Alternative investments with little correlation to the public equities markets can be a good hedge against market volatility. However, in most cases, these investments are private placements, meaning they aren’t offered to the general public. Further, these private placements are also freed of certain Securities and Exchange Commission registration requirements.
To enjoy these exemptions, issuers must be careful to confirm the investors with whom these opportunities are shared are capable of understanding what they’re getting into. Moreover, they must verify that all the investors who participate have sufficient means to weather a loss should the investment not realize its goals.
This brings us to Rules 506(b) and 506(c) of the SEC’s Regulation D.
In a nutshell, Regulation D (Reg D) permits the raising of capital by offering equity or debt securities, without having to register those offerings with the Commission. Generally employed by smaller companies or for crowdfunding, Reg D enables issuers to raise capital more expeditiously and at a lower cost than would a public offering. With that said, there are some state and federal regulatory requirements in place that must be met, including the requirements of Rules 506(b) and 506(c).
Rules 506(b) and 506(c) came about when the SEC divided Reg D into a pair of sub regulations to accommodate smaller companies under the Jumpstart Our Business Startups (JOBS) Act. The SEC was directed to revise the rules of the Securities Act of 1933 to make it easier for smaller companies to attract investors.
Under these two rules, issuers are allowed to operate as follows:
Under Section 4(a)(3) of the Securities act, Rule 506(b) grants an issuer the ability to offer an unlimited number of securities. However, those offers must be made without solicitation or advertising. In other words, investors need to approach the issuer, rather than the other way around. There must also be a pre-existing relationship between the issuer and the investor.
Investors must either be accredited or one of 35 non-accredited investors who meet the standards set forth for sophisticated investors. These investors are responsible for providing proof of status as either accredited or sophisticated. Issuers need only have a reasonable belief the investor meets the standard they are claiming.
There are no limits on the amount of capital an issuer can raise under this rule, nor is there a limit on the amount of money an investor can invest. However, there are limits on the number of investors with which an issuer can work under a 506(b) exemption. In fact, this is true of both 506(b) and 506(c). An issuer with a roster of more than 2,000 investors must meet the full-reporting standard. The same is true if they have more than 500 non-accredited investors.
While recommended, there is no requirement for issuers to provide information about the investment to accredited investors. However, most do anyway to avoid liability under SEC Rule 10b-5. However, information is required to be provided in situations in which even one non-accredited investor participates.
As previously mentioned, advertising deals are not permitted under Rule 506(b). However, brand advertising is allowed. Moreover, transactions may only be conducted with investors with whom the issuer has a pre-existing relationship.
Under this rule, issuers may only work with accredited investors. Further, they must take reasonable steps to verify the accredited status of an investor before they can proceed by reviewing their proof of income and asset statements. There are no dollar limits on the amount of capital that can be raised, nor is a limit placed on the amount of money an investor can invest.
Just as under Rule 506(b), if a company has more than 2,000 investors, it must comply with the requirements of a full reporting company under the tenets of the Exchange Act. Because they are only permitted to work with accredited investors under 506(b), issuers are under no obligation to provide investment information. Again though, most do so just the same to avoid Rule 10b-5 liabilities.
Perhaps the most significant difference — aside from the investor participation requirement — is that advertising is permitted. This can make it easier to attract investors. After all, specific investments can be shown to potential participants right away, with no need to demonstrate a pre-existing relationship. Another key point for issuers is that an offering can be started under 506(b) but can be switched to 506(c) if no non-accredited investors are participating.
A sophisticated investor is a person who has the capital, experience, and net worth to be expected to be capable of evaluating the potential benefits and risks of a minimally regulated investment. While the term “sophisticated investor” is not considered an official term per se, these people are characterized by the SEC as having “sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.” This characterization also assumes the individual has the capability of absorbing a sizable loss without experiencing financial ruin.
An accredited investor is an individual with a net worth exceeding $1 million — excluding the value of their primary residence. People with an annual income of $200K for two consecutive years and the expectation of continued earnings at that level are also considered accredited. Married couples earning $300k annually, within the same parameters, also qualify as accredited investors. Institutions with assets exceeding $5 million are considered accredited as well.
Private placements, such as those covered under Rules 506(b) and 506(c), can be useful tools for portfolio diversification. Traditional portfolio asset allocation envisions a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split incorporating 20% alternative assets may make a portfolio less sensitive to public market short-term swings.
Real estate, private equity, venture capital, digital assets and collectibles are among asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less correlated with public equity, and thus offer potential for diversification.
These assets were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors who buy in at very high minimums — often between $500,000 and $1 million. In other words, accredited investors. Operating under Rule 506(c), Yieldstreet was founded with the goal of dramatically improving access to alternative assets by making them available to a wider range of investors.
Rules 506(b) and 506(c) opened the door for smaller companies to attract accredited investors, as well as those who are not accredited, to avail themselves of certain private placement offerings with minimal SEC regulation. That said, there are still a series of federal and state requirements companies must meet to make these offerings.
However, this fact does not free the investor from the need to conduct stringent due diligence efforts. Actually, it makes doing so more important, because there are instances in which issuers are not required to provide background information about an investment.
Yieldstreet provides access to alternative investments previously reserved only for institutions and the ultra-wealthy. Our mission is to help millions of people generate $3 billion of income outside the traditional public markets by 2025. We are committed to making financial products more inclusive by creating a modern investment portfolio.