There is something weirdly contradictory about Rule 506(c) under Regulation D, which has been available for less than 10 years. Regulation D was adopted years before that as a safe harbor for private offerings under Section 4(a)(2) of the Securities Act. In other words, for companies who didn’t want to undergo the costly and involved process of registering their offering publicly, they could do a simpler offering that’s not marketed widely. That process is reflected in what is now Rule 506(b). However, Rule 506(c), even though it’s within the rule that’s supposed to be for private offerings, expressly permits “general solicitation or general advertising” – so, public marketing of the offering.
There are two conditions for the use of Rule 506(c) that aren’t requirements for Rule 506(b):
1. Every single participant in the offering must be an accredited investor (up to 35 non-accredited investors can be included under Rule 506(b)); and
2. The accredited investor status of each investor must be verified, e.g., through examination of tax returns or brokerage statements, to confirm income or net worth, so, the company cannot just rely on a written representation by the investor.
In practice, condition No. 1 doesn’t matter that much because most Rule 506(b) offerings are made exclusively to accredited investors in any event. Including even one of the 35 non-accredited investors permitted under Rule 506(b) triggers a requirement to provide full business and financial disclosure to all investors that makes it impossible to have a “documentation-lite” approach that makes Regulation D offerings attractive for many companies. So, the real catch when determining whether to rely on Rule 506(c) is the need to comply with condition No. 2, accredited investor verification.
The verification process is still a roadblock even for many prospective investors who easily qualify as accredited. Most companies raising capital don’t want to be involved with directly reviewing the private financial information of their investors and so will outsource the process to a third-party verification service. I’ve found with my clients that a significant number of prospective investors get stuck during the verification process. Surely, in some cases it’s because they weren’t in fact accredited, meaning the rule is serving its proper function, but in others, whether because of privacy concerns, laziness or some other factor, the investor never gets around to giving the verification service what it requires.
However, these practical issues with verification mainly apply to individual investors. For more institutional investors like venture funds, there is no real impediment to their compliance, whether it involves a certification from an accountant or attorney or providing direct evidence of assets to a verification service. On one hand, you might wonder why general solicitation and advertising is even necessary in the context of an institutional-type round, since there is a long-standing practice of conducting these offerings in a traditional, Rule 506(b) setting. But using Rule 506(c) in these offerings frees the company from some of the usual constraints on how it communicates during the offering period. For example, it can mention the offering in press releases and social media posts even before the offering is done.
As always, all company communications are subject to the anti-fraud rules of the securities laws, so there’s never an “anything goes” rule for communications. But relying on Rule 506(c) can allow companies more freedom in how they operate during offerings, with only a slight additional burden imposed by the verification process in larger offerings.