What is syndication and why use different rules (506b versus 506c)

By Alina Trigub

What is a Syndicated Investment?

A syndication is an investment by two or more parties, such as individual investors or companies, who agree to combine their financial resources to invest in a project that would be too expensive to tackle individually. Compared to other types of investment opportunities, a syndicated investment is viewed to be one of the effective means for individual investors or companies in the real estate world to invest in more lucrative or attractive deals. The person or team that performs the setup of the investment and management of the project is referred as General Partner, or more simply–GP, and individuals that invest their funds in the deal are referred to as Limited Partners, or LPs.

Let me share with you how I discovered syndications. My family lives in New Jersey: one of the highest taxed states in the United States. Several years ago, when I attempted to invest in local real estate, I found that I could not locate any viable investments. Hence, I started looking for investments out of state, and in process of my search I came upon an entire world of syndications. Gradually while learning the ins and outs and digging deeper into the benefits of syndication investing, I found an opportunity to become an equity investor in one such syndication. And my real estate investing journey began.

What are the rules that govern syndicated investments?

As with most investment transactions, raising funds in a syndication is equivalent to issuing securities, and is therefore governed by the Securities and Exchange Commission’s Securities Act of 1933. Under this federal law, an offer or a sale of a security must either be registered with the SEC or satisfy certain requirements in order to meet the registration exemption. More specifically, Rule 506 of Regulation D provides two exemptions, Rule 506 (b) and 506 (c).

Rule 506 (b)

Under this rule, syndications can raise any amount of money from unlimited accredited investors. We will detail the definition of an accredited investor, as well as other types of investors later in this article. However, these offerings are subject to the following requirements:

Syndications are neither allowed to perform general solicitations, nor advertising the securities to market
Syndications are not permitted to have more than thirty-five non-accredited investors. In addition, non-accredited investors are required to have sophisticated knowledge of the investment transaction. The individual who raises funds for a syndication is referred to as Issuer. When raising funds from a non-accredited investor, the Issuer must also follow additional rules:
Disclosure documents, which have the same type of information as what is in a registered offering, as well as financial statement information must be provided to non-accredited investors.
The issuer should be available to answer prospective purchasers’ questions, and this is specifically important when dealing with non-accredited investors.

Rule 506 (c)

Following the Jumpstart Our Business Startups Act (Jobs Act), Rule 506 (c) became effective on September 23, 2013. As opposed to Rule 506 (b), it permitted Issuers to solicit and advertise an offering, provided that:

All purchasers are considered to be accredited investors.
The issuer should take reasonable steps to verify the prospective purchasers’ Accredited Investor status, and
Certain other conditions in are satisfied.

In simple terms, the main differences between the two parts of Rule 506 – parts (b) and (c) are that the advertising and solicitation effort being provided by the issuer depend on the type of investor – accredited or non-accredited – that are involved under each provision. Naturally, the law also provides protection for the investors in the form of bad actor disqualification on the side of the issuer. Bad actor disqualification is described in the provisions of Rule 506 (d), where an issuer is disqualified if the person or any other covered person in the offering has a relevant criminal conviction, regulatory or court order or other disqualifying event that occurred on or after September 23, 2013 (effective date of the rule amendment). Furthermore, issuers may still rely on Rule 506, but they have to comply with the disclosure provisions of Rule 506 (e).

Difference between accredited and non-accredited investors

So, what is the difference between an accredited and non-accredited investor? Simply put, individuals are considered to be accredited investors if they have either a net worth of at least $1,000,000, excluding their primary residence, or have an income of $200,000 each year for the last two years ($300,000 combined income if married). However, the definition of an accredited investor is even broader than that since it can also be applied to corporate entities. As per Rule 501 of Regulation D, accredited investors are not just individuals; companies, such as businesses, banks and charitable organizations, and even certain employee benefit plans fit the definition criteria of accredited investors. On the other hand, while non-accredited investors are allowed to invest in syndications, there are certain investment restrictions in place to ensure that they are qualified to participate. For example, as mentioned above, a syndication interested in raising private equity is permitted to receive investments from an unlimited number of accredited investors, however, it is limited to no more than 35 non-accredited investors.

On August 26, 2020, the SEC has modernized the accredited investor definition. Historically, individual investors who do not meet specific income or net worth tests, regardless of their financial sophistication, have been denied the opportunity to invest in our multifaceted and vast private markets. The amendments update and improve the definition to more effectively identify institutional and individual investors that have the knowledge and expertise to participate in those markets.

So, let’s look at a couple of examples.

Ian is single, he works as an IT Executive and makes $210,000 a year. According to the definition of an accredited investor, Ian qualifies as an accredited investor based on the income requirement since a single investor has to earn over $200,000.

In a different example, Paul and Debbie are married and jointly make $250,000 a year. According to the definition of an accredited investor, their income is below the $300,000 per family threshold, however, they own three rentals and both have 401(k) accounts with a net worth of $1.2 Million. Since their net worth is over $1 Million, they do indeed qualify as accredited investors based on their net worth.

In conclusion, Real estate syndication is a great way to enter into real estate investing and to diversify an investment portfolio while minimizing risk. SEC guidelines and regulations help to ensure that investors, whether accredited or non-accredited, are allowed to participate in the deals assuming they meet the qualification requirements, as long as the issuers communicate with investors, answer investors’ questions, provide investors detailed information, and conduct other due diligence. Investors must perform their own due diligence to ensure that they chose the right investment and partner with the right syndicators. As long as syndication follows SEC guidelines and meets investors’ investment criteria, syndicated real estate offerings can be a terrific alternative strategy to Wall Street by offering stronger returns and more favorable tax treatment.