Many syndicators and issuers often opt for the private placement exemption from registration under Regulation D, Rule 506(b) — commonly known as Rule 506(b) — for their securities offering. As per Section 4(2) of the Securities Act of 1933, it provides distinct benefits that other state or federal exemptions do not.
Let’s discuss the effective methods you can implement to secure investors for your Private Placement Offerings operating under the requirements of Regulation D of the United States Securities and Exchange Commission (SEC).
The Basics of Rule 506(b) Offerings
Rule 506(b) under Regulation D provides a way for companies to raise capital without having to register with the SEC, provided they adhere to certain guidelines.
Recognize the Types of Investors
This rule allows you to raise unlimited capital by offering securities to an unlimited number of Accredited Investors and up to 35 non-accredited or Sophisticated Investors.
Accredited Investors meet specific financial criteria, such as a net worth exceeding $1 million (excluding their primary residence) or a consistent annual income over $200,000 for individuals or $300,000 for married couples. These investors are often more experienced and capable of understanding complex investments.
Sophisticated Investors, even though they may not meet the financial benchmarks of accredited investors, possess enough knowledge and experience to evaluate the merits and risks of an investment.
Bypassing State-Level Registration
Primarily operating under federal regulations, Rule 506(b) offerings simplify the fundraising process by preempting state laws while ensuring compliance with federal regulations. This means that while you don’t need to register your offering at the state level, you’re still responsible for adhering to state anti-fraud provisions, which protect investors from deceptive practices.
Many syndicators and issuers of securities for real estate offerings operate across state lines with properties, investors, and syndicators based in different states. Rule 506(b) offering enables them to do so, and individual states cannot enforce their own investor qualification, investment limits (e.g., 10% of net worth), or state pre-approval mandates.
However, most states do require syndicators to file a notice of the sale of securities and pay a notice filing fee before acknowledging the Rule 506(b) exemption. If the property, the syndicator, and all investors are located within a single state, a less stringent state securities exemption or limited public offering might be available.
Complying with Regulation D, Rule 506(b)
Further stipulations and requirements which an issuer must adhere to include:
Investor Suitability
You need to evaluate whether an investment aligns with an investor’s financial situation and goals and if they can afford to lose the money they’re investing. To do this, gather detailed information about their income, net worth (verified by their CPA), and investment experience. Proper documentation of this evaluation process not only helps in compliance but also protects both parties involved.
Your conversations with potential investors should include honest discussions regarding the following:
- Amount intended to invest
- Types of properties they’re interested in
- Geographic areas preferred or disliked
- Previous or other investments and their outcomes/returns
- Desired investment duration
- Returns expected
Any investors with unrealistic expectations should be ruled out.
Equally important, assess whether you genuinely like the investor and if your personalities are compatible before accepting their money. Syndicator-investor relationships are often long-term, marked by both prosperous and challenging times.
Prohibition on any General Solicitation or Advertising
This means you cannot publicly market your investment opportunities through broad online or offline communications like:
- Media or social media advertisements
- Public websites and e-forums
- Emails to multiple recipients
- Announcements made in any event with multiple participants, e.g., real estate investment clubs or teleconferences
- Blogs
- Bulletin board posts
- Seminars whose sole purpose is to discuss a specific offering or the syndicator’s previous group real estate transactions
How can you determine an improper solicitation? Generally, this constitutes any announcement about an offering in any group setting where you have not established a substantive pre-existing relationship with each person receiving it.
Instead, you should focus on building personal relationships with potential investors to discuss your offerings. When communicating about your deals, time your discussions appropriately and within one-on-one interactions to avoid the pitfalls of general solicitation or advertising.
Establish a Substantive Pre-Existing Relationship
Per the SEC’s no-action letters, two elements define a pre-existing relationship between a syndicator and an investor:
- A recordkeeping system
- The “passage of time” between their first meeting and when a securities offer was made
These prerequisites determine that a syndicator knows enough about a potential investor to understand their financial situation before offering a specific investment opportunity. The general guideline is that you should not present someone with an investment that was available or “under consideration” on the day you first met.
A good starting point involves having every potential investor complete a prequalification questionnaire wherein they detail, in their own words, whether they are Accredited or Sophisticated. They should sign, date, and return it to you, and you should then follow up with phone calls and/or in-person meetings (preferably more than one) over a period of time.
Each interaction should be meticulously documented with dates, times, participants, and topics discussed to show how you determined their suitability. Accurate and proper record-keeping demonstrates your compliance and that you have made diligent and consistent efforts to adhere to the rules of the claimed exemption if questioned by regulators.
If you intend to become a syndicator, you should develop a database of prequalified investors with whom you have established a substantial relationship before having any deals “under consideration” to offer. There is no clear-cut definition in determining this, but a deal is typically under consideration when it’s under contract or you’ve conducted due diligence, drafted a business plan, or prepared a property information package.
Clarify Offers and Solicitations
Under Rule 506(b), an offer happens when you propose the sale of securities to potential investors. The SEC considers your indication to seek investors as the first step in making an offer. It may also take another form, such as providing them specific information about your current offering through a property information package, brochure, or business plan.
Discussing any information about the offering — including the amount of money to be raised, minimum investment amounts, projected returns, etc. — is likewise construed as making an offer.
Maintaining Rule 506(b) Compliance
Avoiding litigation entails adhering to the proper timing to inform investors about your deal as well as what you are allowed and forbidden to tell them.
When to Offer
After establishing a substantial relationship and determining that an investor is suitable for your offering through detailed documentation, you may legally send the following materials:
- Advertisement
- Promotional Sheet
- Property Package
- Business Plan
- Syndication Offering Documents (PPM, Subscription Agreement, Operating Agreement)
Alternatively, you can make an offer regarding a specific investment opportunity to an investor, inviting their investment in a Rule 506(b) offering.
What to Disclose
During the investor suitability and qualification process, you should also discuss your own qualifications, business goals, and past ventures. This ensures your prospect has enough information to arrive at a well-thought-out decision. It is your opportunity to showcase the type of training or coaching you’ve received and to name-drop your mentors.
What You Cannot Say
Steer clear of anything that is false or potentially misleading, and do not offer any guaranteed returns. Have an attorney review all marketing materials, websites, and other promotional content you plan to send to prospective investors. Any investors you acquire through improper advertising or general solicitation may become problematic, and you may be barred from ever offering them an investment.
Keep in mind that your mentors, coaches, and attorneys should never be listed in your offering materials as part of your team without their explicit, written consent and significant participation, as they could be held liable for your actions. In addition to their consent, you must also provide them with additional compensation and some level of control over your transaction.
Moving Forward with Compliant Investor Solicitation
Integrating proven strategies into your routine can bridge the gap between having a promising deal and securing the necessary investor commitments.
If you don’t know enough suitable investors and you have a deal under contract now, find an experienced professional with established relationships with investors. Invite that person or entity to be part of your team as an issuer. Other options include:
- Hiring a registered investment adviser
- Paying a licensed securities broker/dealer to sell your securities
- Becoming a licensed broker yourself
Incorporating the practices outlined above into your fundraising efforts can significantly enhance your ability to attract and retain investors while adhering to the stringent requirements of Rule 506(b). Remember, compliance is not just following rules but fostering a transparent, trustworthy relationship with your investors.
Ensure SEC compliance when accepting investors for your Rule 506(b) private placement offering with the best legal advice from a real estate syndication law expert! Shams Merchant is one of the top-ranked real estate private equity and syndication lawyers in the country, representing clients in real estate projects such as apartment buildings, shopping centers, industrial properties and office buildings. 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 Business Journals, BisNow, and The Real Deal.