If you have been investing in real estate or planning to do it, you would often come across 506(b) and 506(c). What are these terms all about? What’s the difference between 506(b) and 506(c)? Let’s find out the answers.
Background
After “The Great Depression” the U.S. government introduced Regulation D to revive the market. Regulation D is a part of “The Securities Act”, which came into force for protecting investors’ interest in the securities market.
Registration D under the Act has the provision for companies raising capital to file for an exemption from registration with the Securities and Exchange Commission (SEC), which is otherwise mandatory for companies if they deal in securities.
SEC registration requires high amount of capital and time investment. Exemption brings the convenience for smaller companies to sell securities without hassles.
506(b) and 56(c) are the two types of exemptions available to private companies to raise capital without registering the offering with SEC. By choosing one of the ways General Partners (GPs) of the company can avoid the regulations mandated by SEC. The difference between 506(b) and 506(c) is what that matters for GPs that completely changes the way capital raising is approached. It will not just affect the capital but the structure of the capital raising process.
506(b)
Under 506(b), GPs have the right to raise the capital without advertisements and general solicitations in the general public.
GPs can exhaust their existing network and can permit unlimited number of accredited investors but with only 35 unaccredited but sophisticated investors. For unaccredited investors GPs will need to issue additional disclosures documents as they are provided in Regulation A offerings.
506(c)
Under 506(c) GPs are allowed to advertise on public platforms and can raise unlimited capital. But this privilege has a condition attached. Accredited investors are allowed to invest in 506(c) offerings but the responsibility to verify the accreditation lies on GPs. They should ensure that reasonable steps are taken for the verification and if needed, they hire a third party to do that.
Accredited investors have net worth of $1 million and this excludes their primary residence. Investors having the minimum income of $200,000 are also accredited. If the investor is investing with the spouse, the joint income should be minimum $300,000.
Difference between 506(b) and 506(c)
- 506(b) does not allow advertisement and general solicitation whereas under 506(c) GPs can advertise on public platforms
- There is no limit on number of accredited investors but there could be only 35 unaccredited investors under 506(b) exemption, if any. Under 506(c) only accredited investors are allowed to participate.
- Under 506(b) additional disclosure documents are to be issued by GPs to unaccredited investors. Whereas in case of 506(c), since only accredited investors are allowed to invest, there is no need for GPs to issue disclosure statement.
- Investors verify their accredited status under the rule of 506(b) however in case of 506(c) it lies on GPs to verify the status of investors and they need to have reasonable documentation to present for verification.
- It takes less time for GPs to raise capital as it is their own network they are tapping on one-to-one basis and investors take the responsibility for their accredited status when it comes to 506(b) rule. On the other side, it takes lot of time and effort to raise capital for the GP under 506(c) as the responsibility for verifying accreditation lies on GPs and documentation process can be lengthy due to the general solicitation of the offer.
It is imperative for GPs to understand the difference between 506(b) and 506(c) as it equips them to plan their capital raising structure appropriately and eliminates the regulatory risks. Moreover it helps them to calibrate their mindset according to what they choose for the efforts they will need to put in for raising funds.
For investors, knowing the difference between 506(b) and 506(c) rules can help them zero-in the decision of choosing the investment deal as limited partner. For anybody holding an accredited status, knowing the rules would make it apparent to them the responsibilities they hold in each case. While unaccredited ones will be aware of their rights and can claim disclosure documents, protecting their interest in the long run.
