Rule 506(c)

Context:

When investment companies (or funds) bring on investors, they are generally considered to be offering the sale of a security to investors: a stake in the fund.  As such, funds are subject to the Securities Act of 1933 (the “Securities Act“), which governs the sale and issuance of securities in the United States.  In contrast to offering public securities, such as via an initial public offering (“IPO“), hedge funds generally seek to offer their securities privately.  In order to do so, the private offering – better known as a private placement – must be considered acceptable by the SEC.  Rule 506(c) provides for one way to conduct an acceptable private placement, although it is less common that its sibling, Rule 506(b).

How does 506(c) work?

506(c) is what’s called a “safe harbor”, which is to say that any private offering conducted in accordance with the restrictions of 506(c) is acceptable as a matter of course.  In other words, investment companies must do – or not do – certain things in the course of their offering in order to qualify for safe harbor.  For 506(c), generally, the primary considerations are:

1. Investor accreditation.  All investors must be accredited investors at minimum.
2. Accreditation validation. The accreditation status and other related financial status(es) of investors cannot simply be self-attested to, as is the case with a 506(b) offering.  Instead, there is a higher standard for the fund manager to ensure that investors meet their required financial status.  Practically speaking, industry standard is most commonly to either (a) require investors to supply a third-party attestation letter from a CPA or qualified legal counsel, or (b) to utilize an investor financial status validation service.  In either case, there are non-trivial additional financial costs to be borne by either or both of the fund manager and any given investor, alongside the administrative friction associated with the third-party validation, which could prove unattractive for potential investors.
3. General solicitation allowed.  Information about the fund and its offering can be made widely available, such as via publicly accessible websites.  As a result, 506(c) offerings have the advantage of allowing managers to access a broader network of potential investors.

What steps need to be taken to conduct a 506(c) offering?

Beyond following the boundaries of 506(c) offering, there is no approval or application process to make such an offering; it is self-executing.  An apt analogy might be driving under the speed limit on a highway; you don’t need to seek permission to do so, but if you go over the limit, you could be pulled over.  Similarly, the SEC and state securities regulators bear the right to validate the legitimacy of any fund’s offering, and have been known to conduct industry-wide compliance sweeps from time to time.  The penalties and ramifications for misrepresenting or conducting a poor private placement can be severe.

Wrap-up:

Due to the increased burden on investors and the fund relating to accreditation validation, 506(c) is less common than its sibling, 506(b), which has much simpler requirements.  However, 506(c) has the critical advantage of allowing for general solicitation, which could be important for a given fund or fund manager to achieve its goals.

Any entity whose principle purpose is to invest and which brings on third-party capital is inherently conducting a securities offering, and as such, the consideration of 506(c) or other private placements is one of the key considerations for any aspiring or existing fund manager.