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What’s The Difference Between Rules 506(b) and 506(c)?

If you’ve already started researching the process of launching your own private fund, you may have heard about rules 506(b) and 506(c). So, what are these rules and why do you need to know about them?

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If you’ve already started researching the process of launching your own private fund, you may have heard about rules 506(b) and 506(c). So, what are these rules and why do you need to know about them?

The Securities Act of 1933

The Securities Act of 1933 governs how entities may offer their securities to investors in the United States, and is one of the three key regulatory frameworks to consider for anyone launching their own fund. 

When funds bring on investors, they are generally considered to be offering the sale of a security to investors: a stake in the fund. In contrast to offering public securities, such as via an IPO, hedge funds generally seek to offer their securities privately. In order to do so, the private offering must be considered acceptable by the SEC. Rule 506(b) provides for one way to conduct an acceptable private placement, alongside its less common sibling rule, Rule 506(c).

What Is Rule 506(b)?

506(b) is a “safe harbor” private placement for funds and other investment companies who offer their securities to investors. It is arguably the most common private placement utilized by hedge funds.

Here are the 3 main points you need to know about Rule 506(b):

#1 Investor Accreditation

Generally, investors must be accredited investors at minimum. It is theoretically possible to allow up to a maximum of 35 non-accredited investors in a 506(b) offering, but practically, this is quite rare, for two reasons.

506(b) specifies that in order to sell securities to such non-accredited investors, those investors must (a) meet the legal standard of having sufficient investing sophistication, and (b) be supplied disclosures substantially similar in nature to those required of a “Regulation A offering”, which is to say, relatively extensive additional legal documents specific to the fund directionally similar in nature to that of a public offering. 

Assuming that the aforementioned is not an issue, the second reason is that regardless of what is allowed in the Securities Act, other applicable acts to hedge funds may introduce restrictions on who may be charged fees or brought on into the fund anyways, rendering the 35 non-accredited investor possibility as potentially moot regardless.

#2 You Cannot Advertise Your Fund

Information about the fund cannot be broadly or publicly accessed, i.e. via a website, advertisements, mailing lists, social media platforms, television, or generally any sort of group or public format where general members of the public could inadvertently come across material information about the fund or any solicitation to invest. Solicitation must be done on a more one-to-one relationship and referral basis, or with the help of a regulated broker-dealer that specializes in investor-to-fund pairing (also known as an “introducing broker”).

#3 Investors Must Self-Attest

The accreditation status and other related financial status(es) of investors can be self-attested to by the investor, which reduces the administrative and liability burden associated with 506(b) offerings greatly. This stands in contrast to certain other offering types, where the fund manager has a higher duty towards validation of fund investor financial status. Fund administrators, such as Repool, typically handle this self-attestation on behalf of the fund.

Find out more about Rule 506(b) here.

What is Rule 506c?

506(c) is a “safe harbor” private placement type for funds and other investment companies who offer their securities to investors. Less common than its sister offering type, 506b, 506c has some unique pros and cons for funds.

Here are the 3 main points you need to know about Rule 506c:

#1 Investors Must Be Accredited

If you’re launching a fund using Rule 506(c), all your investors must be accredited investors at minimum. Accredited investors have to meet a series of qualifications, mainly pertaining to net worth—accredited investors have a net worth of over $1M, excluding their primary residence.

#2 Investors Cannot Self Attest

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 You Can Advertise Your Fund

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.

Read more about Rule 506(c) here.

506b v 506c

Rule 506(b) is an extremely common offering type for emerging managers, likely due its relatively minimal requirements. In contrast, Rule 506(c) places an increased burden on investors and the fund relating to accreditation validation however it does have the critical advantage of allowing for general solicitation, which could be important for a fund manager to achieve their goals.

Ready to take the next step?

Are you already researching what’s needed to launch your own private fund? Deciding between 506(b) or 506(c) is one of the key considerations for any aspiring or existing fund manager.

Whether you’re interested in launching a hedge fund, a crypto fund, or you want to build a track record with an incubator fund, Repool can help you get started.

Get in touch today for your free consultation. We’d love to talk!

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