some key differences between the two rules. Under Rule 506(c), an issuer can sell its securities only to accredited investors. In addition to this, verification of investor status is required before any securities can be sold and general solicitation is permitted. Therefore, in order to offer securities under Rule 506(c), an issuer must take reasonable steps to verify that all investors meet the requirements of being an accredited investor.

Pros and Cons of Rule 506(c)

While the rules under Rule 506(c) are flexible and easy to understand, they are not without their shortcomings. Below mentioned are a few of the pros and cons of offering securities under Rule 506(c).

Pros

• The state blue-sky laws are not applicable under Rule 506(c) of Regulation D. As a result, companies can avoid having to meet state blue-sky laws.
• General solicitation and publicly available advertising are permitted under Rule 506(c). The company is not required to make offering materials that are private and confidential.
• Prior relationship is not required under Rule 506(c). A company can raise capital from any number of accredited investors.

Cons

• Companies might have to spend more time and effort verifying the information provided by investors. This is essential for determining if an investor is accredited.
• Accountants and attorneys are reluctant to certify investor accreditation because of the possible risk involved unless they are working with very large, wealthy customers.

Who can invest in Rule 506(c)?

Under Rule 506(c), companies can raise capital from accredited investors only. But, who are accredited investors? Accredited investors are individuals who have been certified by the SEC as being qualified to invest in complex securities. However, reasonable steps must be taken by the company to verify the information. The investor must provide appropriate documentation that is acceptable by the SEC in order to meet the requirements of Rule 506(c). Thus, there are certain steps that the issuer must take in order to verify the information.

How can 506(c) investors verify LP accreditation?

There are three ways in which these investments can be verified by limited partnerships (LPs). The following are the steps that can be taken:

• The general partnership (GP) may want the LP’s tax returns for the prior two years if the LP is claiming accreditation based on income. The minimum annual income requirement for accredited investors is $200,000 for an individual and $300,000 for couples. GPs would also need assurance that the LP’s income will continue to meet this requirement in the current year.
• If the LP asserts that accreditation is based on net worth, GPs can examine the LP’s assets by obtaining documentation of the buyer’s assets and liabilities from the previous three months, such as bank statements and brokerage reports. Additionally, GPs must get the LP’s approval that all obligations that can affect net worth have been disclosed. An individual must have a net worth of more than $1 million, excluding their primary residence, in order to be an accredited investor.
• The GP would need a copy of the certification if the LP asserts accreditation based on one of the SEC’s recognized professional certificates. It is important that the GP knows if the LP has been accredited by the SEC in order to assess the level of sophistication of the investor. Therefore, it is important to verify the nature of the certificate and how it was obtained.

Main differences between Rule 506(b) and Rule 506(c)

The rules under Rule 506(b) and Rule 506(c) differ in several ways. While both rules allow for companies to sell securities without registration in a private offering, there are some key differences which are as follows:

• Information – On the basis of information about the offering, these two rules have different requirements for the issuer.
  • Rule 506(b) – In the case of accredited investors, the issuer is not required to disclose any information about the offering. On the contrary, for non-accredited investors, the issuer must describe the terms of the offering and confirm that all information is correct.
  • Rule 506(c) – As a matter of fact, the issuer is not required to maintain any information about the offering because accredited investors are involved. This means that information about the offering can be completely private.
• Verification – Verification requirements differ between the two rules in terms of who is involved and what needs to be verified.
  • Rule 506(b) – Usually, verification under Rule 506(b) is not performed by any third party. Instead, it is performed by the issuer itself and hence the statement of the investor is considered evidence of the investor’s status.
  • Rule 506(c) – On the other hand, verification, in this case, is performed by the issuer and any third party that is considered fit by the issuer. This can be done via tax returns, bank statements and brokerage reports.
• Advertising – Depending on the rules, public advertising of the offering differs in the following ways:
  • Rule 506(b) – Issuers are prohibited from advertising any information about the offering. That being said, a prior relationship is required and the offering is made only to a limited group of investors.
  • Rule 506(c) – Issuers are permitted to advertise the offering with the general public under certain conditions. The general public is made aware of the offering through public advertising because accredited investors are involved.

Other ways Rule 506(b) and Rule 506(c) differ

Now that you know the main differences between Rules 506(b) and (c), you need to know which one is more appropriate in the specific scenario of your business. Here are other ways these two rules differ from one another:

• Investors – Under Rule 506(b), accredited investors and up to 35 non-accredited investors can invest. On the other hand, under Rule 506(c), only accredited investors are eligible to invest.
• Verification of accredited investors – In terms of verification, Rule 506(b) requires verification on the bases of statements made by the investor while Rule 506(c) requires verification through documentation.
• Limits – There is no limit to the size of the offering under Rule 506(b) and Rule 506(c). Additionally, unlimited accredited investors can invest in both cases. Hence, the limit is the same for both rules.
• Number of shareholders – Any company has more than 500 non-accredited investors or 2,000 investors, it becomes a reporting company as per the Exchange Act. This remains the same for Rule 506(b) and Rule 506(c).
• Required information – There is no information requirement for accredited investors under Rule 506(b). However, under Rule 506(c), the issuer must describe the terms of the offering, confirm that all information is correct and obtain express consent from any potential investor.
• Post-sale filing – Form D and forms to each state where the investor resides is required to be filed by the issuer under Rule 506(b) and Rule 506(c). Likewise, it remains the same for both rules.
• Advertising – Rule 506(b) prohibits any information about the offering from being advertised to the general public. On the contrary, Rule 506(c) permits the issuer to advertise to the general public with certain conditions in place.

Switching from Rule 506(b) to Rule 506(c)

It is possible to switch from Rule 506(b) to Rule 506(c). As long as you don’t have any non-accredited investors, the switch can be done. Moreover, reasonable verification must be done by the issuer and no information must be disclosed to any investor who is not an accredited investor. As a result, the switch from 506(b) to 506(c) is quite a simple process.

Future of Rule 506

The increase in the pool of qualified investors could be beneficial to GPs conducting serial 506(c) offerings as the SEC has permitted various accreditation techniques in addition to the requirement for income verification. Although these changes do not address the burdens of initial income verification, they may not be sufficient for 506(c) fundraising. In addition to this, Regulation D and Form D will be amended to ease the compliance burden. While in case of non-compliance, SEC might enforce strict penalties.

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