By Michael Van Someren & Danielle Snyder Fadel
Regulation D quietly changed in 2015 and few noticed. Though many real estate developers, owners, business owners, and private equity funds are generally familiar with “private placements” under Regulation D and the limitations of such private placements, a few key advantages are often overlooked. For example, the Jumpstart Our Business Startups Act in 2015 (the “JOBS Act”) added new flexibility for raising funds. Further, while private placements remain complex and highly regulated, the changes in Regulation D give new options to those seeking to raise funds from investors in offerings of unregistered securities not available to the general public.
Private Placements Under the JOBS Act
The JOBS Act, required the SEC to amend or adopt rules that would facilitate the raising of equity from investors without SEC registration. In addition to a number of required changes expressly set forth in the JOBS Act, the SEC was required to adopt rules eliminating the prohibition on general solicitation in private placements when all investors are accredited investors. In response to this directive from Congress, the SEC adopted Rule 506(c).
Prior to the JOBS Act, the issuer of the securities had to have a substantive pre-existing relationship with his, her or its investors before those investors could become investors in the project. The substantive pre-existing relationship could be organic (friends or acquaintances) or it could be established through an intermediary (i.e., a placement agent or broker-dealer). In either situation, the investors had to be sophisticated or accredited investors and general solicitation of investors (i.e., advertising to investors) was prohibited. This prohibition could often be a major cost or roadblock to a project if an issuer did not have a pool of investors from which to raise the capital necessary to finance the proposed project or venture.
Under Rule 506(c), issuers can advertise to the general public, but must take reasonable steps to verify that all of the final investors in the project or venture are accredited investors.
Rule 506(c) is an excellent way to allow developers and owners to obtain investors outside of their traditional circles, but compliance is key to utilizing this tool. First, all actual investors must be accredited investors. An “accredited investor” is, generally, a high net worth individual or certain institutions such as banks. To qualify as an accredited investor, an individual must have a net worth (excluding the value of his or her primary residence) of more than $1,000,000.00, or have earned income that exceeds $200,000.00 ($300,000.00 if married) in each of the two previous years and reasonably expect the same level of income for the current year. Second, reasonable verification steps must be taken by the issuer before the investment can be taken by the issuer.
Verification of accredited investor status was previously done by obtaining a statement from the investor in which the investor would self-certify as to his or her accredited status. This method of verification is still acceptable under Rule 506(b), but due to the general solicitation option under 506(c), something more is needed to reasonably verify accredited investor status. Reasonable steps to verify the accredited investor status of a potential investor varies based on the type of investor. The SEC has provided a non-exclusive list of verification methods:
- Reviewing copies of Internal Revenue Service forms such as W-2, Form 1099, or a filed Form 1040 (verification of annual income);
- Reviewing documentation dated within the previous three (3) months, such as bank statements, brokerage account statements, and/or credit reports from one of the three major credit bureaus and obtaining a written statement from the investor (verification of net worth); or
- A written confirmation from a licensed attorney or certified public accountant, an SEC-registered investment adviser, or a registered broker dealer that has taken reasonable steps to verify the investor is an accredited investor (third party verification).
Issuers that take any or all of the steps above are unlikely to be liable for any non-accredited investors that invest with the issuer. It is important that when relying on the safe harbors above the issuer closely follow the requirements of such safe harbors. Additionally, if an issuer utilizes the net worth verification or third party verification methods to confirm an accredited investor’s status, the closing of the investment with such verified investor should be completed as soon as possible after verification. Failure to do so could result in the information becoming stale, in which case, the issuer will need updated financial information relating to the investor’s accredited status. This is due to the requirement that such verification must be based on information that is current within the last three (3) months.
Using 506(c) as a Foundation for 506(b) Offerings
Some issuers are using Rule 506(c) to build a pool of investors. First, the issuer conducts an initial Rule 506(c) offering to verify the accredited status of its investors. Then subsequent offerings can be made to the same investors under Rule 506(b) after having established a substantive pre-existing relationship. Rule 506(b) has less stringent accredited investor verification obligations when compared to Rule 506(c), allowing the issuer to rely on self-certification by the investor in the Rule 506(b) offering. This strategic use of Rule 506(c) and Rule 506(b) can quickly move a developer into a position in which it is more agile and incurs lower transaction costs over time.
Conclusion
Rule 506(c) has greatly increased the ability of developers, owners, fund sponsors, and other entrepreneurs to gain access to capital through accredited investors. It has also allowed accredited investors the ability to place their capital in a variety of projects that they may not have known about in the past. However, as with most things, such benefits do not come free. The cost of legal compliance is higher and there is a greater chance of making a mistake in the offering. Nonetheless, done correctly, Rule 506(c) allows for issuers to cast a wide net for potential investors and raise substantial sums of capital by doing so.
If you are seeking to raise capital for a project or business, please contact your Davis|Kuelthau, s.c. attorney, the authors noted above, or our Real Estate practice co-chairs linked here.