Materialty: Finding the Disclosure Balance in Rule 506 Offerings
by Paul Johnson, Esq.
The finance, commercial real estate, and business transactions team at Moran Reeves Conn had a busy 2021 and shows no signs of slowing down. A large part of the practice revolves around securities offerings, and MRC attorneys often hear the client question, “do we really need to disclose this?” The answer is often a frustrating blend of “the best disclosure would include . . .” and “it depends.” This short article seeks to briefly provide a framework through which clients can make decisions regarding disclosures in a private securities offering.
The vast majority of unregistered securities offerings are made through the exemptions provided under Regulation D. Briefly, Regulation D provides an exemption to securities registration in Rules 504 and 506. Rule 504 provides an exemption from federal registration for offerings up to $10 million, but the issuer must comply with the state securities laws in the states in which the securities are offered or sold. Rule 506, on the other hand, provides a safe harbor for certain offerings to accredited, and even non-accredited investors, and issuers are exempt from compliance with state securities laws. Under Rule 506(b), issuers may sell securities to an unlimited number of accredited investors, but they are limited to 35 non-accredited investors, and general solicitation is not allowed. Under Rule 506(c), issuers may only sell securities to an unlimited number of accredited investors, and general solicitation is permitted.
The disclosure requirements under Rules 506(b) and 506(c) vary greatly depending upon whether the investor meets the definition of an accredited investor, which is contained in Rule 501. Where the investor is non-accredited in a Rule 506(b) offering, the issuer must provide disclosures that are generally the same as those given in a Regulation A or registered offering. This includes financial statements, which may need to be audited. If an issuer does not have these disclosure materials otherwise prepared, preparing them for a limited number of non-accredited investors is often prohibitively expensive when compared to the amount that could be raised from non-accredited investors.
Accredited investors, on the other hand, come with no explicit disclosure requirements in Rule 506 offerings. Issuers have flexibility to determine what disclosures to make to accredited investors, provided that the issuers comply with the anti-fraud provisions of the federal securities laws. The anti-fraud provisions can be broken into two categories: scienter-based and not scienter-based. The scienter-based anti-fraud provisions include, but are not limited to, Section 10(b) of the Securities and Exchange Act of 1934 and Section 17(a)(1) of the Securities Act of 1933, which establish “scheme liability” and generally prohibit fraudulent practices in connection with the sale of securities. Other anti-fraud provisions such as Section 17(a)(2) prohibit untrue statements, or omission, of material facts without a scienter requirement. Therefore, it is incredibly important that issuers accurately disclose all material information in connection with an offering.
The Supreme Court articulated the materiality standard in TSC Industries, Inc. v. Northway, Inc. It stated in part, “[a]n omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote . . . [it] would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” Given this interpretation of materiality, the question of whether information is material is intensely fact-specific, and issuers should attempt to step into the shoes of potential investors when determining what information should be disclosed. The best rule of thumb for issuers concerned about disclosures is that they should focus on two goals: (1) accurately stating the information that they have decided to disclose, and (2) stepping into the investors’ shoes to determine which information to provide. When in doubt, disclosure will, at a minimum, reduce the risk of future litigation.