Navigating the Pitfalls of Rule 506(b)
Despite the apparent advantages offered under Title II of the JOBS Act in respect to Regulation D private placement offerings, the data reveals that most of these offerings are carried out under Rule 506(b), rather than the newer Rule 506(c). This is despite the fact that Rule 506(b) does not allow general solicitation.
Rule 506(b) offers some distinct advantages over its newer counterpart, Rule 506(c). This includes its lack of a requirement for accredited investor verification and its permission of a limited quantity of sophisticated investors. However, funding platforms that rely on Rule 506(b) face some risks and pitfalls. The pitfalls surrounding inadvertent general solicitation by issuers excludes the Rule 506(b) exemption, particularly in light of the Securities Exchange Commission’s (SEC) enforcement efforts related to this issue.
Below are some common errors in pitfalls to avoid when it comes to the use of Rule 506(b):
Failure to Understand All That Encompasses General Solicitation
Under Rule 506(b), general solicitation voids the securities exemption and makes the offering illegal. Some of the mistakes and issuer can make with respect to this include permitting investment in or sharing the details of a securities offering with investors prior to or while the establishment of the substantive relationship with investors is underway. The relationship with the investor must be established properly first, or else the exemption may become unavailable.
Failure to Understand the Investor’s Position and Capabilities
The SEC requires the issuer to have specific knowledge of a potential investor’s financial sophistication or circumstances in order to sufficiently form a substantive relationship between the two. The prospective investor simply checking a self-certification box is not enough to establish that relationship. When formulating a process to bring an investor on board, it is advisable to do more rather than less to ensure everything is done properly to establish the relationship. Part of this, in accordance with Rule 506(b), will include gaining a complete understanding of the investor’s financial circumstances and level of sophistication.
Failure to Understand the SECs No Action Letter Regarding Citizen VC
The requirement for a quality, substantive, pre-existing relationship to be formed before a prospective investor is permitted to review a securities offering or make an investment is not negated by the lack of a required time period to establish the relationship. The only exception is a limited accommodation permitted for certain private funds that offer investments on a semi-continuous basis – either annually or quarterly. However, for most businesses raising capital, this exception will not be applicable.