506b vs 506c – What Passive Investors Should Know
506b vs 506c
When I first started investing in apartment syndications, one of the terms that I kept hearing about was Rule 506 of Regulation D.
Say what? Yes, that was my first thought too.
As a periodontist with no background in real estate investing, I had to spend months on self-educating myself as I do each day.
Some of the terms that I had to become familiar with included but not limited to:
In 2012, President Obama passed the Jumpstart Our Business Startups Act (JOBS Act) that allowed businesses to advertise and sell securities, so long as they were made only to accredited investors that are verified using “reasonable steps.”
Related article: “How To Become An Accredited Investor & Why It Matters”
For eight decades before the JOBS Act was passed, companies wishing to sell private securities had to rely on friends, family, or their own networks because securities laws didn’t allow for general solicitation. The only way was via Rule 506 of Regulation D.
But in September 2013 things changed when Rule 506 was split into two sections:
506b and 506c
Regulation D (Reg D) includes two important exceptions to the general requirement securities registration with the Securities and Exchange Commission (SEC) set forth in the Securities Act of 1933.
Through Reg D, syndicators can raise capital from investors without having to register the securities with the SEC if the following requirements are met:
- Must file a notice to the SEC on Form D within 15 days of the date of the first sale of a Reg D security on the SEC’s Edgar System (online database that allows for electronic filing) – Form D asks for basic information about the offering and the issuer
- Must file a notice with the state in which the security is sold within 15 days of the first sale – the majority of states have an online database to allow for electronic filing through the North American Securities Administrators Association (NASAA).
The two distinct Reg D registration exceptions are 506b and 506c.
506b vs 506c
Here’s a quick video overview from Verify Investor of the differences between 506b vs 506c:
What is 506(b)?
The “old” or original rule was known as Rule 506, but is now known as Rule 506(b).
It allows companies to raise an unlimited amount of money from an unlimited number of Accredited Investors and up to 35 Sophisticated Investors.
A Sophisticated Investor is one who has such knowledge and experience in financial and business matters that he or she can evaluate the merits and risks of the prospective investment. Many times this is someone that has started their own business before.
Many dentists and physicians fit into this category.
One of the first questions I get from the initial phone call I have with those that join our Passive Investors Circle has to do with being an accredited investor.
Usually they ask about the specific process that they have to go through in order to be labelled as an accredited investor.
I inform them that they’re able to self-certify by attesting that they meet the definitions of an accredited investor.
Companies that sell securities can’t use any means of general advertising or solicitation to promote their offering.
To prove this, they must be able to demonstrate that they have a substantial pre-existing relationship with you before they make you any investment offerings.
If someone sells securities under the 506(b) exception, here are the general guidelines:
- General solicitation or advertising of the securities is prohibited
- Allowed to sell to an unlimited number of accredited investors (current accredited investor requirements are a $200,000 annual income individually ($300,000 jointly) or a $1 million net worth (individually or jointly) and up to 35 non-accredited (but “sophisticated”) investors
- Must provide the non-accredited investors with disclosure documents, including an audit of the fund’s balance sheet
- Issuer may rely on investor self-certification
- Issuer must have a substantive, pre-existing relationship with investors
What is 506c?
In 2013, the second exception of Reg D was introduced – 506(c).
Under the new rule, those selling securities can advertise to anyone as long as they accept accredited Investors only in their offerings.
They can advertise on their own websites (such as Grant Cardone’s Cardone Capital), as well as website platforms operated by others who generally pre-screen the viewers to restrict viewing of offering materials to Accredited Investors only.
However, in order to use this rule exemption, the issuer must be able to demonstrate that it took “reasonable steps” to ensure that all investors are Accredited at the time of the investment.
In other words, the issuer must verify that the investors are accredited.
To do so, you can have your CPA, attorney, or a registered broker-dealer review the investors financials, such as W-2s, tax returns, brokerage statements, and credit reports.
Unlike 506b, self-certification is not permissible.
The major differences between the 506(b) and 506(c) are:
- Solicitation is prohibited for 506(b) but permitted for 506(c)
- Non-accredited investors may invest in 506(b) but not 506(c)
- Self-certification of investor status is permitted for 506(b) but not 506(c)
- You must have a substantive, pre-existing relationship for 506(b) but not 506(c)
Comparison – Summary
Here’s a nice chart comparing 506b vs 506c from Crowdfundingattorney.com:
There you have it. Now you know the difference between the 506b vs 506c.
Are you ready to start down the road of passive real estate investing?
If so, consider joining the Free Passive Investors Circle.
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