How Pre-Existing, Substantive Relationships Affect General Solicitation

by | Jan 27, 2022 | Money & Finance

Rule 506(b) of Regulation D includes a requirement that no general solicitation or advertising be engaged in offers or sales of private securities. The means of proving no general solicitation has occurred is showing that you have a pre-existing, substantive relationship with the investor, regardless of the investor’s accredited status.

Documenting a Pre-Existing Relationship
The issuer that claims an exemption under Rule 506(b) must have a written procedure or policy (or record-keeping system) to document the relationship with the investor, such as meetings conducted, what was discussed, and persons present, and to demonstrate that a certain space of time had occurred between the first meeting and the offering of securities.

The length of time that must pass has not been specified by the SEC, but the SEC has commented that the most important factor is the quality of the relationship as opposed to the length of time.

SEC Guidance
The SEC answers question from issuers periodically in the form of interpretive letters called No Action Letters. These letters give guidance to issuers of securities and the securities legal community as to whether certain proposed programs would adhere to relevant securities laws.

In one of these letters in the summer of 2015, the SEC confirmed its stance on pre-existing relationships for a Rule 506(b) offering. Its position is as follows:

  1. A pre-existing, substantive relationship between investor and issuer must exist which also proves no general solicitation has been conducted. The relationship cannot be exclusively based on a short-form accreditation questionnaire or a certain duration of time.
  2. The relationship between the issuer and investor must have been established before the date of the offering.
  3. The relationship may be established by following certain procedures and policies both offline and online (as relevant) which empower the issuer of securities to examine the potential investor’s financial circumstances, sophistication, and suitability, and his or her ability to understand the type and risks of making an investment; and that the issuer adhered to this process in order to conduct such an evaluation.
  4. The issuer must have a system of keeping records that record its compliance with items 1 through 3 above.

The rules are the same for accredited and non-accredited investors alike as long as the issuer is depending on Rule 506(b) exemption.

The rules are the same for accredited and non-accredited investors alike as long as the issuer is depending on Rule 506(b) exemption.

In Conclusion
All investors participating in Rule 506(b) offering must have had a pre-existing, substantive relationship with the issuer to show no general solicitation is involved. This is true regardless of the investor’s financial status. Although a pre-qualification questionnaire is a good starting point, by itself it is not adequate to prove a pre-existing relationship. Before making an offer, the issuer must communicate with the investor about his or her financial circumstances, sophistication, and fitness.

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