Music theory or the study of note patterns and combinations, tuning systems, and music notation conventions is a core class for music majors. Music theory can be challenging for musicians whose focus has been on performing notes written on a page. Although keyboard players have been exposed to harmonic notation, singers and other instrumental musicians frequently have not.

Fortunately for music theory students, Western music uses a standard music notation method consisting of the familiar five-line staff, oval notes with lines, and symbols designating sharps and flats. However, that was not always so.

Early Western plainchant used wavy lines called neumes, which could designate a single note or multiple notes, to indicate a specified musical shape or contour. The earliest neumes showed relative pitches between notes but did not indicate a musical key, nor did they indicate a specific rhythm.

An 11th-century monk named Guido of Arrezo is sometimes credited with creating the framework for modern Western music notation by notating specific pitches, consisting of square notes on a four-line staff. By the 14th century, rhythmic notation was added. And by the 17th century, Western music consistently used the five-line stave and oval notes we use today.

Standardization in music notation proved critical to the development of Western music. In contrast, securities law, which developed via statutes and regulations adopted over the past 90 years, can be far from consistent. An attorney who knows reporting requirements for a public company will find the requirements for a private placement are very different.

On November 2, 2020, the Securities and Exchange Commission (SEC) amended several rules to harmonize requirements for exempt offerings, which will be effective in 2021 (60 days after publication in the Federal Register). The revised rules were designed to help small issuers raise money in private markets. These changes also will help real estate sponsors raise money through the private placements they commonly use.

This article is part of a series discussing the new SEC rules. This article focuses on changes to the disclosure requirements for non-accredited investors in Rule 506(b) offerings.

Non-Accredited Investors in Rule 506(b) Offerings

In 1982, the SEC adopted Regulation D (Reg D) under Section 4(2). Rule 506(b) of Reg D establishes a safe harbor for issuers that desire to rely upon the private placement exemption in Rule 506(b). Issuers may not engage in general solicitation or general advertising to market Rule 506(b) offerings. And Rule 506(b) limits sales of securities to an unlimited number of accredited investors but no more than 35 non-accredited investors.

If the offering is sold to any non-accredited investors, there are additional requirements. Every non-accredited investor, “either alone or with his purchaser representative(s) has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.”

All investors must receive accurate disclosure of material information. However, there are no specific disclosure requirements for offerings sold only to accredited investors. However, if an offering is sold to any non-accredited investors, Rule 502(b) requires disclosure similar to that which would be required for a public offering.

For non-reporting issuers that are not foreign private issuers, disclosure to non-accredited investors must include:

“(1) Offerings up to $2,000,000. The information required in Article 8 of Regulation S-X. . ., except that only the issuer’s balance sheet, which shall be dated within 120 days of the start of the offering, must be audited.

(2) Offerings up to $7,500,000. The financial statement information required in Form S-1 . . . for smaller reporting companies. If an issuer, other than a limited partnership, cannot obtain audited financial statements without unreasonable effort or expense, then only the issuer’s balance sheet, which shall be dated within 120 days of the start of the offering, must be audited. If the issuer is a limited partnership and cannot obtain the required financial statements without unreasonable effort or expense, it may furnish financial statements that have been prepared on the basis of Federal income tax requirements and examined and reported on in accordance with generally accepted auditing standards by an independent public or certified accountant.

(3) Offerings over $7,500,000. The financial statement as would be required in a registration statement filed under the [Securities Act of 1033] on the form that the issuer would be entitled to use. If an issuer, other than a limited partnership, cannot obtain audited financial statements without unreasonable effort or expense, then only the issuer’s balance sheet, which shall be dated within 120 days of the start of the offering, must be audited. If the issuer is a limited partnership and cannot obtain the required financial statements without unreasonable effort or expense, it may furnish financial statements that have been prepared on the basis of Federal income tax requirements and examined and reported on in accordance with generally accepted auditing standards by an independent public or certified accountant.

It can be costly and, sometimes, impossible to provide this additional disclosure. Therefore, Rule 506(b) offerings frequently are limited to accredited investors.

Regulation A Offerings

In An A Isn’t the Same for Everyone–Why Regulation A+ Might be a B or C for Real Estate Funds, I wrote about Regulation A, another exemption small businesses can use to raise equity. Like sales to non-accredited investors under Rule 506(b), Regulation A requires significant financial disclosure. But the financial disclosure required by Regulation A differs from that required by Rule 502(b). Rather than incorporating requirements from Regulation S-X, Form S-1, or other registration statements, like Rule 502(b), Regulation A has tiered disclosure requirements. For Tier 1 (up to $20 million) offerings, those requirements are in Form 1-A. Regulation A has no limit on the number of non-accredited investors. However, Regulation A limits the amount non-accredited investors may invest in Tier 2 (up to $50 million) offerings.

A Tier 1 Regulation A offering requires only consolidated balance sheets for the previous two fiscal years and consolidated statements of comprehensive income, cash flows, and stockholders’ equity for the issuer. Tier 1 financial statements need not be audited. Financial information for guarantors and affiliates sometimes also is required. Like Rule 502(b) requirements for offerings over $7.5 million, Tier 2 offering disclosure requirements follow those in Article 8 of Regulation S-X.

How the New Rule Changes Rule 502(b) Disclosure Requirements

The new rule changes the Rule 502(b) disclosure requirements to match Regulation A’s disclosure requirements. Therefore, Rule 506(b) offerings sold to non-accredited investors will need only disclose unaudited financial statements, as long as the offering amount is no more than $20 mil. Rule 506(b) offerings over $20 million will need only to make the disclosures in Article 8 of Regulation S-X, instead of the disclosures required in a registration statement.

These new disclosure requirements apply only to Rule 506(b) offerings sold to non-accredited investors. The new rule does not change the requirement that non-accredited investors meet sophistication requirements. Rule 506(b) offerings limited accredited investors will continue to have no specific disclosure requirements, as long as the issuer accurately disclosures all material information.

The Future for Rule 506(b) Offerings

Until now, Regulation A offered issuers access to non-accredited investors without the burdensome disclosures required for Rule 506(b) offerings. The ability to advertise Regulation A offerings also made them attractive.

However, Regulation A offerings were unattractive because they require an initial qualification with the SEC. And Tier 1 offerings additionally require qualification under state securities laws. The time necessary to complete those qualifications has made Regulation A unattractive for many real estate sponsors. The new rule also simplifies Regulation A compliance. Those changes are beyond the scope of this article.

The new rule likely will increase the number of Rule 506(b) offerings available to non-accredited investors. In particular, real estate funds usually can provide unaudited financial information, so sophisticated, non-accredited investors may gain access to those investments.

Although the SEC harmonized the disclosure requirements under Regulation A and Rule 506(b), Rule 506(b) offerings still may be sold to only 35 non-accredited investors. Regulation A does not contain the same limitation.

Still, it took many years before musicians arrived at the modern Western notation system. And it likely will require additional rule modifications before there is a uniform regulatory scheme.

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.