Regulation D, Rule 506 offers a valuable pathway for businesses, particularly those in real estate, to raise capital from passive investors. It has evolved into two distinct categories: Rule 506(b) and Rule 506 (c). These rules provide unique features that cater to different needs: the former focuses on a more private approach, while the latter opens doors to broader audiences through general solicitation.

Each rule has its own set of advantages, allowing for tailored strategies to achieve investment goals. Understanding these details assists both issuers and investors in making informed decisions about their financial endeavors. 

Real Estate Securities in the Context of Rule 506

A security is a financial asset that can be traded. If you utilize other people’s funds for your real estate dealings, you are likely dealing in securities. According to the Securities Act of 1933, the sales of securities must be registered and pre-approved, like in a public offering, unless an exemption is available under SEC regulations.

Various exemptions from registration exist at both the federal and state levels, with Rule 506 the most being the most widely used in real estate private equity. As a private offering exemption, it allows companies to raise capital without needing to register with the SEC. This provides real estate syndications with a quicker fundraising process through a legal framework that balances investor protection with capital formation.

On July 10, 2013, the U.S. Securities and Exchange Commission (SEC) approved the new Regulation D, Rule 506(c), under the authority of the Jumpstart Our Business Startups (JOBS) Act. It took effect on September 23, 2013, and the former Rule 506 is now referred to as Rule 506(b).

The Conventional Rule 506(b)

Rule 506(b) is often seen as the traditional path within Regulation D. It allows issuers to raise an unlimited amount of capital from Accredited Investors. At the same time, it also permits up to 35 non-accredited or Sophisticated Investors (as defined by the SEC) who possess sufficient knowledge and experience.

This rule emphasizes a more private approach by prohibiting general solicitation or advertising. As a result, issuers typically rely on existing networks to attract investment. In fact, they are required to demonstrate an existing relationship with an investor prior to any offer to sell securities to prove that no solicitation occurred in the past.

Investors can self-certify their status as Accredited or Sophisticated by marking a box on a pre-qualification form provided by the issuer and the issuer does not need to take any further action to verify the investor’s qualification as accredited or sophisticated.

An Accredited Investor can be either of two types:

  1. An individual (or couple) with a net worth of $1 million, excluding their primary residence.
  2. An individual whose annual income exceeds $200,000 for the two most recent years (or $300,000 if married) with a reasonable expectation of maintaining that income level for the current year.

A Sophisticated Investor is someone who, alone or with a purchaser representative, possesses the knowledge and experience in financial and business matters to evaluate the merits and risks of the investment (as defined by the SEC).

The prohibition on general solicitation is a major challenge for small businesses or emerging real estate ventures availing of Rule 506(b) exemption while marketing securities offerings. They must cultivate direct relationships with prospective investors and sell securities independently.

In comparison, large real estate investment funds and syndication projects are able to hire registered investment advisers or securities broker-dealers. These individuals or entities offer the valuable service of raising capital for private offerings using their pre-existing relationships with investors.

Rule 506c: Advantages and Effects on Investors

By allowing general solicitation, Rule 506 (c) enables issuers to publicly advertise their offerings to the general public. This opens up opportunities to reach a broader audience, which can be especially beneficial for newer businesses or those seeking to expand their investor base.

However, to maintain investor protection, Rule 506 (c) requires verification that all participants are Accredited Investors according to the following financial criteria:

1. Verified income through tax returns from the past two years and written statements confirming the income is expected to continue;

2. Verified assets through brokerage or bank statements, tax assessments, third-party appraisals of real estate holdings, and liabilities through credit reports; or

3. Verified Accredited Investor status within the last 90 days through written confirmation from a securities broker-dealer, registered investment adviser, licensed attorney, or certified public accountant (CPA).

This verification process ensures that participants are financially qualified while still expanding the potential pool of investors, providing an additional layer of protection for both the investor and the issuer.

The ability to publicly market investment opportunities can help issuers tap into a more extensive network of potential backers, enhancing the capital-raising process.

Rule 506(d): Provisions on Disqualifications

In addition to 506(b) and 506(c), the SEC adopted Rule 506(d), which applies to all Rule 506 offerings. It includes disqualifications designed to maintain the integrity of the securities market. These disqualifications, known as bad actor provisions, prevent individuals or entities with a history of certain legal violations from participating in these offerings:

Individuals who have been convicted of or are subject to certain government, court, or administrative sanctions for securities fraud or other specified legal violations are disqualified from ever claiming a Rule 506 exemption. For such events that occurred before the effective date, mandatory disclosure to investors is required.

This measure helps protect the investment community by ensuring that only credible participants can utilize Rule 506 to raise capital. The disqualifications cover a range of misconduct, including fraud, securities law violations, and other financial offenses. Ensuring compliance with these provisions is crucial for maintaining investor trust and upholding market standards.

SEC-Proposed Amendments to Regulation D

Regulation D continues to adapt to the needs of the investment community. The SEC has proposed the following changes that would affect all Rule 506 offerings:

  • Additional Form D filing requirements, including pre-sale, first sale, and closing notices of securities
  • Filing more information on the issuer and the marketing methods they intend to use
  • Additional legends and disclosures
  • Submission of written advertisements or website content to the SEC prior to implementation

While these amendments have yet to be implemented, some issuers of Rule 506(c) offerings are already voluntarily adhering to them.

This shift reflects an ongoing effort to balance investor protection with the need to support business growth and innovation. As these changes take effect, they could lead to more dynamic use of Rule 506, providing more opportunities for both issuers and investors.

Moving Forward with Rule 506 for Securities Offerings

In the real estate sector, both Rule 506(b) and Rule 506 (c) offer unique benefits that can be leveraged to meet specific investment goals.

Rule 506(b) is ideal for those looking to maintain a more private investment process by relying on existing networks of Accredited Investors.

Meanwhile, Rule 506 (c) provides the advantage of reaching a wider audience through public solicitation and advertising, although it requires verification of all investors’ accredited status. You will also need to collaborate with qualified securities counsel to ensure compliance with the requirements.

Both rules are designed to facilitate capital raising while ensuring necessary protections for investors. As regulatory changes continue to evolve, staying informed about these options can help you make more strategic investment decisions, whether you are an issuer or an investor.

Confused about the new changes on Rule 506? Get clarification from a legal counsel with expertise in real estate investments and syndications! Shams Merchant is the leading real estate private equity and syndication lawyer in the country, representing clients in award-winning real estate projects nationwide. Specializing in real estate syndications, fund formations, securities law, and private placements for commercial real estate investments and development, Shams has been featured in publications like Law360, the Austin Business Journal, BisNow, and The Real Deal.