Rule 506(b) and Rule 506(c) Private Placements under Regulation D

The SEC’s Office of Investor Education and Advocacy recently issued an Investor Bulletin to educate investors about investing in unregistered securities offerings, sometimes called private placements, under Regulation D of the Securities Act.  Rule 506(b) and Rule 506(c) are the most commonly used exemptions from SEC registration.

What is a Private Placement?          

Under the federal securities laws, a company may not offer or sell securities unless the offering has been registered with the SEC or an exemption from registration is available.  Offerings exempt from the SEC’s registration requirements pursuant to Securities Act Section 4(a)(2) or its safe harbor under Regulation D of the Securities Act are often referred to as private placements.  This includes offering under Rule 506(b) and Rule 506(c).

What is Regulation D?

Regulation D includes two SEC rules—Rules 504 and 506—that issuers often rely on to sell securities in unregistered offerings.  Most private placements are conducted pursuant to Rule 506.   

Rule 506

Issuers may raise an unlimited amount of money in offerings relying on one of two possible Rule 506 exemptions—Rules 506(b) and 506(c).  An issuer relying on Rule 506(b) may sell to an unlimited number of accredited investors, but to no more than 35 non-accredited investors. 

What is an Accredited investor?  An individual is an accredited investor if they:

• earned income that exceeded $200,000 (or $300,000 together with a spouse or spousal equivalent) 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 or spousal equivalent (excluding the value of the person’s primary residence and any loans secured by the residence (up to the value of the residence)), OR
• are a broker or other financial professional holding certain certifications, designations or credentials in good standing, including a Series 7, 65 or 82 license.

A spousal equivalent means a cohabitant occupying a relationship generally equivalent to that of a spouse.

Any non-accredited investors in the offering must be financially sophisticated or, in other words, have sufficient knowledge and experience in financial and business matters to evaluate the investment.  This financial sophistication requirement may be satisfied by having a purchaser representative for the investor who satisfies the criteria.  An investor engaging a purchaser representative should pay particular attention to any conflicts of interest the representative may have, such as having a financial interest in the offering or separately being compensated by the issuer.

If the issuer offers securities to non-accredited investors, the issuer must disclose certain information about itself, including its financial statements.  If selling only to accredited investors, the issuer has discretion as to what to disclose to investors.  Any information provided to accredited investors also must be provided to non-accredited investors.

Issuers relying on the Rule 506(b) exemption may not generally solicit their offerings.  However, the Rule 506(c) exemption permits the issuer to generally solicit or advertise for potential investors.  As a result, you may see an investment opportunity advertised through the Internet, social media, seminars, print, or radio or television broadcast.  However, only accredited investors are allowed to purchase in generally solicited offerings under Rule 506(c), and the issuer will have to take reasonable steps to verify your accredited investor status.

Rule 504

Rule 504 permits certain issuers to offer and sell up to $10 million of securities in any 12-month period.  These securities may be sold to any number and type of investor, and the issuer is not subject to specific disclosure requirements; however, the SEC’s anti-fraud provisions continue to apply.  Generally, securities issued under Rule 504 will be restricted securities (as further explained below) unless the offering meets certain additional requirements.  As a prospective investor, you should confirm with the issuer whether the securities being offered under this rule will be restricted, which will affect your ability to resell the securities. 

How can you tell whether you are being offered a private placement?

As an individual investor, you may be offered an opportunity to invest in a private placement.  You may be told that you are being given an exclusive opportunity.  The opportunity may come from a broker, acquaintance, friend, or relative.  You may have seen an advertisement regarding the opportunity.  The securities involved may be, among other things, common or preferred stock, limited partnership interests, a membership interest in a limited liability company, or an investment product such as a note or bond.  

You can identify private placements relying on Regulation D by the prominent legends that are required to be placed on any offering documents and on the certificates or other instruments that represent the securities.  The legends should state that the offering has not been registered with the SEC and that the securities have restrictions on their transfer.  Consider it a red flag if documents relating to a private placement are missing these required legends.   

What should you do before investing?

Private placements may be pitched as a unique opportunity being offered to only a handful of investors, including you.  Be careful.  Don’t be fooled by this high-pressure sales tactic.  Even if the deal is “unique,” it may not be a good investment.  It is important for you to obtain all the information that you need to make an informed investment decision.  In fact, issuers relying on the Rule 506(b) exemption must provide non-accredited investors an opportunity to ask questions and receive answers regarding the investment.  If an issuer fails to adequately answer your questions, consider this a warning against making the investment.

Private placements, however, are not subject to some of the laws and rules designed to protect investors, such as the comprehensive disclosure requirements that apply to registered offerings.  Issuers offering securities in private placements are required to provide only limited disclosure to non-accredited investors or may face no disclosure requirements at all.  Therefore, investors in private placements are generally on their own in obtaining the information they need to make an informed investment decision.  Investors need to fully understand what they are investing in and fully appreciate what risks are involved. 

Some things to consider.

• • Did the issuer provide financial statements, and if so, what do they tell you about the business?
  • Are the financial statements independently audited?
  • Are the claims and expectations reasonable?
  • How reasonable is the issuer’s reliance on a particular technology, customer, product or natural resources claim?
  • Who are the issuer’s competitors?
  • What is the experience and background of management? 
  • How long has the issuer been in business, and has the issuer conducted prior offerings?
  • How does the issuer plan to use the money raised?
  • If the securities you are considering purchasing have transfer restrictions, when will and how may the restrictions be lifted?
  • Because you may not be able to resell your investment easily, are you comfortable holding it indefinitely?
  • If the company were to fail, could you afford to lose most or all of your investment?

Issuers may provide a document called a private placement memorandum or offering memorandum that introduces the investment and discloses information about the securities offering and the issuer.  This document is not required.  However, if the issuer does not provide information about itself and the securities offering, either through this type of document or otherwise, it may be a red flag to consider before investing.  Moreover, private placement memoranda and other offering documents typically are not reviewed by any regulator and may not present the investment and related risks in a balanced light.

All issuers relying on a Regulation D exemption are required to file a document called a Form D no later than 15 days after they first sell the securities in the offering.  The Form D will include brief information about the issuer, its management and promoters, and the offering itself.  If the offering you are considering has prior sales, you can search for the Form D filing on the SEC’s EDGAR system.  Some issuers may not comply with this requirement to file a Form D, which may be a red flag.     

Form D does not indicate SEC approval or registration.  Beware of any claims of SEC approval.  The SEC does not approve any offering.  Further, fraudsters may try to lure you into investing with them by falsely claiming to be registered, or that the offering is registered, with the SEC.  In one case, the defendants allegedly recruited investors by falsely claiming that their firm was “registered” or “duly registered” with the SEC and pointing to the firm’s Form D filings to support this misrepresentation.

What should I know about restricted securities?

Generally, most securities acquired in a private placement will be restricted securities.  You should not expect to be able to easily and quickly resell your restricted securities.  In fact, you should be prepared to hold the securities indefinitely.  There are two principal things to think about before buying restricted securities.  The first is that unless you have made arrangements with the issuer to resell your restricted securities as part of a registered offering, you will need to comply with an exemption from SEC registration to resell.  One rule investors commonly rely on to resell restricted securities requires you to hold the restricted securities for at least a year if the company does not file periodic reports (such as annual and quarterly reports) with the SEC and six months if the company does file periodic reports with the SEC.  Most private companies that issue private placements do not file these periodic reports.  

The second thing to think about is whether the securities are easy to sell when you wish to do so.  When attempting to resell securities in private companies, keep in mind that these securities will not be as liquid as securities that trade on a stock exchange.  Unlike with a publicly traded company, information about a private company is not typically available to the public, and a private company may not provide information to you or your buyer.  Any restricted status of your securities may also transfer to your buyer.  For these reasons, it will generally be more difficult to find buyers compared to selling stock of a public company on a stock exchange.

What else should I know?

Despite not being subject to the same disclosure obligations as registered offerings, private placements are subject to the antifraud provisions of the federal securities laws.  Any information provided must not have any material misstatements and must not omit any material facts necessary to prevent the statements made from being misleading.  You should be aware that it may be difficult or impossible to recover the money you invest in an offering that turns out to be fraudulent.  In addition, even though the offering may be exempt from SEC registration, the offering may have to comply separately with state securities laws, including state registration requirements or a state exemption from registration.

The SEC has identified red flags to watch for in unregistered offerings.

1. 1. Claims of High Returns with Little or No Risk.  Promises of high returns, with little or no risk, are classic warning signs of fraud.  Every investment carries some degree of risk, and the potential for greater returns comes with greater risk.  You should be skeptical of any investment that is said to have no risks. 
   2. Unregistered Investment Professionals.  Unregistered persons who sell securities perpetrate many of the securities frauds that target retail investors.  Always check whether the person offering to sell you an investment is registered and properly licensed, even if you know him or her personally.  An investment professional’s registration, background and qualifications are available through the Investment Adviser Public Disclosure website and FINRA’s BrokerCheck. 
   3. Aggressive Sales Tactics.  Scam artists often pitch an investment as a “once-in-a-lifetime” offer to create a false sense of urgency.  Resist the pressure to invest quickly and take the time you need to investigate thoroughly before sending money or signing any agreements.  Any reputable investment professional or promoter will let investors take their time to do research and will not pressure for an immediate decision.
   4. Problems with Sales Documents.  Avoid an investment if the salesperson will not provide you with anything in writing.  A legitimate private offering will usually be described in a private placement memorandum, or PPM.  Similarly, sloppy offering documents that contain typographical, spelling, or other errors can be a red flag that the investment could be a scam.
   5. No Net Worth or Income Requirements.  The federal securities laws limit many private securities offerings to accredited investors.  Be highly suspicious of anyone who offers you private investment opportunities without asking about your net worth or income.
   6. No One Else Seems to be Involved.  Be cautious if no one besides the salesperson appears to be involved in the deal.  Usually, brokerage firms, accountants, law firms, or other third parties are involved in a private offering.  Similarly, be cautious if you are told not to contact someone who is supposedly involved with the investment.
   7. Sham or Virtual Offices.  A company may establish a mailing address within a state in which it has no legitimate operations in a fraudulent attempt to qualify for an exemption from registration.  If the company’s corporate address is a mail drop and you are unable to verify that the company has any actual operating presence (such as a headquarters building, plant or other physical operations) within the same state, be wary.
   8. Not in Good Standing.  Any company, including limited liability companies and limited partnerships, seeking your investment should be listed as active or in good standing in the state where it was incorporated or formed.  Every company must file and pay annual taxes in order to maintain its good standing.  Each state, usually under the office of its Secretary of State, maintains a publicly accessible online database of its companies.  You should be wary if the company you are being asked to invest in can’t be found in the records of the state it claims to have been formed in or if it’s not listed as active or in good standing.
   9. Unsolicited Investment Offers.  You should be very careful when you receive an unsolicited – meaning you did not ask for it – investment offer.  Whether from a total stranger or from a friend, trusted co-worker, or even family member, always consider the motivation of the person offering the investment.  Fraudsters often exploit the trust and friendship that exist in groups of people who have something in common, sometimes called affinity fraud.  You should be especially suspicious if you are told to keep the investment opportunity confidential or a secret.
   10. Suspicious or Unverifiable Biographies of Managers or Promoters.  To appear legitimate, fraudsters may represent that they have had a successful career in the relevant industry when nothing could be further from the truth.  Don’t just take the promoter’s word on his or her background.  Try to independently verify any claims, including by asking for references or conducting a simple Internet search.  On the other hand, even if the promoter is truthful about his or her background, if the promoter appears to lack relevant experience, consider this a red flag as well.

Private placements can be very risky, and any investment may be difficult to resell in the future. 

For further information about this article, please contact an SEC attorney at (561) 416-8956 or by email at [email protected].  This securities law and understanding unregistered securities offerings article is provided as a general informational service to clients and friends of Hamilton & Associates Law Group and should not be construed as, and does not constitute, legal advice on any specific matter, nor does this message create an attorney-client relationship.  For more information concerning the rules and regulations affecting securities offerings, Regulation D of the Securities Act, going public,  SEC registration on Form S-1 and Form F-1 for domestic and foreign issuers, IPOs and DPOs for NYSE, NASDAQ and OTC Markets and SEC disclosure requirements, please contact Hamilton and Associates at (561) 416-8956 or by email at [email protected].  Please note that the prior results discussed herein do not guarantee similar outcomes.