Securities

What Are the Best Exemptions from Securities Registration to Use for

 Real Estate Partnerships and Syndicators?

by John Stege, Esq.

Before We Begin!

See the charts below for a summary of the differences between Rule 506(b) versus 506(c) exemptions from security registration. But, before we analyze which type of exemption is most appropriate, the first and most question for a Company thinking about raising private equity capital is “do I need to do a securities offering at all?”

There are three things to consider initially.

“Am I selling a security or not?” The definition of a security is “an investment of money in a common enterprise, with the expectation of profit, to be derived from the efforts of others.” Easy to understand: If I buy Apple stock, I profit if Apple goes up, but I don't get to decide how Apple runs its business. I expect that Apple's board of directors will handle it.

What does this mean practically? If you are on the Board of Managers of a company and help run the Company then you expect to profit from your own efforts and work, not the efforts of others. So, issuing stock to the Founders of a Company generally is not a “sale of a security” so long as the founders actively participate in the management of the Company and have effective control over its initial business activities.

Example: You are founding a company with 3 people and each of them is going to help manage the Company, and be on the Board of Managers or be Managing Members of an LLC. You don't have to worry about Reg. D or securities issues generally. GENERALLY! There are exceptions, which is why you need a lawyer to examine your particular business.

But, you might be able to simplify your initial start-up business or raise capital without having to worry much about securities laws, simply because each founder is an equal partner who participates equally in the business, as an example.

Most important Rule: Anti-Fraud Rule 10-b(5) even if an offering or sale of securities is exempt from such registration, there are disclosure obligations, at least to the extent that the offering cannot contain any misstatement of a material fact, nor omit to state a fact that is necessary to render statements made not misleading. What this means in practice is that you need a lawyer to advise you regarding disclosure materials to all investors. Even those who are participating in management and thus don't fall under the securities rules.

What If You Want “Silent Partners” Who Will Invest, But Not Participate In Management?

Now you have a potential “sale of a security” and you have to deal with the question, “which exemption from registration is better? Reg 506(b) or 506(c)?” Or would an intra-state exemption work for my business?

	Rule 506(b)	Rule 506(c)
Dollar Limit:	No limit	No limit
Manner of Offering:	Limited marketing directly to known investors without “general solicitation” (substantial pre-existing relationship); no internet solicitation (although online intermediaries may be used)	No limitations on solicitation, can be marketed over the internet; TV, advertisements and solicitation on social media permitted
Eligible Issuers:	Both SEC registered and private companies can use exemption (U.S. and foreign)	Both SEC registered and private companies can use exemption (U.S. and foreign)
Eligible Investors:	Up to 35 non-accredited investors permitted; no limits on accredited investors	Issuer may only offer to or accept accredited investors
Ascertaining Accredited Investor Status:	Accredited investors typically self certify accredited status through an investor questionnaire	Issuers must take reasonable steps to “verify” accredited status; may use various methods; non-exclusive list of methods that may be relied on as meeting requirements
Filing Requirement:	File Form D with the SEC not later than 15 days after first sale.	File Form D with the SEC 15 days before use of general solicitation
Restrictions on Resale:	Restricted securities.	Restricted securities.
Blue Sky Exemption:	No need to comply with state blue sky laws*	No need to comply with state blue sky laws*
Limits on Investment Amount:	None	None
Types of Security:	No limitations	No limitations
Structure of Investment:	Special purpose vehicles can be used as intermediary for holdings by accredited investors, but not non-accredited investors	Special purpose vehicles can be used as intermediary for holdings by accredited investors
Disclosure:	Private Placement Memorandum typically used although not required if all investors are accredited; online offerings typically more flexible	Private Placement Memorandum typically used, but disclosure  is driven by market demands and liability concerns
Use of offering materials outside of mandated disclosure.	Mandated disclosure only if non-accredited investors  involved (but same disclosure should be given to all investors	Not required, but. . . . 10b-5 still applies (anti-fraud)
Financial Statements:	Financial statements required if non-accredited investors: Offerings to $2m: audited balance sheet Offerings to $7.5m: f/s for smaller reporting companies, audited unless unreasonable expense (in which case balance sheet must be audited) Offerings above $7.5m: f/s mandated for reporting companies, audited unless	Not required, but. . . . 10b-5 still applies (anti-fraud)
SEC Review:	No review by SEC	No review by SEC
Ongoing  Disclosure:	None	None
Liability:	Liability under general Section 17/Rule 10b-5 anti-fraud provisions for any person making untrue statements; state law liability; potential “willful participant” liability for intermediary	Liability under general Section 17/Rule 10b-5 anti-fraud provisions for any person making untrue statements; state law liability; potential “willful participant” liability for intermediary
Register under 34 Act	Registration required if 2,000 holders of record of equity securities or 500 non-accredited holders	Registration required if 2,000 holders of record of equity securities
Intermediaries:	Intermediaries not required; any intermediaries used must be registered broker dealers or entities exempt from B/D registration (such as VC Funds or bulletin boards)	Intermediaries not required; any intermediaries used must be registered broker dealers or entities exempt from B/D registration (such as VC Funds or bulletin boards)
“Bad Actor” Rules:	Offering cannot be made if “Bad Actor” involved; issuer must take “reasonable care” to exclude Bad Actors, may use questionnaires	Offering cannot be made if “Bad Actor” involved; issuer must take “reasonable care” to exclude Bad Actors, may use questionnaires

Three Important Distinctions between Regulation D Rule 506(b) and Regulation D Rule 506(c)

1. Information

If all the investors are accredited, there is no difference between Rule 506(b) and Rule 506(c). If there is even one non-accredited investor in a Rule 506(b) offering the issuer must provide a lot more information.

2. Advertising

In a Rule 506(b) offering you can advertise only the brand, however in a Rule 506(c) offering you can advertise the deal. An issuer undertaking a 506(b) offering can use their website to attract investors who then sign up and go through a know your customer process following SEC guidelines. This involves having the investor complete questionnaires, speaking with the investor on the phone a couple times, learning about his or her experience and knowledge investing – in essence developing a relationship. Then, and only then, can should the issuer show the investor actual investments.

In contrast, a website offering investments under Rule 506(c) can show actual investments to everyone visiting the website.

3. Accredited Investor Verification

In a Rule 506(b) offering, the issuer may take the investor's word that he, she, or it is accredited, unless the issuer has reason to believe the investor is lying.  In a Rule 506(c) offering, the issuer must take reasonable steps to verify that every investor is accredited.

The Securities and Exchange Commission's regulations allow an issuer to rely on primary documents from an investor like tax returns, brokerage statements, or W-2s, but they also allow the issuer to rely on a letter from the investor's lawyer, accountant or broker.

I do not recommend to my clients that they handle the verification process, but rather than they obtain a certification letter from the investor's lawyer, accountant or broker.  Alternatively, issuers can use a third party service such as  VerifyInvestor. [I'll go further and say that you should absolutely NOT verify Investor verification yourself any more than you should operate on yourself.]

About John Stege

John Stege has been practicing law for over 30 years. John's legal practice focuses on real estate and securities law. John focuses on deal structuring for new emerging and established companies throughout the United States on forming and operating real estate partnerships and joint ventures. John also advises clients on all aspects of real estate including HOAs, commercial purchase and sales, joint ventures, title review and insurance commitment, equity and debt financing issues and leases.  John is serious about providing compassionate conflict-avoiding solutions for investors and businesses.