ADISA Video: Implementing 506(c) Offerings in a Historically 506(b) World
The DI Wire’s publisher, Damon Elder, interviewed Darryl Steinhause, a partner with DLA Piper, to discuss the emergence of 506(c) private placement offerings and their increasing acceptance with broker-dealers and the benefits they provide compared to traditional 506(b) offerings.
Video Transcript
Damon Elder 00:10
Welcome to another edition of Focus on Alternatives hosted by ADISA, the Alternative and Direct Investment Securities Association. I’m Damon Elder, publisher of The DI Wire and today we’re joined by Darryl Steinhause partner with DLA Piper. Darrell, this morning we’re gonna talk about a pretty topical subject it’s certainly growing in popularity I think in the industry and that’s regulation D rule 506 B versus Rule 506 C. So, 506 C was introduced in the wake of the Great Recession 2013 Jobs Act. What are the differences between 506 B and 506 C?
Darryl Steinhause 00:43
It’s interesting because when you look at this this came about because of technology. In the old days you had to have a pre-existing relationship with someone in order to sell them at a private security. Now you sell things on the Internet to everyone every day. And what this is trying to do is match the current world with a 1933 technology or drafted law. So now you are allowed to have general solicitation when you sell securities. But when they put this law into place the SEC was concerned and Congress was concerned that you’d have people who would say that they’re accredited and they’re qualified and they would just tell you that which is the old rule.
Under B used to be able to just certify I’m an accredited investor and that was good enough to get you into the game. But because of the general solicitation provisions the SEC said what can we do to change this. So, what they did is they added a provision that said first you have to be an accredited investor in Reg D rule 506 B transactions, you can be a non accredited investor to a limited extent you can have up to 35 individuals in some circumstances. But in this case, you have to be accredited, and then the issuer whoever is issuing the securities has to make sure and they have to verify that you’re actually accredited in this situation. So, when you’re looking at the B versus the C one accredited only two you gotta check the right box on the form D and three you have to make sure that you verify that your investors are accredited
Damon Elder 02:21
So, that seems to be a big hurdle to you know verify the accreditation. How do the issuers go about doing that?
Darryl Steinhause 02:30
So, the SEC was smart enough to put in certain safe harbors, there’s no set rule. So, you can use if you’re selling to Bill Gates you can say hey I know you’re accredited investor and you don’t have to do much more. However, what they did is they put six safe harbors in the in the rules one you can verify by determining their net income by getting their their tax returns for the last several years. Two you can verify their net worth by looking at financial information including like bank statements real property tax reports those kinds of things. And then there’s four other ones that are actually the ones that are used the most. You could have an RIA a broker dealer and attorney or an accountant certified that they have determined that you’re accredited within the prior three months.
Damon Elder 03:23
So, it’s the issuers responsibility, essentially the investment sponsor. What role does the broker dealer play what is their responsibility in the 506 C process?
Darryl Steinhause 03:32
So, when you have a broker dealer involved, it kind of adds an extra element to the mix because the broker dealer has the relationship with the investor or they’re going to have the relationship with the investor. There’s been a lot of confusion because when you look at those six items that I gave you, early on in the when the law was passed the broker dealers were fearful that if they were the ones that were verifying the investor was accredited that they had to go back to #1 and #2, the net income and the net worth.
But if you look at the reports from the SEC, it’s slightly different. The SEC has indicated in its release that the… if you’re the issuer and you have a substantive relationship with this investor that you can rely on a certificate OK, and you don’t have to go through everything again. So, when you’re a broker dealer these rules will put in place because the broker dealer has a a very tight relationship with their investors. They know what their investors net worth is they should know what their investors net income is. And is this suitable? So, under FINRA, FINRA requires that these broker dealers determine that the investor is suitable for the transaction.
In order to determine that your investor is suitable you have to have a substantive relationship with them, you have to dive into the facts you have to figure out everything. So, if you have done your duty under the suitability requirements which is required in all cases, then you should take this the next step which is as a broker dealer you should be able to rely on a certificate only from a broker dealer because you already have that pre-existing relationship. And you know this is not legal authority but in private discussions with the SEC they said if we wanted everybody to do the net worth and net income test including the broker dealers and RIAs we would have set the test up that way. We didn’t set it up that way, there’s six choices not two choices.
Damon Elder 05:47
So, 506 C has been around now for nearly ten years, adoption I think safe to say it was very slow in the early years. Now depending on who you talked to 15% to 20% of private placements are apparently being structured under Rule 506 C. Broker dealer seemed to becoming more comfortable with 506C, you know what are you seeing what do you think the future holds for 506 C versus 506 B?
Darryl Steinhause 06:10
The real issue here is the broker dealers don’t want to be shut out of the game. And there’s a way that you can work with 506 C and broker dealers and do effectively the same transaction that we’re doing today but protecting from foot faults. And that’s what 506 C does. You can’t inadvertently put up a advertisement website um… Tombstone any of those items and get in trouble if you’re under 506 C. And by the way with with all the different social media opportunities that people have, someone’s going to make a mistake in these transactions.
Damon Elder 06:51
Your safe harbors are greater under 506 C isn’t there? You’re protections?
Darryl Steinhause 06:55
Your protections are greater because if you foot fault and you and you advertise, you’re OK because you’re allowed to. So, if we can resolve the issue of how do we use 506 C and still keep the broker dealers involved which some of the sponsors are now doing saying…
Damon Elder 07:11
Capital Square, Passco other big sponsors of very successfully raising capital through the broker-dealer channel with 506 Cs.
Darryl Steinhause 07:17
Yes, and they’re saying in these documents we’re gonna proceed the exact same way we were doing it under a B, we’re just gonna check the C box because we’re protecting you. And FINRA has been looking at the contemplation issue and the contemplation issue says if I’m a broker dealer I cannot sell a security to someone that I obtained through a general solicitation if that deal was existing or contemplated when I met the person. So, in this short world of DSTs where you have you know your clock ticking before you can make your investment. The broker dealers are figuring out what are we going to do? If you’re under 506 B if you advertise on a website you bring an industrial in you can’t put them into any existing deals technically. There’s been several enforcement actions over the last year, where FINRA going after the broker dealer saying you violated the contemplation rule therefore the exemption was lost on the securities, and you were selling illegal securities.
Damon Elder 08:23
It blows the whole deal up, right?
Darryl Steinhause 08:24
It blows the whole deal up potentially. So, if we can get to a place where people can follow the 506 C rules and still utilize the broker dealers it seems like the win win situation here for the industry.
Damon Elder 08:35
Well, it’s a complicated issue but I think you’ve added a lot of clarity this morning so thanks Darrell and thank you for watching another episode of focus on alternatives,
For more information on 506 Bs and 506 Cs and all things related to alternative investments visit www.adisa.org and of course feel free to check out The DI Wire.com for your daily alternative investment news, thanks so much.
For more ADISA news, please visit their directory page.
