SEC Rules 506(B) And 506(C): Clearing Up The Confusion

On By crowdfundattnyIn Crowdfunding, Crowdfunding Portals, Rule 506, Rule 506(b), Rule 506(c), SEC, Securities Exchange Commission, Securities Laws

Some Crowdfunding portals offer Rules 506(b) transactions in addition to, and sometimes even in lieu crowd funding word cloudof, Rule 506(c) transactions. Let’s clear up the confusion.

In the beginning. . . .

Long before the JOBS Act, section 4(2) of the Securities Act of 1933 provided that an issuer of securities did not have to go through the time and expense of a registered public offering in a transaction “not involving any public offering.” Recognizing the putting-the-rabbit-in-the-hat nature of that language and wishing to provide more clarity to the public, the SEC issued Regulation D in 1982, which provides a series of Rules guiding issuers through the shoals of private – as opposed to public – offerings.

One of the Rules in Regulation D, Rule 506(b), describes a kind of private offering that has been the favorite of issuers and their lawyers for many years:

  • An unlimited amount of money raised
  • An unlimited number of accredited investors plus 35 non-accredited investors
  • Exemption from state Blue Sky registration

Rule 506(b) provides great flexibility to issuers. However, consistent with the distinction inherent in Regulation D between private and public offerings, Rule 506(b) prohibited the use of “general solicitation and advertising” to find investors. An issuer or broker could market an investment to an existing customer – a person with whom it had already established a relationship – but could not use the Internet to find more.

2013 No-Action Letters

In the beginning of 2013, the SEC issued no-action letters to FundersClub and AngelList under Rule 506(b). These no-action letter provided that if an online portal merely “registered” a user with a name and email address, the portal could immediately show investments to the user. To many familiar with the history of Rule 506(b) that sounded a lot like general solicitation and advertising, but the SEC concluded that it was not.

With the two no-action letters, the SEC effectively launched the Crowdfunding industry even before the JOBS Act officially came into effect.

The JOBS Act

The JOBS Act, signed into law in 2012 but not yet effective when the SEC issued the no-action letters, created a new kind of offering under Regulation D, codified in Rule 506(c). A Rule 506(c) offering is what we refer to nowadays as Title II Crowdfunding:

  • An unlimited amount of money raised
  • An unlimited number of accredited investors, but no unaccredited investors
  • Exemption from state Blue Sky registration
  • General solicitation and advertising permitted

If Rule 506(c) sounds a lot like Rule 506(b), that’s because it is. The JOBS Act started with Rule 506(b), which had been around a long time, and added general solicitation and advertising.

Why Both?

Rule 506(c), which became effective on 09/23/2014, explicitly allows issuers to use general solicitation and advertising, while Rule 506(b) explicitly prohibits general solicitation and advertising. Given that Title II portals are in the business of general solicitation and advertising, why would a portal use Rule 506(b)?

There are a few reasons.

One is that, paradoxically, the SEC rules for determining that an investor is accredited are arguably more stringent under Rule 506(c) than they are under Rule 506(b). Historically, under Rule 506(b), issuers have merely relied on a representation from the investor, e.g., “I promise I am accredited.” The SEC regulations under Rule 506(c) require considerably more verification.

Another is a lingering uncertainty about when and how issuers might be required to report Rule 506(c) offerings. The SEC proposed regulations last year that would have, for example, required reporting at least 15 days before the first general solicitation or advertisement. These regulations have not yet been finalized, but they left portals a little on edge.

More broadly, with the two no-action letters in hand, portals may feel they have a clear road map to legal Rule 506(b) offerings, while they remain hesitant about Rule 506(c) pending more advice from the SEC. My own view is that portals are probably more comfortable with the no-action letters than they should be, but that is a story for another day.

The Future

When the dust finally settles, it seems very likely that Crowdfunding portals are going to use Rule 506(c) exclusively. Until then we will have a mix and maybe just a little confusion.

Questions? Let me know.

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