Establishing a Substantive Pre-existing Relationship Under Rule 506(b)

Most private offerings of securities in the US are offered under Rule 506(b), which generally requires that you have a substantive, pre-existing relationship with investors to whom you offer and sell securities. Find soft and asked me to help determine whether a substitute pre-existing relationship exists. I often get questions about how many degrees of separation is too far. Obviously, if it's true that everyone on Earth is connected by only six degrees of separation, of course can extend out there. Exactly how do we determine what is substantive and what is sufficient to constitute a pre-existing relationship.

The Securities and Exchange Commission (SEC) has answered questions about what it means for a relationship to be “substantive.” and pre-existing:

Substantive Relationship

A “substantive” relationship is one in which the issuer (or a person acting on its behalf) has sufficient information to evaluate, and does, in fact, evaluate, a prospective offeree’s financial circumstances and sophistication, in determining his or her status as an accredited or sophisticated investor. Self-certification alone (by checking a box) without any other knowledge of a person’s financial circumstances or sophistication is not sufficient to form a “substantive” relationship.

See Question 256.31: https://www.sec.gov/corpfin/securities-act-rules

Pre-existing Relationship

A “pre-existing” relationship is one that the issuer has formed with an offeree prior to the commencement of the securities offering or, alternatively, that was established through either a registered broker-dealer or investment adviser prior to the registered broker-dealer or investment adviser participation in the offering.

See Question 256.29: https://www.sec.gov/corpfin/securities-act-rules

Whether a relationship is pre-existing, depends on the quality of the relationship, not necessarily the duration. Earlier precedent had indicated that 30 days is likely sufficient time to establish the required relationship, but later precedent has focused more on the quality of the relationship rather than the duration.

Keep in mind, however, that, to minimize risk, issuers are encouraged to ensure they have a pre-existing documented relationship–especially for those investors where the duration of the relationship is minimal.

Establishing a Substantive Pre-existing Relationship Online

It may be a good idea to call out here that Rule 506(c) or some other exemption (Reg A, Crowdfunding) may be better exemptions if you want to generally advertise an offering. But those exemptions have their own benefits and drawbacks, which will not be discussed here.

There is no black and white answer to this question, so we are left with varying degrees of risk, and possible ways to mitigate the risk. Before going further, I want to point out some of the risk involved when relying on Rule 506(b).

Risks When Relying on Rule 506(b)

As a baseline rule, all offerings and sales of securities must be registered or exempt. If they don’t fall into one of these two categories, the offering or sale was illegal. As such, an issuer who sells securities in violation of securities laws could risk (from a very high level) any of the following:

• Private causes of action & rescission rights.
• Civil sanctions, fines and penalties by securities regulators (the SEC or state securities regulators).
• Criminal referral for criminal prosecution.

Claims Under Section 12(a)(1)

Section 12(a)(1) of the Securities Act of 1933 imposes strict liability for anyone who illegally sells securities. Technically, Rule 506(b) is a safe harbor under Section 4(a)(2) of the Securities Act, which is broader in scope than Rule 506(b) alone, so if you fail to comply with Rule 506(b), you may be able to fallback on Section 4(a)(2). However, Rule 506(b) preempts State law, while Section 4(a)(2) does not, which means you also must comply with all State law requirements if you fail to comply with Rule 506(b).

Damages Under Section 12(a)(1)

The primary remedy under Section 12 is rescission. The investor returns any securities sold in exchange for the original purchase price, plus interest (reduced by any payments made on the securities in the interim). The exemption under Sections 4(a)(2) and Rule 506(b) apply to the offering and sale generally, so any non-compliance with respect to a particular investor may infect the entire offering, spreading to all other investors. While it may be unlikely that several investors would band together to bring rescission claims, it is possible.

Statute of Limitations Under Section 12(a)(1)

The statute of limitations under Section 12(a)(1) requires that actions be commenced within 1 year from the date of the violation or three years from the date the security was offered to the public, in a public offering.

Note 1: Section 12(a)(2) offers remedies for making a material misstatement of fact or omitting a material fact. These claims assume the offering and sale were in compliance with Securities laws.

Note 2: Section 10(b) and Rule 10b-5 of the Exchange Act may also be used by investors to bring private causes of action for claims of fraud or material misrepresentations.

Note 3: This discussion does not include any commentary on State law rights. If the exemption fails under Section 506 but still complies with Section 4(a)(2), the offering must also be compliant with State law, which may have more expansive protective rights given to investors than federally.

As you can see, it is important to ensure compliance with whatever exemption you choose. While possible to establish a substantive pre-existing relationship over the internet, we do not have bright-line rules to follow. Each offer and sale is evaluated on a case-by-case basis, and any investor or securities regulator could claim failure to comply with Rule 506 in an action brought against an issuer.

Developing a Process to Establish a Substantive Pre-existing Relationship

The appropriate way to establish procedures and processes is to take a risk-based approach in developing a plan. We know that self-certification alone is insufficient. The goal is to “evaluate prospective offerree’s financial circumstances and sophistication, in determining his or her status as an accredited or sophisticated investor.

There are many factors and questions that can be asked to help determine the financial circumstances and sophistication of an individual. For example, a persons’s employment may be one datapoint that should be considered–the CEO of a fortune 100 company gets points added to that investor, while a customer support representative likely does not. No single factor is dispositive, and you likely need more than simply looking at a LinkedIn profile, for example. A relationship still must be established.

When building out this process, I typically recommend having someone like a compliance officer (whose role is to protect the company, not raise capital), review a documented history and then making a risk based decision about whether a sufficient relationship has been established. Then, this person can “click a button” that, for example, adds a checkbox to the firm’s CRM stating that a 506(b) substantive pre-existing relationship has been established. Then, and only then, can any offer of securities be made. Yes, Rule 506(b) applies to offerings of securities, so you cannot post anything that would be construed as an offering on a website (or email or talk about the offering) until the relationship has been established. If you want to do that sort of thing, look at Rule 506(c) instead.

CitizenVC Case Study

Citizen VC, Inc. wrote to the SEC (https://www.sec.gov/divisions/corpfin/cf-noaction/2015/citizen-vc-inc-080615-502-incoming.pdf) requesting a no-action letter (https://www.sec.gov/divisions/corpfin/cf-noaction/2015/citizen-vc-inc-080615-502.htm), which was granted. The SEC did not affirmatively state that their procedures would be sufficient and clarified that this is a case-by-case determination. However, a review of their policies and procedures may help determine a starting point for your firm.

• No offerings were made and all offerings were behind a members only password protected part of the site. Members had to register and become accepted as members.
• Prospective investors were required to complete an online questionnaire, which included a self-certification of the investor’s “accredited investor” status.
• Citizen VC would then use various means to connect with the prospective investor to further evaluate the investor’s sophistication, including:
  • Calling the investor to discuss their background, investment goals and strategy, suitability, risk and other topics;
  • Emailing the investor introductory information;
  • Electronically reaching out to the investor to answer questions and otherwise determine investor sophistication;
  • Pulling the prospective investor’s credit report;
  • Encouraging the investor to explore public parts of the site that included the manager’s investment strategy, philosophy and investment objectives; and
  • Fostering interactions, both offline and online, between Citizen VC and the prospective investor.
• Once Citizen VC was satisfied that the investor met the suitability and sophistication criteria it had established, it would grant the investor access to its securities offerings.

The order is important here. A substantive pre-existing relationship must be established first. Then, and only then, can any securities be offered to the investor.

It should also be noted that Citizen VC was in the business of forming special purpose investment vehicles (SPVs) to invest in single venture capital investments. Other business models may require different steps than those provided above.

The Citizen VC steps are a potential starting point. The SEC did not grant a stamp of approval, so any policies should be built out based on the issuer’s appetite for risk.

Possible Questions to Ask of Prospective Investors

• What is your occupation?
• Have you made prior [investment type] investments?
  • How many?
  • How much (ranges may be less intrusive)?
• What percentage of your portfolio have you allocated to [investment type]?
• What is your annual household income (ranges may be less intrusive)?
• What is your net worth (ranges may be less intrusive)?
• How do you qualify as an accredited investor?
  • I have a net worth of $1 million or more.
  • I have over the past two years over $200k (or $300k with my spouse).
  • I have my Series 7, Series 65 or Series 82 certification from FINRA.
  • Other. Please clarify: _____________

As always, the above is no substitute for independent legal counsel. Please consult with an attorney and do not rely on the information herein for you situation. Your particular facts and circumstances may not fit within the above or other exemptions may be more suitable for you.