Regulation Governing Joint Financial Endeavors Among Acquaintances and Kin
Forming an investment club with friends or colleagues can be an exciting way to learn about investing and potentially grow your wealth. However, it's essential to understand the securities regulations that apply to these groups.
In the United States, the Securities Act of 1933 requires companies or private funds to register with the Securities and Exchange Commission (SEC) before offering or selling securities, unless an exemption from registration is available.
Exemptions from Registration
For private placements, Regulation D provides exemptions from the registration requirements. Rule 504, 505, and 506 are three such exemptions.
Rule 506 is the most common exception for startups, allowing them to offer securities only to preexisting contacts who are either accredited investors or not. Entities such as banks, partnerships, corporations, nonprofits, and trusts may also be accredited investors.
When raising money from non-accredited investors in a private placement under Rule 506, the relevant rule is Rule 506(b), not Rule 506(c). Rule 506(b) permits raising unlimited capital from unlimited accredited investors and up to 35 non-accredited investors, but it does not allow general solicitation or advertising. The non-accredited investors must be "sophisticated," meaning they have sufficient knowledge and experience in financial and business matters to evaluate the investment risk.
In contrast, Rule 506(c) allows general solicitation and advertising but requires all investors to be accredited, with issuers taking "reasonable steps" to verify accreditation status. No non-accredited investors are allowed under 506(c).
Compliance with Securities Regulations
Companies relying on Rules 504, 505, or 506 exemptions do not have to register their offering of securities with the SEC, but they must file a "Form D" electronically with the SEC after they first sell their securities. This form includes the names and addresses of the company's promoters, executive officers, and directors, and some details about the offering.
Investment clubs, including real estate investment clubs, are subject to a complex web of securities regulations at both the federal and state level. For instance, in California, a company can sell securities to an unlimited number of accredited investors and company executives, and up to 35 non-accredited investors, under the "friends and family" exemption in 25102(f).
It's crucial to note that failure to comply with securities regulations at both the federal and state level can result in negative consequences for investment clubs.
Summary
Here's a summary table to help clarify the differences between Rule 506(b) and Rule 506(c):
| Aspect | Rule 506(b) | Rule 506(c) | |-------------------------------|----------------------------------------------|---------------------------------------------| | Solicitation | No general solicitation or advertising | General solicitation allowed | | Accredited investors | Unlimited | All investors must be accredited | | Non-accredited investors | Up to 35, must be sophisticated | None allowed | | Verification of accreditation | Self-certification allowed | Issuer must take reasonable steps to verify | | Form D filing | Required within 15 days of first sale | Required within 15 days of first sale |
In conclusion, securities laws allow non-accredited investors in private placements only under Rule 506(b), limiting their number to 35 and requiring sophistication. Rule 506(c) excludes non-accredited investors entirely and involves stricter verification and advertising rules.
For those in states like California without rich uncles, Rule 504 could be a good alternative because this state has a "friends, family, and business partners" exemption. Rule 506 remains the most attractive option for raising capital because of state law preemption, but dealing with accredited investors only is the easiest course of action.
In the context of an investment club in the United States, it's important to understand that Rule 506(b) allows a club to raise funds from up to 35 non-accredited investors, provided they are financially sophisticated, and unlimited accredited investors, but without general solicitation or advertising. On the other hand, Rule 506(c) permits general solicitation and advertising, but only accredited investors are allowed, and the issuer must take reasonable steps to verify their accredited status. Compliance with these securities regulations is crucial to avoid negative consequences for the investment club.
