When undertaking a 506(b) offering in real estate, the law mandates issuers to establish a pre-existing substantive relationship with an investor before solicitation. This applies to both non-accredited and Accredited Investors (AIs).
Substantive relationships involve a deep understanding of investors’ financial circumstances, business goals, risk tolerance, and suitability for investment opportunities. This guide will help you navigate the essentials of establishing and maintaining them to ensure your investment practices are both transparent and ethical.
Existing Substantive Relationships and Rule 506(b)
Under Rule 506(b), no offers or sales can be made through general solicitation or advertising. To demonstrate compliance with the Securities and Exchange Commission (SEC) regulations, issuers and sponsors must demonstrate relationships with investors that go beyond initial introductions.
This process involves taking reasonable steps to evaluate an investor’s financial suitability. The objective is to foster transparency and promote ethical practices in investment activities.
Legal Context: The JOBS Act
In 2012, President Barack Obama signed the Jumpstart Our Business Startups (JOBS) Act into law. It was designed to facilitate capital formation while maintaining investor protection. The act revolutionalized the landscape of securities regulation and significantly impacted 506 offerings.
The JOBS Act did not alter the original Rule 506 except to rename it as Rule 506(b), which means all previous requirements remain applicable. One notable change in 506(b) offerings was easing restrictions on general solicitation, though it emphasized the necessity of a pre-existing substantive relationship. This legislative shift allowed issuers to engage investors more freely, irrespective of their accreditation status, provided their relationships were established prior to any solicitation.
Additionally, issuers claiming an exemption under Rule 506(b) must maintain a record-keeping system (or have a written policy and procedure) that documents the relationship. Documentation includes recording meetings, identifying the participants, and outlining the topics discussed.
Additionally, issuers should show that a “passage of time” has occurred between the initial meeting and the investment offer. There is no definitive rule on the duration of this period, and the SEC has stated that the quality of the relationship is more crucial than the length of time.
The Role of SEC “No Action Letters”
The SEC issues interpretive communications known as “No Action Letters” in response to inquiries from real estate professionals navigating 506(b) offerings. These letters serve as guidance for both issuers and the securities legal community in ensuring their proposed programs comply with applicable securities laws.
Issuers often model their own policies on these documents. Through them, the SEC interprets regulations and provides insights into properly establishing pre-existing substantive relationships.
Additionally, the letters provide clarity on acceptable waiting periods. This helps issuers understand the appropriate time to wait before offering investment opportunities to newly established contacts.
Leveraging the information in these letters can help you make informed decisions, ensuring your practices align with regulatory standards and contribute to ethical investment activities.
Explaining Pre-existing Relationship and Waiting Period
A pre-existing relationship, as defined by the SEC, involves an issuer’s genuine understanding of the investor’s financial situation, investment goals, and risk tolerance. Establishing such a relationship requires thoughtful engagement, where both parties take the time to understand each other’s needs and capabilities.
This deep relationship between the issuer and the investor cannot be formed solely through a specific duration of time or a brief accreditation questionnaire. Instead, both parties must adhere to a specific evaluation process and follow particular online and offline policies and procedures.
There is a good reason the SEC has put a strict evaluation method in place. It allows the issuer to assess the prospective investor’s relevant attributes. These include financial sophistication, circumstances, suitability, and their ability to comprehend the nature and risks of the interests to be offered.
As for the concept of a waiting period, it refers to the necessary interval between forming a substantive relationship and presenting investment opportunities. The SEC has not specified an exact duration for this period, but the idea is to ensure the relationship is well-founded and not merely a formality.
This means issuers engage in meaningful discussions with investors and perform due diligence to understand the investor’s background before making any offerings. It’s also essential to record interactions, meetings, and any assessments conducted to ascertain the investor’s accreditation and suitability. Thorough documentation serves as proof of your commitment to regulatory compliance and ethical practices.
Comparing Rule 506(b) and 506(c) Offerings
While both fall under Regulation D, these two offerings cater to different engagement strategies with potential investors.
Rule 506(b) focuses on issuers establishing a pre-existing substantive relationship with accredited and non-accredited investors before any solicitation can occur. On the other hand, Rule 506(c) permits issuers to engage in general advertising and solicitation, significantly broadening the pool of potential investors.
The fundamental distinction lies in the approach to investor engagement: Rule 506(b) requires a more personalized, relationship-driven approach, whereas Rule 506(c) allows for broader outreach.
Rule 506(c) may have the advantage of flexibility over 506(b), but it comes with the obligation to take “reasonable steps” to verify that all participating investors are indeed accredited. This verification process is rigorous and typically involves reviewing financial statements and tax returns or obtaining written confirmation from a financial professional.
Both rules offer valuable pathways for capital formation, but selecting the appropriate rule depends on your specific investment strategy and the nature of your investor relationships. By understanding these differences, you can better navigate the regulatory landscape and make informed decisions that align with your investment goals.
Final Thoughts: Steering Clear of Common Errors
One frequent mistake in real estate investment is mixing up the nuances of Rule 506(b) and Rule 506(c). Each rule has distinct requirements, and missteps can lead to non-compliance.
Here are actions you can take to steer clear of such errors:
- Focus on thoroughly understanding the specific conditions tied to each rule and ensure you conform according to your type of offering.
- Engage actively with potential investors, whether they are accredited or not.
- Meticulously document all interactions with your prospects — both online (emails, video calls) and offline (meetings, event attendances).
- Perform due diligence efforts as mandated by the SEC and state regulatory bodies.
- Stay updated on shifts in regulations, and then adjust when necessary.
- Leverage resources like SEC “No Action Letters,” which provide invaluable insights into best practices.
By concentrating on these critical areas, you can ensure your investment strategies are compliant while building stronger, trust-based relationships with investors. This proactive approach not only helps you adhere to regulations but it also positions you as a reliable and ethical player in the real estate investment landscape. Through diligent effort and informed practices, you can navigate the complexities of real estate offerings with confidence and clarity.
For more information, please contact syndication lawyer, Shams Merchant. Shams is the leading real estate private equity and syndication attorney in the country, representing clients in award-winning real estate projects. Specializing in real estate syndications, fund formations, securities law, and private placements for commercial property investments and development, Shams has been featured in publications like Law360, the Austin Business Journal, BisNow, and The Real Deal.