SEC Compliance: Rule 506(b) vs. 506(c)

In the past, smaller investors faced significant barriers when it came to investing in real estate. However, recent Securities and Exchange Commission (SEC) rulings have made real estate syndication more accessible to smaller investors by removing those barriers. Rule 506(b) and Rule 506(c) are two popular SEC rules that investors can use to raise capital, and choosing between them will impact their capital raising strategies in various ways. Dugan Kelley, managing partner at Kelley Clarke, PC, and head of the firm’s securities and real estate practice, discussed the differences between the two rules in a recent conversation. It is important to note that this information is not legal advice and investors should consult with their attorney before conducting a 506(b) or 506(c) offering. The podcast episode featuring the full discussion can be found for those interested in learning more.

What are Rules 506(b) and 506(c) for?

Rules 506(b) and 506(c) are both part of Rule 506 of Regulation D (Reg D) of the Securities Act, which provides exemptions for companies to sell securities without registering with the SEC. This allows companies to raise capital from investors without the expense and complexity of a public offering. For syndications, raising capital is often the biggest challenge, but with these rules, operators can legally raise funds from investors to acquire properties. Dugan Kelley emphasizes the importance of overcoming the fear of asking for money and utilizing these exemptions to raise capital. The primary exemptions utilized by most syndicators are Reg D 506(c) and 506(b).

Rule 506(b) and Rule 506(c): What’s the difference?

Rule 506(b)

Under this rule, syndications can raise an unlimited amount of capital from an unlimited number of accredited investors and up to 35 non-accredited sophisticated investors. It is not necessary to obtain SEC pre-approval for the offering, as long as the exemption rules are followed.

• Syndications are not allowed to conduct general solicitations or advertise the offering in the market

• To prove they did not solicit investors, operators must be able to demonstrate a pre-existing, substantive relationship with an investor that must pre-date any offer to invest

• Syndications may raise capital from an unlimited number of accredited investors defined as an individual (or a couple) with a net worth of $1 million, excluding their primary residence, or an individual whose annual income exceeds $200,000 for the two most recent years (or $300,000 if with a spouse) and a reasonable expectation of the same for the current year.

• Syndications are limited to 35 non-accredited investors only. Non-accredited investors are required to be sophisticated investors, meaning they must possess knowledge and experience in financial and business matters so that they can evaluate the merits and risks of the prospective investment.

• When raising funds from non-accredited investors, the syndicator must also follow additional rules such as: 

• Provide disclosure documents that have the same type of information as what is in a registered offering, as well as financial statement information

• The syndicator should be available to answer prospective purchasers’ questions 

• Investors in 506(b) offering may self-certify that they are accredited or sophisticated through a pre-qualification form or a questionnaire provided by the syndicator

• The syndicator must file Form D electronically with the SEC within 15 days of the first equity being raised. This form provides the SEC with information on the business, the principal, the amount of money being raised, and some details about the offering. Once the offering is completed and all funds have been raised, the SEC doesn’t require any ongoing reporting.

Rule 506(c)

The Jobs Act of 2012 led to the creation of Rule 506(c), which offers more opportunities for businesses and real estate investors to raise capital. With this rule, syndicators can still raise unlimited capital from an unlimited number of investors. Unlike Rule 506(b), Rule 506(c) allows syndicators to advertise and solicit the offering to the general public, subject to certain conditions.

• All investors must be accredited investors. 

• The syndication should take reasonable steps to verify the prospective investors’ accredited investor status which could include reviewing documentation, such as W-2s, tax returns, bank and brokerage statements, credit reports, and the like.

• Similar to 506(b), Form D must be filed with the SEC within 15 days of the first equity being raised.

The key difference between Rule 506(b) and Rule 506(c) is the ability to advertise and solicit offerings. While Rule 506(b) prohibits advertising or general solicitation, Rule 506(c) allows sponsors to advertise more broadly. However, Rule 506(c) requires syndicators to perform additional work to verify the accreditation status of each investor using federally prescribed “reasonable steps” and maintain records of the verification process. Despite the availability of Rule 506(c), most private syndication offerings in the US are still conducted under Rule 506(b), which allows unlimited accredited investors and up to 35 sophisticated investors with whom the syndicator has a pre-existing relationship.

How will I know if I have a substantive pre-existing relationship with my investors?

Advertising Offerings

Dugan advises syndicators to make full use of the advertising opportunities available under Rule 506(c) by promoting their offerings through various channels, such as social media platforms, podcasts, and meet-ups. He emphasizes that creativity is the only limit when it comes to promoting a 506(c) offering, but warns syndicators who primarily operate under Rule 506(b) to exercise caution and judgment when publicizing their projects on social media and other channels. They should avoid violating securities laws and regulations by sharing too much information with potential investors who do not have a pre-existing relationship with them. Instead, they should focus on sharing positive news about their company without making direct solicitations to new investors.

Educating your investors vs. Preconditioning the market

According to Dugan, there is a clear distinction between educating and providing general information about your company, and preconditioning the market. The latter is when a post or any other material that you release indicates your intention to attract new investors or elicit responses from potential investors whom you don’t know personally. This is not allowed. However, you can share information about the good things happening in your company in an honest, transparent, and authentic way without preconditioning the market. Dugan emphasizes that sharing general information to help people discover your company is acceptable and can be published, such as your company’s overall vision or mission, strengths, or general activities. But, you must avoid crossing the line by talking about specific returns, offering, or property with the intention of attracting more potential investors to you.

506(b) or 506(c): Which is better for me?

Choosing between Rule 506(c) and 506(b) depends on whether you have potential investors in your network who can invest in your deal or not. If you plan to raise funds from people in your personal network, who may or may not be accredited investors, 506(b) would be a better option. Typically, first-time syndicators prefer 506(b) since they initially rely on their personal network. However, they may not be able to raise funds from them for subsequent deals and would require advertising for the offering, making 506(c) the only option.

Under Rule 506(c), you can expand your investor network beyond your personal network, so you need to establish your credibility, reputation, and track record to attract new investors. Apart from promoting the benefits of your deal, showcasing your past numbers should entice potential investors.

Regardless of which rule you choose, ensure that you maintain comprehensive records of your relationship with investors for 506(b) and the accredited investor verification process for 506(c).

FINAL THOUGHTS

Rule 506(b) or 506(c) both provide excellent opportunities for real estate syndicators to raise capital and fund their deal acquisition without complicated government regulation. The rules may give registration exemption, but you should be diligent in following requirements. Hire or consult an experienced attorney to confidently navigate the process and succeed in your investing goals.