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Real Estate Funds and Rule 506

Posted on August 7, 2018 at 10:40 PM

The overwhelming majority of real estate funds rely on Rule 506 under Regulation D of the Securities Act to raise capital.

Previously, Rule 506 required hedge fund managers to have a pre-existing relationship with investors and it placed a firm prohibition on general solicitation and advertising practices. Under Rule 506(c), issuers may engage in general solicitation and advertising practices when offering securities, although purchasers of the securities must be verified as accredited investors.

Under an expanded Rule 506 framework, issuers have the option to continue to rely on the original Rule 506 exemption—now found under Rule 506(b)—which still prohibits general solicitation and advertising practices. Although Rule 506(c) removes the general solicitation and advertising prohibition—effectively freeing fund managers to advertise fund offerings through television, newspapers, websites, etc.—surprisingly few issuers have taken advantage of it.

In 2016, SEC Chair Mary Jo White stated that from September 2013 through late 2015, 506(c) offerings only had a $71 billion market as opposed to the $2.8 trillion market for 506(b) offerings. This is partially due in part to the heightened verification requirement of Rule 506(c): whereas Rule 506(b) allows potential investors to self-certify their accredited status, Rule 506(c) requires issuers to take reasonable steps to verify the accredited status of each investor.

Rule 506(c) sets out three primary methods of verification: Income: Issuers can review any I.R.S. form that reports the investor’s income for the two most recent years. This includes Form W-2, Form 1099, Schedule K-1 to Form 1065, and Form 1040. In addition to I.R.S. forms for the two most recent years, an investor must represent that she or he has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor.

Net worth: Issuers review documents dated within the prior three months to determine whether an investor meets the requisite net worth.

For assets, issuers review bank statements, brokerage statements, certificates of deposits, tax assessments, and appraisal reports. For liabilities, issuers can use a consumer report from a consumer reporting agency.

Professional Verification: Issuers can obtain written confirmation from persons or entities that have taken reasonable steps to verify the investor is an accredited investor within the prior three months and has determined that the investor is an accredited investor. This includes: a) a registered broker-dealer; b) an investment adviser in good standing with the SEC; c) a licensed attorney, or d) a CPA.

The SEC has indicated issuers may be able to satisfy verification obligations through other means. Accordingly, there has been an increase in independent, third party verifiers who conduct accredited investor status verification and certification.

Please feel free to contact Private Placement Advisors LLC if you have any questions about exempt offerings under Rule 506(c) or other aspects of Regulation D.

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