Suppose you are planning a private musical soiree where a famous string quartet will perform. You have a core group of friends and families who regularly attend these intimate gatherings, and you expect that they will jump at the chance to attend this one.

Then, you discover there is another event that conflicts with your soiree that most of your friends and family will attend. To have a big enough crowd, you decide to post your invitation to your community listserv, which includes people you don’t know. The soiree venue isn’t large, so you limit attendance to the first music lovers who respond to the public announcement.

Although it may not be challenging to open up a private event to the public, the reverse would be difficult. Once you have invited the public to an event, it could be awkward at the minimum to announce that the soiree you posted on the community listserv no longer is open to all and that attendance will be limited to your close friends and family.

Imagine how much more difficult it would be to change who was invited to your soiree if you had to delay the event for six months if you changed from a public to a private event. Right now, federal securities laws include a six-month safe harbor if an issuer wants to change from an advertised Regulation D Rule 506(c) offering to a Rule 506(b) offerings, which do not allow general advertising. The reasoning has been that it’s difficult to tell whether the advertising might have caused investors in the second offering to invest.

On March 4, 2020, the Securities and Exchange Commission (SEC) proposed a new rule, which would clarify and harmonize integration concepts for several types of exempt offerings. The new rule also would shorten the safe harbor in Regulation D from six months to 30 days, which will provide more flexibility for small business and real estate securities offerings.

Although the proposed rule addresses numerous offering types, this article summarizes the integration of sequential Rule 506(b) and Rule 506(c) offerings, the two most popular registration exemptions, with $1,492 billion and $66 billion, respectively in 2019.

Rule 506(b) and Rule 506(c)

The Securities Act of 1933 (1933 Act) requires that all securities offerings be registered with the SEC unless there is an exemption. Registering securities is a costly and time-consuming process because it requires SEC review and approval. Therefore, small businesses and real estate funds offer securities under an exemption. Most frequently, they use the exemption under Rule 506(b) of Regulation D, which prohibits general advertising offering and general solicitation of investors.

The Jumpstart Our Business Startups Act (JOBS Act) of 2012, directed the SEC to create an exemption that permitted general advertising and general solicitation. In response, the SEC added Rule 506(c) to Regulation D, which allows publicly advertised securities offerings. However, Rule 506(c) also limits sales to accredited investors who meet net worth, asset, or income requirements and requires more intense scrutiny into investors’ financial situations than Rule 506(b), which may be a deterrent for high net worth individuals to invest. Perhaps due to these requirements, Rule 506(c) lags far behind Rule 506(b) in popularity with small businesses and real estate funds.

Current Integration Rule

A critical difference between Rule 506(b) and Rule 506(c) offerings is that general solicitation and general advertising aren’t allowed for Rule 506(b) offerings but are permissible in offerings under Rule 506(c). Because of this, there is a concern that an issuer might use a publicly advertised offering to obtain investors for a Rule 506(b) offering.

To combat this concern, in the 1960s, the SEC developed a five-factor test to determine whether two offerings should be integrated:

• Whether the offerings are part of a single plan of financing

• Whether the offerings involve issuance of the same class of security

• Whether the offerings are at or about the same time

• Whether the same type of consideration is to be received

• Whether the offerings are made for the same general purpose

The five-factor test is a “facts and circumstances” test, which relies on the judgment of the issuer’s securities attorney. There is no pre-established priority among the five factors, so even securities attorneys may disagree on the analysis of a particular situation, particularly, for instance, when four of the five factors are satisfied.

The SEC made an integration analysis easier for Rule 506(b) offerings by adopting a safe harbor, Rule 502(a). The safe harbor provides offerings won’t be integrated if they are six months apart. Because Rule 502(a) is a non-exclusive safe harbor, sponsors still can rely upon the five-factor test to possibly engage in offerings that are less than six months apart. However, this rarely happens, and most sponsors structure successive offerings to fall under the safe harbor.

Integration Under Proposed Rule

The proposed rule would replace the five-part test with the general principle that offerings will not be integrated if the issuer can establish that each offering either has been appropriately registered with the SEC or is exempt from registration. Safe harbors also would continue to be available.

For Rule 506(b) offerings and other offerings (which I’ll call Rule 506(b) offerings) where general solicitation isn’t allowed, there are additional requirements. Either the issuer reasonably believes that

• the purchasers in the Rule 506(b) offering were not solicited through general solicitation, or

• the purchasers had a substantive relationship with the issuer (or the issuer’s agent) before the commencement of the Rule 506(b) offering.

Also, if the offering documents for the Rule 506(b) offering mention a Rule 506(c) offering or another offering that allows general solicitation, the offering materials must contain the legends required for each exemption.

What constitutes a “substantive” relationship would largely remain the same. The issuer (or agent) needs to have sufficient information to evaluate (and does evaluate) the investor’s financial circumstances and sophistication.

A footnote in the Release for the proposed rule notes that “self-certification alone (by checking a box) without any other knowledge of a person’s financial circumstances or sophistication” would NOT be sufficient to form a “substantive” relationship. Securities laws include suitability requirements when broker-dealers are involved in the sale of securities. But what an issuer needs to do to evaluate investor financial information and sophistication is determined on a “facts and circumstances” basis.

Proposed Safe Harbor

The proposed rule also would shorten the safe harbor waiting period between a Rule 506(c) offering and subsequent Rule 506(b) offering from six months to 30 days, provided the same two conditions used for integration above are met for the Rule 506(b) offering. There wouldn’t be a waiting period if the Rule 506(c) offering started after the Rule 506(b) offering is terminated or completed.

Under the proposed rule, an Regulation D offering would be terminated or completed on the later of

Other Changes

SEC Release 33-10763 (the “Release”), which proposes these changes, consists of 340 pages, and this article is just a summary of a few changes. Besides Rule 506(b) and 506(c) offerings, the Release proposes rules for Rule 504, Regulation A, Regulation CF, Rule 147, and Rule 147A offerings. It also includes clarification of the bad actor disqualification provisions.

The proposed changes represent an excellent attempt to harmonize current practices into a more uniform structure. The proposal also recognizes the faster pace required for offerings with technological advances in the 21st century.

Yet, the proposal doesn’t go far enough in creating safe harbors or bright-line tests to guide issuers. Although offerings differ, different issuers experience similar concerns when evaluating whether there is a “substantive” relationship or whether they may reasonably conclude that an investor is accredited.

It can take years for issuers to gain clarity under new standards either through SEC No-Action letters or other guidance or through informal development of issuer best practices. In the meanwhile, issuers are likely to take a more conservative position than necessary, slowing capital formation when the economy can ill-afford it.

This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.