Rule 506 (c) and the State of the Crowdfunding Regulatory System
Crowdfunding is rapidly becoming a familiar concept among experienced real estate developers and investors alike. This new method of financing is creating a profound shift in the world of real estate investment. Yet, Rule 506 (c) and other regulations created to address this nascent industry currently lag behind the growth of the industry itself. Below, we outline the main regulatory mechanisms.
Regulation D – 506(b) v. 506(c)
Generally, businesses must register offerings with the SEC unless they qualify for an exemption. Regulation D provides the most common regulatory exemption used by crowdfunding portals today. It exempts private placement offerings under Rule 506(b), which is used for Type I equity crowdfunding (ECF), or 506(c), which is used for Type II ECF. Rule 506 (c) was recently adopted on September 23, 2013.
Rule 506 of Regulation D is considered a "safe harbor" for the private offering exemption of Section 4(a)(2) of the Securities Act. Companies relying on the Rule 506 exemptions can raise an unlimited amount of money.
Below is a brief comparison of some of the noteworthy differences between the two rules:
|Rule 506(b)||Rule 506(c) (Title II of the JOBS Act)|
|General solicitation allowed||No||Yes|
|Cooling off period||Yes (common practice is 21 days)||No. Investor may invest immediately|
|Accredited investor status required||Yes. "Unlimited number of accredited investors and up to 35 other non-accredited, sophisticated purchasers"||Yes. Unlimited number of accredited investors only.|
|Verification of accredited investor status||Investor must satisfy the accreditation requirement or the issuer must reasonably believe the investor is accredited.||Must take "reasonable steps" to verify the investor is accredited, which includes verification by income, and net worth for natural persons|
Despite the popularity of this mechanism with most platforms, Regulation D limits participation to accredited investors only, as defined in Rule 501 of Regulation D.
The federal securities laws define the term "accredited investor" as:
- a bank, insurance company, registered investment company, business development company, or small business investment company;
- an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;
- a charitable organization, corporation, or partnership with assets exceeding $5 million;
- a director, executive officer, or general partner of the company selling the securities;
- a business in which all the equity owners are accredited investors;
- a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person;
- a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or
- a trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes.
Recognizing the need to provide regulatory guidance for Type III ECF, or crowdfunding for unaccredited or mainstream investors, the SEC has issued proposed crowdfunding legislation known as Title III of the JOBS Act for comments. The proposed legislation has three policy goals: 1) provide an easy, low-cost way for startups to raise money online; 2) protect investors from new forms of fraud; and 3) create incentives for financial firms to run crowdfunding websites.
While the proposed regulation attempts to provide accessibility and protection for ordinary, non-accredited investors it also appears to create significant, additional requirements for crowdfunding companies. It is unclear when or if the SEC will issue a final rule for Title III.
- Companies would be able to reach accredited and non-accredited investors alike (subject to a total investment limit of up to 5% of an investors’ income) based on the non-accredited investor’s income and net worth).
Cons: Companies would be restricted to:
- Advertising only to the funding portals' direct potential investors
- A limited annual raise per issuer
- Must complete substantial, non-standardized pre-sale information on each investment
- Submit laborious and costly audited financials for raises over $500,000.
Regulation A+ (or A Plus) is a proposed expansion of Regulation A under Title IV of the JOBS ACT. Regulation A exempts a securities offering that does not exceed $5 million from SEC registration if certain requirements are met. However, businesses still must file an offering statement that includes an offering circular and financial statements with SEC, and SEC staff review filings for consistency with applicable rules and accounting standards. In addition, Regulation A does not exempt offerings from states’ registration requirements, which are also intended to protect investors.
However, Regulation A is now rarely used due in part to its bureaucratic approval process. In fact, the number of qualified offerings dropped from 57 in 1998 to 1 in 2011. Concerned about the decline in the number of public offerings, the JOBS Act requires SEC to amend Regulation A (or to adopt a new regulation) to raise the threshold for use of that registration exemption from $5 million to $50 million.
Regulation A+ promises to expedite the approval process through the creation of two tiers of offerings: the first tier for offerings of up to $5 million and the second tier for offerings of up to $50 million, each within a 12-month period. These proposed changes have already undergone the 60 day comment period.
Pros: The new regulation appears to:
- Streamline the government approval process by eliminating state filing requirements and allowing electronic filing
- Increase the funding maximum from $5 million in a 12-month period under original Tier 1 offerings, up to $50 million in a 12-month period (subject to individual investor limitations based on income)
- Permit general solicitation
- Allow Canadian investors to invest
- Offer tradable, non-restricted securities, unlike the other previously discussed regulations
- Preempt state securities laws that regulate the offering inside their borders
- Companies would still face significant pre-sale disclosure, on-going reporting obligations and audited financial requirements
- Excludes asset-back securities
Intrastate Equity Crowdfunding Exemptions
In an attempt to increase access to capital, multiple states have begun to propose and enact their own intrastate equity crowdfunding exemptions, often with less required documentation than federal rules but also with lower investment amounts. Georgia Quinn and Anthony Zeoli report that, as of July 2014, the following 12 states now have crowdfunding laws on their books:
Additionally, 11 other states that have begun the process to legalize equity crowdfunding as of today.
- Illinois Missouri
- North Carolina
- New Jersey
- South Carolina