Rule 506

A company that satisfies the following standards may qualify for an exemption under this rule:

  • Can raise an unlimited amount of capital;
  • Seller must be available to answer questions by prospective purchasers;
  • Financial statement requirements as for Rule 505; and
  • Purchasers receive restricted securities, which may not be freely traded in the secondary market after the offering.

The rule is split into two options based on whether the issuer will engage in general solicitation or advertising to market the securities.

 

If the issuer will not use general solicitation or advertising to market the securities then the sale of securities can be issued under Rule 506(b) to an unlimited number of accredited investors, and up to 35 non-accredited investors.

All non-accredited investors in a 506 offering, either alone or with a purchaser representative, must be sophisticated – that is, they must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.

In July 2013, the SEC issued new regulations as required by 2012 Jumpstart Our Business Startups Act.

These new regulations add Rule 506(c) to allow general solicitation and advertising for a private placement offering. However, in a Rule 506(c) private offering all of the purchasers must be accredited investors and the issuer must take reasonable steps to determine that the purchaser is an accredited investor

Current Rule 506 Offering Process

Companies seeking to raise capital through the sale of securities must either register the securities offering with the SEC or rely on an exemption from registration. Most of the exemptions from registration prohibit companies from engaging in general solicitation or general advertising – that is, advertising in newspapers or on the Internet among other things – in connection with securities offerings. Rule 506 of Regulation D is the most widely-used exemption from registration.

In an offering that qualifies for the Rule 506 exemption, an issuer may raise an unlimited amount of capital from an unlimited number of “accredited investors” and up to 35 non-accredited investors. Under SEC rules, accredited investors are individuals who meet certain minimum income or net worth levels, or certain institutions such as trusts, corporations, or charitable organizations that meet certain minimum asset levels.

JOBS Act

In April 2012, Congress passed the Jumpstart Our Business Startups Act (JOBS Act). Section 201(a)(1) of the JOBS Act directs the SEC to remove the prohibition on general solicitation or general advertising for securities offerings relying on Rule 506 provided that sales are limited to accredited investors and an issuer takes reasonable steps to verify that all purchasers of the securities are accredited investors. By requiring the SEC to remove this general solicitation restriction, Congress sought to make it easier for a company to find investors and thereby raise capital.

While issuers will be able to widely solicit and advertise for potential investors, the JOBS Act required the SEC to adopt rules that “require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission.” In other words, there is no restriction on who an issuer can solicit, but an issuer faces restrictions on who is permitted to purchase its securities.

The law also directed the SEC to amend Rule 144A under the Securities Act, an exemption from registration that applies to the resale of securities to larger institutional investors known as qualified institutional buyers (QIBs). Under current Rule 144A, offers of securities can only be made to QIBs. Under the new rule, Rule 144A is amended so that offers of securities can be made to investors who are not QIBs as long as the securities are sold only to persons whom the seller reasonably believes are QIBs.

2012 Proposal

Last August, in order to comply with the Congressional mandate to implement Section 201(a)(1) of the JOBS Act, the Commission proposed a rule that would remove the general solicitation ban for certain 506 offerings in which sales of securities would be limited to accredited investors and issuers would be required to take reasonable steps to verify such accredited status. After doing so, the Commission received numerous comments, including requests seeking greater clarification on the types of verification that would be considered reasonable under the rule.

Commenters also suggested that the SEC consider measures that they believed would provide additional protections for investors in connection with removing the general solicitation ban. Several of those additional measures identified by these commenters are included in a separate proposal that the Commission approved today.

New Rulemaking

Rule 506

The final rule approved today makes changes to Rule 506 to permit issuers to use general solicitation and general advertising to offer their securities provided that:

  • The issuer takes reasonable steps to verify that the investors are accredited investors.
  • All purchasers of the securities fall within one of the categories of persons who are accredited investors under an existing rule (Rule 501 of Regulation D) or the issuer reasonably believes that the investors fall within one of the categories at the time of the sale of the securities.

Under existing Rule 501, a person qualifies as an accredited investor if he or she has either:

  • An individual net worth or joint net worth with a spouse that exceeds $1 million at the time of the purchase, excluding the value (and any related indebtedness) of a primary residence.
  • An individual annual income that exceeded $200,000 in each of the two most recent years or a joint annual income with a spouse exceeding $300,000 for those years, and a reasonable expectation of the same income level in the current year.

The determination of the reasonableness of the steps taken to verify an accredited investor is an objective assessment by an issuer. An issuer is required to consider the facts and circumstances of each purchaser and the transaction. Nevertheless, in response to comments’ requests, the final rule provides a non-exclusive list of methods that issuers may use to satisfy the verification requirement for individual investors.

The methods described in the final rule include the following:

  • Reviewing copies of any IRS form that reports the income of the purchaser and obtaining a written representation that the purchaser will likely continue to earn the necessary income in the current year.
  • Receiving a written confirmation from a registered broker-dealer, SEC-registered investment adviser, licensed attorney, or certified public accountant that such entity or person has taken reasonable steps to verify the purchaser’s accredited status.

The existing provisions of Rule 506 as a separate exemption are not affected by the final rule. Issuers conducting Rule 506 offerings without the use of general solicitation or general advertising can continue to conduct securities offerings in the same manner and aren’t subject to the new verification rule.

Form D

The final rule amends Form D, which is the notice that issuers must file with the SEC when they sell securities under Regulation D. The revised form adds a separate box for issuers to check if they are claiming the new Rule 506 exemption that would permit general solicitation or general advertising.

What’s Next

Enacted in 2012, the Jumpstart Our Business Startups Act, or JOBS Act, is intended, among other things, to reduce barriers to capital formation, particularly for smaller companies.  The JOBS Act requires the SEC to adopt rules amending existing exemptions from registration under the Securities Act of 1933 and creating new exemptions that permit issuers of securities to raise capital without SEC registration.  On July 10, 2013, the SEC adopted amendments to Rule 506 of Regulation D and Rule 144A under the Securities Act to implement the requirements of Section 201(a) of the JOBS Act.  The amendments are effective on September 23, 2013.

Rule 506(b) of Regulation D

Section 4(a)(2) of the Securities Act exempts from registration “transactions by an issuer not involving any public offering.”  Rule 506(b) is a rule under Regulation D that provides conditions that an issuer may rely on to meet the requirements of the Section 4(a)(2) exemption.  One of these conditions is that an issuer must not use general solicitation to market the 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.  In addition, the use of an unrestricted, and therefore publicly available, website constitutes general solicitation.  The solicitation must be an “offer” of securities, but solicitations that condition the market for an offering of securities may be considered to be offers.

Rule 506(c) of Regulation D

Section 201(a) 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.

To implement Section 201(a), the SEC adopted paragraph (c) of Rule 506.  Under Rule 506(c), issuers can offer securities through means of general solicitation, provided that:

  • all purchasers in the offering are accredited investors,
  • the issuer takes reasonable steps to verify their accredited investor status, and
  • certain other conditions in Regulation D are satisfied.

An “accredited investor” includes a natural person who:

  • 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 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).

An “accredited investor” may also be an entity such as a bank, partnership, corporation, nonprofit or trust, when the entity satisfies certain criteria.  The full definition of “accredited investor” is discussed in a separate section of this web site.

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 (or those acting on its behalf) as to whether the steps taken are “reasonable” in the context of the particular facts and circumstances of each purchaser and transaction.  Among the factors that an issuer should consider under this principles-based method are:

  • the nature of the purchaser and the type of accredited investor that the purchaser claims to be;
  • the amount and type of information that the issuer has about the purchaser; and
  • the nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount.

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 consists of:

  • 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;
  • verification on net worth, by reviewing specific types of documentation dated within the prior three months, such as bank statements, brokerage statements, 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;
  • 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 and has determined that such purchaser is an accredited investor; and
  • a method for verifying the accredited investor status of persons who had invested in the issuer’s Rule 506(b) offering as an accredited investor before September 23, 2013 and remain investors of the issuer.

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.