The SEC exemption referred to as Rule 506(b) limits the way in which private security can be sold to investors. The major restriction is that the issuer may not perform general solicitation to attract investors. Under Rule 506(b), the issuer may only offer and sell a security to an investor if that issuer has a substantial, pre-existing relationship with the investor. However, issuers operating under Rule 506(b) should take great care to ensure they have a relationship with a prospective investor mentioned above to avoid any inference that general solicitation is involved. Below, we cover how accredited investor self-certification under Rule 506(b), and now partially under Rule 506(c), plays into these facts.
How Rule 506(b) Works
Under Rule 506(b), the issuer is exempted from the SEC’s registration requirements for any size offering. However, qualification for the exemption under this rule is contingent upon only accredited investors and no more than 35 non-accredited investors purchasing the securities. The unaccredited investors must also meet specific criteria, such as operating as an officer of the firm issuing the securities.
Also, under 506(b), the issuer may not conduct general solicitation to sell the securities. The issuer must also have a reasonable belief that the individuals buying the securities meet the established criteria as accredited investors and the 35 or fewer unaccredited investors must fulfill specific financial sophistication requirements.
Self-Certification – Rule 506(b) vs. 506(c)
Under Rule 506(b), the investor with a substantial, pre-existing relationship with the issuer may go through an accredited investor self-certification process that affirms they meet the definition of accredited investor. Initially,self-certification is not permitted under Rule 506(c).
To qualify as an accredited investor under Rule 506(c), an issuer must take reasonable steps to verify that a prospective investor meets the definition of an accredited investor per SEC rules. In order to do this, the issuer must usually hire a licensed attorney, a CPA, an SEC-registered investment adviser, or a registered broker-dealer to review the financial information submitted by prospective investors in order to verify if they qualify as accredited investors. This financial information may include tax returns, W-2s, credit reports, and brokerage statements.
On the other hand, under a 506(b) offering, an issuing company will certify that a prospective investor is accredited by having the investor fill out a questionnaire confirming as much. However, this simple process, and its success, are based on the honesty and good faith of the investor. It is possible for someone to lie about their qualifications to be an accredited investor, so it may be prudent to have the investor go through an actual accredited investor review with one of the professionals mentioned above.
As mentioned, an advantage of Rule 506(b) over Rule 506(c) for the issuer and investor is that the investor may self-certify, avoiding the more stringent verification requirements under Rule 506(c). Nevertheless, as we mentioned regarding the condition for a “substantive relationship” between the investor and issuer under Rule 506(b), the issuer under this Rule must have knowledge about the financial sophistication or circumstances of the individuals to have such a relationship.
