Guest Contributor: Understanding 506(c) Offerings and Avoiding the Contemplation Rule
By Marc H. Slavny, chief investment officer, Fortitude Investment Group – and written in collaboration with the 506(c) Working Group
Rule 506(b) under Regulation D provides an exemption from registration for the issuance of securities under the Securities Act of 1933. It allows issuers to raise an unlimited amount of money from up to 2,000 investors and up to 35 non-accredited investors (although non-accredited investors are subject to additional requirements), without having to register their securities with the U.S. Securities and Exchange Commission. An issuer with more than 2,000 investors must become a reporting company under the Securities Act of 1934, as amended. However, Rule 506(b) prohibits issuers from using general solicitation or advertising to offer their securities. General solicitation includes advertisements published in newspapers and magazines, public websites, communications broadcasted over television and radio, and seminars where attendees have been invited by general solicitation or general advertising.
One of the limiting provisions in Rule 506(b) is the contemplation rule. Under the contemplation rule, investors cannot participate in an offering in which a broker-dealer contemplated participating or actually participated in the offering prior to the time a substantive relationship was established with the investor if the investor was brought in through general solicitation. There must be a relationship that existed prior to the time the broker-dealer signed the selling agreement for the offering.
- A “preexisting” relationship is formed before the start of the offering or is established through a broker-dealer or investment adviser prior to that investment professional’s participation in the Rule 506(b) offering.
- A “substantive” relationship is formed when the entity offering securities (i.e., the company or its broker-dealer or investment adviser) has sufficient information to evaluate and does evaluate a potential investor’s status as an accredited investor.
Where it becomes problematic is during times similar to what the industry is currently experiencing. Imagine you are a sponsor, and you launched a Rule 506(b) offering in the last 12 months. For those offerings that have not yet become fully subscribed, all the newly acquired clients of the advisers in the selling group cannot invest in that older program. According to Mountain Dell Consulting, for 1031 programs they track as of Dec. 31, 2023, 93 programs with available equity had an average Days on the Market of 264 days! How is the sponsor going to close out their programs? They either need to bring new broker-dealers into the selling group, hope that advisers currently in the selling group have existing clients who have a sudden need to invest, or convert the offering to a Rule 506(c) offering.
Regarding a prospective investment in a Rule 506(b) offering, some broker-dealers will allow an investment from a qualified Intermediary referral to an adviser where the relationship started after the broker-dealer signed the selling agreement. There is no requirement that an informal network relationship preexisted the broker-dealer participation in the offering as long as the prospect was not acquired through general solicitation.
The Rule 506(c) exemption is a critical provision in U.S. securities law that facilitates the offering of securities through general solicitation and advertising. This exemption allows companies to reach a wider pool of potential investors without the limitations of traditional private placement regulations. This article – the third in a series written in collaboration with the 506(c) Working Group – provides an analysis of Rule 506(c), focusing particularly on how it aids in solicitation, along with best practices for compliance and effective utilization.
Understanding Rule 506(c) and Its Parameters
Rule 506(c) allows companies to publicly advertise and solicit offerings, provided that all purchasers in the offering are verified as accredited investors. Accredited investors, as defined by the SEC, generally include individuals with a high-net worth, financial institutions, and certain other entities. By adhering to the stipulated verification procedures, companies can access a broader investor base while maintaining regulatory compliance.
Best Practices for Effective Utilization and Compliance
Adherence to best practices is crucial for effectively utilizing Rule 506(c). Companies should implement robust internal compliance protocols, including regular training sessions for employees involved in solicitation and advertising activities.
Section 201(a) (1) of the JOBS Act requires the SEC to eliminate the prohibition on using general solicitation under Rule 506 where all purchasers of the securities are accredited investors, and the issuer takes reasonable steps to verify that the purchasers are accredited investors, as opposed to allowing the purchasers to confirm accreditation themselves.
An “accredited investor” (as defined under Rule 501 of Regulation D of the Securities Act) is a natural person and includes:
- Earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same or greater for the current 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);
- Holds in good standing one or more professional certifications or designations or credentials from an accredited educational institution that the SEC has designated as qualifying an individual for accredited investor status (includes attributes the SEC will consider for this purpose);
- Is a ‘knowledgeable employee’ as defined in rule 3c-5(a)(4) under the Investment Company Act of 1940, of the issuer of the securities being offered or sold where the issuer would be an investment company, as defined in section 3 of the 1940 Act, but for the exclusion provided by either section 3(c)(1) or 3(3)(7) of the 1940 Act; and
- Is a director, executive officer, or general partner of the issuer or a general partner of the issuer.
An “accredited investor” may be an entity such as a bank, partnership, corporation, nonprofit, or trust when the entity satisfies certain criteria.
The JOBS Act requires that issuers wishing to engage in general solicitation take “reasonable steps” to verify the accredited investor status of purchasers. Rule 506(c) sets forth a principles-based method of verification which requires an objective determination by the issuer as to whether the steps taken are “reasonable” in the context of the particular facts and circumstances of each purchaser and transaction.
In addition to this flexible, principles-based method, Rule 506(c) includes a non-exclusive list of verification methods that issuers may use, but are not required to use, when seeking greater certainty that they satisfy the verification requirement with respect to natural person purchasers. This non-exclusive list of verification methods includes verification based on income, by reviewing copies of any Internal Revenue Service form that reports income, such as Form W-2, Form 1099, Schedule K-1 of Form 1065, and a filed Form 1040, and obtaining a written representation from the investor:
- Verification of net worth, by reviewing specific types of documentation dated within the prior three months, such as bank statements, brokerage statements, the qualified intermediary’s funds in escrow statement for the investor, certificates of deposit, tax assessments and a credit report from at least one of the nationwide consumer reporting agencies, and obtaining a written representation from the investor; and
- A written confirmation from a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney, or a certified public accountant stating that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the last three months. Rule 506(b) remains unchanged following the adoption of Rule 506(c) and continues to be available for issuers that wish to conduct a Rule 506 offering without the use of general solicitation or that do not wish to limit sales of securities in the offering to accredited investors.
In conclusion, by far, the most significant advantage of an offering’s structure under Rule 506(c) is the ability to generally solicit or market the offering. While a substantive relationship is always required prior to soliciting a transaction with an investor, no preexisting relationship requirement exists. This means that issuers can take their offering and publicly communicate the offerings and the issuer’s attributes utilizing channels previously prohibited including web, in a magazine, on a billboard, or most any other way they can imagine. This not only allows issuers to show their current offering to the world, potentially resulting in an expedited completion of their raise, but it also creates a larger investor base for future investments the issuer may offer. Given that over the past year offerings have taken much longer to fully subscribe, one would have to believe sponsors are taking another look at Rule 506(c).
Marc H. Slavny is the chief Investment officer and a licensed registered representative at Fortitude Investment Group, carrying more than 28 years of investment management experience, and 40 years of real estate investment experience. He is a member of the 506(c) Working Group, which is comprised of representatives from several leading law firms and investment sponsors, including Urban Catalyst.
The views and opinions expressed in the preceding article are those of the author and do not necessarily reflect the views of The DI Wire.
506(c) WORKING GROUP MEMBERS
Will Bohannan
Director Capital Markets
Revere Capital Management
Catherine Bowman
Founder
The Bowman Law Firm, LLC
Daniel Castaneda
Real Estate Business Development
NexPoint
Al DiNicola, AIF, CEPA
Investment Adviser Representative
NAMCOA
Geoffrey D. Flahardy
President of Strategic Relations
ExchangeRight
Jay Frank
President
Cantor Fitzgerald Asset Management
Deborah Froling
Partner
Kutak Rock LLP
Carol Jones
Director of Due Diligence
Arkadios Capital
Michele Kyoko Wiens
Senior Vice President, National Accounts
Capital Square
Greg Mausz
Senior Managing Director and Chief Operating Officer
Skyway Capital Markets
Trevor Nesbit
Managing Director
venture.co
Sean Raft
CAO and General Counsel
Urban Catalyst
Crystal H. Rutkowski, AIF
Senior Vice President, Business Development
Urban Catalyst Funds
Marc H. Slavny
Chief Investment Officer
Fortitude Investment Group (broker-dealer – Concorde Investment Services)
Darryl Steinhause
Partner
DLA Piper LLP (US)
For those interested in joining the 506(c) Working Group, please contact Crystal at crystal@urbancatalystfunds.com.
For more Urban Catalyst news, please visit their directory page.
