If you are thinking about putting an investor in a private placement one of the first questions you should ask is:
Is it a 506(b) or a 506(c) offering?
Then they tell you, and you go: Uhhhhh…….
DON'T PANIC - Douglas Adams, The Hitchhiker's Guide to the Galaxy
Let's back up just a little. What's 506?
Section 506 is part of the Regulation D section of the Securities Act of 1933 (17 CFR § 230.506 if you're a nerdy lawyer - like me), exempting issuers having to register or file documents with the Securities and Exchange Commission (SEC).
Section 506(b) has been around for many years (since 1982 - making it an "elder millennial" as defined by Iliza Schlesinger in her 2018 Netflix special of the same name). It was the only option until July 2013, when 506(c) became effective. Eight years seems so long ago but also like yesterday. To put it into perspective, that was the same year Disney's Frozen was released. #Andnowthatsongisinyourhead #sorrynotsorry
So then what's the big deal between the two?
At first things were very confusing. Everything was so entirely different from the world I had known - even the flowers. - H.G. Wells, The Time Machine
Many things are the same, especially since both are Regulation D offerings. There are only a few key differences between a 506(b) and a 506(c) offering. The three most significant are:
|Investor type||Accredited investors and up to 35 sophisticated investors.||Accredited investors only.|
|Accredited investor verification||The issuer may rely on an investor statement.||The issuer must verify that investors are accredited, typically through a third party.|
|Advertising||No advertising of the actual deal is allowed. Issuers can only sell directly to those with whom it has a pre-existing relationship.||General solicitation is allowed — no limitation on the type of advertising.|
What does this mean? Well, suppose your client is not an accredited investor. In that case, they are only eligible to invest in a 506(b) offering so long as there are not already 35 unaccredited investors in the pool. While a limited number of unaccredited investors are allowed under 506(b), most private placements that we review allow for accredited investors only. If you have an accredited investor, they can invest in either type of offering.
If it is a 506(c) offering, you need to be aware that the issuer must take reasonable steps to verify the accredited investor status of each investor. As part of our due diligence process of 506(c) offerings, we like to ask what steps an issuer is taking to verify investor status. Typically, issuers will use a third-party verification service, such as Verify Investor, and/or require that the investor provide a letter from their accountant or lawyer, representing that the investor's representative has verified their income or net worth.
The most discussed difference is the advertising one. The general solicitation advertising allowed under 506(c) allows the issuer to advertise the deal to the general public. The issuer must ensure that general solicitations comply with Rule 156 (guidance on types of information in sales literature that may be misleading) and all anti-fraud provisions. There was confusion when 506(c) initially became effective that issuers would not use a managing broker-dealer for an offering, or would compete with a managing broker-dealer when it created a 506(c) offering. That is not necessarily the case, as many issuers use managing broker-dealers to create selling groups for 506(c) offerings. Although, some broker-dealers we work with have expressed apprehension over 506(c) offerings, particularly in instances where the issuer connects with broker-dealer clients directly.
Should the issuer not take reasonable steps to verify an investor's status or be found to violate Rule 156, it could become subject to an order of the SEC, and the offering would lose its exempt status. Loss of the offering's exempted status would require the Fund to register with the SEC under the Securities Act of 1933. The costs for registering the offering and the required information and document filings may be burdensome and expensive for the Fund and its investors to bear and could result in the offering not meeting its investment objectives.
When we reach the city. - Ray Bradbury, Fahrenheit 451
And so we've reached the end.
From your perspective, a broker-dealer must realize that the issuer's use of general solicitation increases your due diligence burden because you must take additional steps to confirm that the issuer is compliant with general solicitation conditions and rules regarding advertising and FINRA. Additionally, if the issuer is not using a managing broker-dealer, you must determine the use of advertising, even issuer-provided advertising. These determinations include if you should file the advertising with FINRA according to Rule 5123 and the nature of communications with the public under Rule 2210. Failure to comply with these rules could lead to disciplinary actions with FINRA.
Hopefully, this post will allow you to take that 506(b) and 506(c) confusion and #LetitGoLetitGOOOOO!!! #seethatsongwasstillinyourhead