Financing Through Exempt Private Capital Raise Transactions Under Regulation D of the Securities and Exchange Commission. Part III.

Regulation D, Rules 506(b) and 506(c) – The Conditions of the Rules

Part II of this article noted that despite the continued or alternative availability of section 4(a)(2) of the Securities Act of1933 (the Securities Act) as a valid stand-alone transactional exemption from registration of the securities where not involving any public offering, Regulation D offers a safe harbor for compliance.  In 2012, the Jumpstart Our Business Startups Act, or JOBS Act intended to, among other things, reduce barriers to capital formation, particularly for smaller companies. The JOBS Act required the Securities and Exchange Commission (SEC) to adopt rules amending existing exemptions from registration under the Securities Act of 1933 (i.e., Rule 506 in its prior general solicitation-prohibited form (Old 506)) to enable new exemptions that would permit issuers of securities to raise capital without SEC registration.  The SEC amended Rule 506 of Regulation D to implement the requirements of the JOBS Act effective in September 2013, bifurcating Old 506 into Rules 506(b) and 506(c).

Rule 506(b) thereafter continued the previously applicable manner of offering prohibition against general solicitation safe harbor under section 4(a)(2) providing objective standards for meeting the exemption, thereby providing confidence of an issuer’s compliance with exemption. An issuer that fails to satisfy the specific criteria of Regulation D may still rely on the broader section 4(a)(2) private placement exemption. The safe harbors under Rule 506(b) and (c) of Regulation D, however, have the added advantage of providing a statutory blue sky exemption under the National Securities Markets Improvement Act of 1996 and section 18 of the Securities Act, yet not from any state’s anti-fraud laws.

Rule 506(b) Conditions – In order for an issuer to rely on Rule 506(b) of Regulation D, the offering must satisfy the following conditions (i.e., with limitations on manner of offering): 

• Limitation on number. There can be no more than 35 non-accredited investors in the offering, while the number of accredited investors that can be included is not limited;
•  Nature of purchasers. The issuer must reasonably believe that any non-accredited investors have such knowledge and experience in financial and business matters that they are capable of evaluating the merits and risks of the prospective investment;
• Information disclosure. There are no information or disclosure requirements when all the investors are accredited (i.e., in a Rule 506(c) offering), but if the issuer sells to any non-accredited investors (i.e., under Rule 506(b)) and is not already registered with the SEC, then it must provide the same information that it would in an SEC-registered offering, including financial statements that meet the requirements mandated for registration. See Part IV of this article enumerating the information disclosure requirements for a Rule 506(b) offering;
• Prohibition on general solicitation. Neither the issuer nor any person acting on its behalf may offer or sell the securities by any form of general solicitation or general advertising; and 
• SEC notice. Issuers are required to file a Form D with the SEC within 15 days of the first sale of securities.

Rule 506(c) Conditions – The JOBS Act (Jumpstart Our Business Startups) required the SEC’s removal of its the prohibition against general solicitation under Old 506 under Reg D by adopting paragraph (c) of Rule 506 where accredited status of investors is present. Under Rule 506(c), for an issuer to be relieved of the manner of offering limitations (e.g., no general solicitation), all investors were, and are, required to be accredited and an issuer is required to take reasonable steps to verify their accredited status. Verification of accredited status requires an objective determination by the issuer, including either that supported by satisfactory evaluation of an investor’s threshold income (e.g., review of W-2, 1099, K-1, 1065 and 1040 documentation) or an investor’s satisfaction of a minimum net worth criteria (e.g., via review of bank or brokerage statements of investors or the written confirmations of CPAs, investment advisers, attorneys, and registered broker dealer regarding said criteria). An accredited investor who is an individual qualifies if earned income that exceeded $200,000 (or $300,000 together with spouse) in the two most recent taxable years with a reasonable expectation of same in the current taxable year, or has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence). 

Bad Actor Disqualification: The exemption under Rules 506(b) and 506(c) are generally unavailable if the issuer or any of its officers, directors or controlling shareholders/insiders has been convicted of a violation of securities laws. See Part II of this article, Regulation D Transactional Exemptions – The Anti-Fraud and “Bad Boy” Rules.