I have been fortunate to have had the opportunity to be involved with several private placements under Rule 506(c) since the rule became effective on September 23, 2013. Rule 506(c) permits the use of general solicitation and general advertising when selling securities in a private placement so long as the issuer takes reasonable steps to verify that all of the investors that purchase securities in the private placement are accredited. The reasonable steps that must be taken include obtaining tax returns, W-2s, 1099s, bank statements or letters from an investor’s accountant or lawyer as proof that the investor is accredited. I have found that this extra step of “taking reasonable steps to verify that an investor is accredited” can significantly delay the timetable for an offering or limit the potential pool of accredited investors because investors do not readily provide such sensitive information to issuers, and even when they do, it takes a lot of time and multiple requests before they hand the information over. As a result, I generally advise my clients to avoid general solicitation and general advertising if they believe that they can raise the capital they need without having to advertise their offering.
But, what about issuers that don’t want to rely on Rule 506(c) and instead want to conduct a traditional private placement under Rule 506(b)? It becomes critical for these issuers to know what the definition of “general solicitation” is because “general solicitation” cannot be employed in a traditional Rule 506(b) offering.
In traditional Rule 506(b) private placements, the manner of offering is limited by Rule 502(c). That rule generally provides that in a Rule 506(b) private placement neither the issuer nor any person acting on its behalf may offer or sell the securities by any form of general solicitation or general advertising. The rule provides some examples of what is meant by general solicitation and general advertising. Those examples include the following:
- Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and
- Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising.
The recent Citizen.vc no-action letter and related SEC compliance and disclosure interpretations (CDIs) provide some guidance about what is and what is not a general solicitation for issuers engaging in traditional private placements under Rule 506(b).
The Citizen.vc No-Action Letter
The Citizen.vc no-action letter addresses the situation where an issuer desires to use a password protected web page (the Site) to sell securities under Rule 506(b) without the use of the Site being deemed a “general solicitation” and thereby being subject to the additional “investor verification” requirements imposed by Rule 506(c). Citizen VC, Inc. (CVC) is an online venture capital firm. It creates special purpose vehicles (SPVs). Each SPV invests only in one issuer (a Portfolio Company) that is identified by CVC and none of the SPVs are blind pool investment vehicles. The SPVs are organized and managed by a manager controlled by CVC. Interests in the SPVs (Interests) are offered to persons who have become members (Members) of the Site. CVC has developed policies and procedures that it uses to establish a substantive relationship with a visitor to the Site before it allows such visitor to become a Member.
In the CVC no-action letter, the staff of the Securities & Exchange Commission (the staff) concurred with CVC’s conclusion that the policies and procedures described in its letter create a substantive, pre-existing relationship between CVC and prospective investors such that the offering and sale on the Site of Interests in SPVs that will invest in a particular Portfolio Company will not constitute general solicitation or general advertising within the meaning of Rule 502(c) of Regulation D. The staff stated that the quality of the relationship between an issuer (or its agent) and an investor is the most important factor in determining whether a “substantive” relationship exists. The staff noted that 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. The staff focused on the fact that CVCs policies and procedures are designed to evaluate the prospective investor’s sophistication, financial circumstances and ability to understand the nature and risks of the securities to be offered. The staff also agreed that there is no specific duration of time or particular short form accreditation questionnaire that can be relied upon solely to create such a relationship.
The staff stated that the determination of whether an issuer has sufficient information to evaluate, and does in fact evaluate, a prospective offeree’s financial circumstances and sophistication will depend on the facts and circumstances. The staff focused on the fact that the relationship with new Members will pre-exist any offering and that a prospective Member is not presented with any investment opportunity when that Member is in the process of being qualified to join the platform. Any investment opportunity would only be presented after the prospective investor becomes a Member. The staff also focused on the fact that the SPVs are not blind pool investment vehicles.
For venture capital funds, portals and others that desire to offer and sell securities behind a password protected portion of their website, the key will be the policies and procedures that they adopt. These funds and portals should adopt policies and procedures similar to those adopted by CVC, which will likely be viewed in the industry as best practices for password protected securities offerings. In the case of CVC, a visitor that wishes to investigate the password protected sections of the Site accessible only to Members must first register and be accepted for membership. In order to apply for membership, CVC requires all prospective investors, as a first step, to complete a generic online “accredited investor” questionnaire. According to CVCs letter, the satisfactory completion of the online questionnaire is only the beginning of CVCs relationship building process. Once a prospective investor has completed the online questionnaire and CVC has evaluated the investor’s self-certification of accreditation, CVC will initiate the “relationship establishment period.” During this period, CVC will undertake various actions to connect with the prospective investor and collect information it deems sufficient to evaluate the prospective investor’s sophistication, financial circumstances, and its ability to understand the nature and risks related to an investment in the Interests. These activities include
- contacting the prospective investor offline by telephone to introduce representatives of CVC and to discuss the prospective investor’s investing experience and sophistication, investment goals and strategies, financial suitability, risk awareness, and other topics designed to assist CVC in understanding the investor’s sophistication,
- sending an introductory email to the prospective investor,
- contacting the prospective investor online to answer questions they may have about CVC, the Site, and potential investments,
- utilizing third party credit reporting services to confirm the prospective investor’s identity, and to gather additional financial information and credit history information to support the prospective investor’s suitability,
- encouraging the prospective investor to explore the Site and ask questions about the CVC’s investment strategy, philosophy, and objectives, and
- generally fostering interactions both online and offline between the prospective investor and CVC.
Additionally, prospective investors are advised that every SPV offering will have a significant minimum capital investment requirement for each investor, which will be not less than $50,000 per individual investment, and in some offerings significantly higher.
It is also important to note that CVC’s publicly accessible homepage contains only generic information about CVC and no information about any of the current SPVs, Portfolio Companies, investment opportunities or offering materials.
Citizen.vc Related CDIs
Shortly after issuing the CVC no-action letter, the staff issued related compliance and disclosure interpretations (CDIs). Following is a summary of the CDIs.
- The use of an unrestricted, publicly available website to offer or sell securities constitutes a general solicitation for purposes of Rule 502(c). However, Rule 506(c) — which does not require compliance with Rule 502(c) — is available to issuers when offering or selling securities through unrestricted, publicly available websites or other forms of general solicitation.
- An issuer can widely disseminate information not involving an offer of securities without violating Rule 502(c). The example given by the staff is factual business information. The SEC stated that factual business information that does not condition the public mind or arouse public interest in a securities offering is not an offer and may be disseminated widely. Information that involves an offer of securities through any form of general solicitation would contravene Rule 502(c).
- According to the staff, what constitutes factual business information depends on the facts and circumstances. Factual business information typically is limited to information about the issuer, its business, financial condition, products, services, or advertisement of such products or services, provided the information is not presented in such a manner as to constitute an offer of the issuer’s securities. The staff stated that factual business information generally does not include predictions, projections, forecasts or opinions with respect to valuation of a security, nor for a continuously offered fund would it include information about past performance of the fund.
- An offer of securities in a Regulation D offering to a prospective investor with whom the issuer, or a person acting on the issuer’s behalf, has a pre-existing, substantive relationship does not constitute a general solicitation in contravention of Rule 502(c). The existence of such a pre-existing, substantive relationship is one means, but not the exclusive means, of demonstrating the absence of a general solicitation in a Regulation D offering. Accordingly, an offer of the issuer’s securities to the person with whom the issuer, or a person acting on its behalf, has such a relationship would not constitute a general solicitation and, therefore, would not be in contravention of Rule 502(c).
- There are some circumstances such as through an investor club or angel network under which an issuer, or a person acting on the issuer’s behalf, can communicate information about an offering to persons with whom it does not have a pre-existing, substantive relationship without having that information deemed a general solicitation. The staff stated that is aware of long-standing practices where issuers and persons acting on their behalf are introduced to prospective investors who are members of an informal, personal network of individuals with experience investing in private offerings. The staff acknowledged that groups of experienced, sophisticated investors, such as “angel investors,” share information about offerings through their network and members who have a relationship with a particular issuer may introduce that issuer to other members. Issuers that contact one or more experienced, sophisticated members of the group through this type of referral may be able to rely on those members’ network to establish a reasonable belief that other offerees in the network have the necessary financial experience and sophistication. The staff noted that whether there has been a general solicitation is a fact-specific determination. In general, the greater the number of persons without financial experience, sophistication or any prior personal or business relationship with the issuer that are contacted by an issuer or persons acting on its behalf through impersonal, non-selective means of communication, the more likely the communications are part of a general solicitation.
- Persons other than broker-dealers, such as registered investment advisers, may be able to form a pre-existing, substantive relationship with a prospective offeree as a means of establishing that a general solicitation is not present in a Regulation D offering. The staff stated that as fiduciaries, such advisers owe their clients the duty to provide only suitable investment advice. To fulfill the obligation, an adviser must make a reasonable determination that the investment advice provided is suitable for the client based on the client’s financial situation and investment objective, such that a substantive relationship could exist.
- 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.
- There is no minimum waiting period required for an issuer, or a person acting on its behalf, to establish a pre-existing, substantive relationship with a prospective offeree in order to demonstrate that a general solicitation is not involved. However, other than in the case of the limited exception relating to private funds, the issuer must establish such a relationship prior to the commencement of the offering, or, if the relationship was established through either a registered broker-dealer or investment adviser, the relationship must be established prior to the time the registered broker-dealer or investment adviser began participating in the offering.
- The staff explained that 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.
- In answering the question of whether someone other than a registered broker-dealer or investment adviser can form a pre-existing, substantive relationship with a prospective offeree as a means of establishing that a general solicitation is not involved in a Regulation D offering, the staff stated that the presence or absence of a general solicitation is always dependent on the facts and circumstances of each particular case. Thus, there may be facts and circumstances in which a third party, other than a registered broker-dealer, could establish a “pre-existing, substantive relationship” sufficient to avoid a “general solicitation.” However, in the absence of a prior business relationship or a recognized legal duty to offerees, the staff believes it is likely more difficult for an issuer to establish a pre-existing, substantive relationship, especially when contemplating or engaged in an offering over the Internet. Issuers would have to consider not only whether they have sufficient information about particular offerees, but also whether they in fact use that information appropriately to evaluate the financial circumstances and sophistication of the prospective offerees prior to commencing the offering. Issuers may therefore wish to consider whether conducting the offering under Rule 506(c) would provide greater certainty that an exemption may be available for the offering.
- Whether a demo day or venture fair constitutes a general solicitation for purposes of Rule 502(c) is a facts and circumstances determination. Of course, if a presentation by the issuer does not involve an offer of a security, then the requirements of the Securities Act are not implicated. Where a presentation by the issuer involves an offer of a security, the presentation at a demo day or venture fair may not constitute a general solicitation if, for example, attendance at the demo day or venture fair is limited to persons with whom the issuer or the organizer of the event has a pre-existing, substantive relationship or have been contacted through an informal, personal network such as an investment club or angel network. If potential investors are invited to the presentation by the issuer or a person acting on its behalf by means of a general solicitation and the presentation involves the offer of a security, Rule 506(c) may be available if the issuer takes reasonable steps to verify that any purchaser is an accredited investor and the purchasers in the offering are limited to accredited investors.
If you have any questions about how to establish a substantive pre-existing relationship with an investor or whether your securities offering constitutes a general solicitation or not, please feel free to contact me at email@example.com or by phone at 202-203-8665.