Tag: Rule 502(c)

Pre-existing, Substantive Relationship

Rule 506(b) of Regulation D provides a safe harbor for issuers to engage in private placements. Private placements undertaken pursuant to Rule 506(b) are limited by Rule 502(c) of Regulation D, which imposes as a condition on offers and sales under Rule 506(b)that “… neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising…”

The SEC Staff has issued various interpretive letters that have tried to clarify the regulation. One of those was the statement that a general solicitation is not present when there is a “pre-existing, substantive relationship” between an issuer, or its [agent], and the offerees.

The SEC has published some Q and A’s on the topic. 256.31 says “substantive” means you have sufficient information to determine the offeree is an accredited or sophisticated investor. Blast emails to unknown investors would not be substantive.

As to the “pre-existing” prong, question 256.30 says there is no minimum waiting period, but there is a waiting period. The Lamp Technologies No Action letter in 1997 said that 30 days is sufficiently long to be pre-existing. (See Footnote 6). So somewhere between 0 days and 30 days is pre-existing enough, as long as you know the potential investor is accredited, to send information on offering.

There is also the question of what amounts to an offering. If it’s at the early stages of a fund, before its formed, perhaps there is no actual security sell. It’s hypothetical information about an upcoming offering.

This all circles back to the IR people asking whether they can leave a copy of the pitchbook for a fund at the initial meeting with an investor. I think the answer is generally “no”, unless you can show that there is a pre-existing substantive relationship with the investor. An initial meeting is generally the 0-day period, unless there has been a series of discussions prior to that initial meeting.

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On line portals for fundraising

As part of the updates on private placements, the Securities and Exchange Commission granted a no-action letter to Citizen VC, an online venture capital firm. The main question was whether the firm was creating “substantive, pre-existing relationships” with prospective investors through its website. The firm wanted to avoid a result that its offers & sales under Rule 506(b) would be considered general solicitation or general advertising under Rule 502(c) of Regulation D.

citizen vc

For CitizenVC the first step is a generic online “accredited investor” questionnaire.

That moves into the “relationship establishment period.” During that period CitizensVC may

  1. Contact the prospective investor by telephone to discuss the prospective investor’s investing experience and sophistication, investment goals and strategies, financial suitability, risk awareness, and other topics designed to assist CitizenVC in understanding the investor’s sophistication
  2. Send an introductory email to the prospective investor.
  3. Contact the prospective investor online to answer questions they may have about CitizenVC, the Site, and potential investments.
  4. Utilize 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.
  5. Encourage the prospective investor to explore the Site and ask questions about the Manager’s investment strategy, philosophy, and objectives.
  6. Generally foster interactions both online and offline between the prospective investor and CitizenVC.

Maybe it’s just me, but only 1 and 3 seem particularly meaningful and substantive. But the rest don’t hurt. Apparently it is enough to create a “substantive, pre-existing relationship” once the potential member is admitted as a member. A prospective Member is not presented with any investment opportunity when being qualified to join the platform.

I found it more meaningful that the minimum capital investment requirement is not less than $50,000 per deal. That means they are not targeting small investors.

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Updates on Private Placements

One of the troubling aspects of private placements is trying to draw the line between public advertising for the business and public advertising for selling securities. This aspect is even more apparent for private equity funds and real estate funds that want to tout their deals without jeopardizing their fundraising. The Securities and Exchange Commission offered some updated guidance.

private placement

The SEC published The 11 Securities Act Rules Compliance and Disclosure Interpretations that provide guidance on “general solicitation” under Rule 502(c)

Question 256.24 What information can an issuer widely disseminate about itself without contravening Rule 502(c)?

Answer: Information not involving an offer of securities may be disseminated widely without violating Rule 502(c). For example, 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). [August 6, 2015].

Which of course leads to the next question:

Question 256.25: What is factual business information?

Answer: 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. 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. (Release No. 33-5180). [August 6, 2015]

Not deep guidance, but it’s still guidance.

Questions 256.26 through 256.33 offer insight into the pre-existing, substantive relationship you need to avoid general solicitation.

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.

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The SEC is Looking at Advisers’ Use of Social Media

According to a story in Investment News, the Securities and Exchange Commission began a sweep of investment advisers’ use of social media and social networking last month.

The story hast a quote from Doug Flynn, an adviser at Flynn Zito Capital Management LLC, that is exactly on target for traditional investment advisers:

“I’d love to start tweeting to the general public once they can clearly tell me what I can and can’t do. However, putting yourself out there too much without specific guidelines is just not worth the risk.”

I don’t think the same is true for private fund managers who will soon have to register with SEC as investment advisers. How does the SEC’s regulation of Web 2.0 affect private fund managers once they register as investment advisers?

Not much.

Private funds are limited by the prohibition on general solicitation and advertisement.  They usually rely on Regulation D to keep from having to register the interests in their funds. Rule 502(c) of Regulation D states that “neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising, including, but not limited to, the following:

1. Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and

2. Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising. . . “

The very public nature of social media and social networking sites are going to put them squarely in the box limited by this regulation. Even though there is some ability for a fund manager to use social media under the Investment Advisers Act, that ability is curtailed by the limitations under the Securities Act. Certainly, fund managers and their personnel can use web 2.0 tools for personal reasons and business reasons not related to advertising their firm or its funds. (You will notice that I don’t publish posts about my firm or its funds.)

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Whether the Advertising or Solicitation Was General in Nature Under Rule 502(c)

Barnum and Bailey Limited Stock Certificate Earlier, I posted on Fund Raising Publicity. I ended by pointing out that Rule 502(c) prohibits general solicitation or general advertisement that occurs in connection with a Regulation D securities offering. This is to separate typical company advertising if a company advertises with no intention to “offer or sell the securities of the issuer” then such advertising should not violate rule 502(c). Yesterday, I focused on the first part of the analysis is Did Advertising or Solicitation to Offer or Sell Securities Occur?

This post focuses on whether the advertising or solicitation was general in nature.

The S.E.C. has interpreted Rule 502(c) to allow for non-general advertising, meaning advertising in which the issuer and offeree have a “pre-existing, substantive relationship.”

In 1982 the SEC gave no-action relief to a partnership that proposed to mail a written offer to three hundred and thirty people who had previously invested in another limited partnerships from the same sponsor. (Woodtrails -Seattle, No Action Letter, 1982 WL 29366, (Aug. 9, 1982)) The Commission found that these investors had a pre-established relationship with the general partner, who was described to have had a reasonable belief that the offerees were knowledgeable and experienced in financial matters.

In comparison, when a partnership dedicated to boarding, breeding, and training race horses sought to solicit investments by conducting a mailing to the Thoroughbred Owners and Breeders Association members, distributing brochures at a horse sale, and advertising in a horse racing trade journal The Commission did not give relief. Aspen Grove, No-Action Letter, 1982 WL 29706 (Dec. 8, 1982). So related interests alone are not enough to create a substantive relationship.

“The types of relationships with offerees that may be important in establishing a general solicitation has not taken place are those that would enable the issuer (or a person acting on its behalf) to be aware of the financial circumstances or sophistication of the person with whom the relationship exists or that otherwise are of some substance and duration.” Mineral Lands Research & Marketing Corp., S.E.C. No-Action Letter, 1985 WL 55694 (Dec. 4 1985).

The other alternative is the use of a broker-dealer. A broker-dealer may establish a relationship through general advertising or general solicitation, so long as such solicitation does not promote the offer or sale of securities. The broker-dealer can then solicit information from a potential investor to see if they have sufficient financial circumstances or sophistication. “A satisfactory response by a prospective offeree to a questionnaire that provides a broker-dealer with sufficient information to evaluate the respondent’s sophistication and financial situation will establish a substantive relationship.” H.B. Shaine Co., S.E.C. No-Action Letter, 1987 WL 108648 (May 1, 1987). The questionnaire cannot be too general otherwise you won’t be able to determine if the offering would be appropriate in light of the suitability standards established by the issuer . Questionnaires to potential investors must be “generic in nature” and can “not make reference to any specific investment currently offered or contemplated for offering.” Bateman, S.E.C. No Action Letter, 1985 WL 55679 (Dec. 3, 1985).

The consequences of making a general solicitation or general advertisement can be seen an administrative action taken against Kenman Corporation. The SEC found that Kenman violated Section 5 of the Securities Act by engaging in a public offering without registration. Kenman’s offering did not qualify for exemption under Regulation D or Section 4(2) because the SEC determined that Kenman had engaged in general solicitation. They had mailed materials to  a large number of people taken from a list of executive officers of Fortune 500 companies, a list of physicians, a list of company presidents in a certian area and other general lists. Kenman Corp. Administrative Proceeding File No. 3-6505 (Apr. 19, 1985)


The image is Barnum and Bailey Limited Stock Certificate in the public domain and available on Wikimedia Commons.

Advertising or Solicitation to Offer or Sell Securities Under Rule 502(c)

BirminghamMotorsStock.jpeg Stock certificate for 10 shares of Birmingham Motors automobile company

Yesterday, I posted on Fund Raising Publicity. I ended by pointing out that Rule 502(c) prohibits general solicitation or general advertisement that occurs in connection with a Regulation D securities offering. This is to separate typical company advertising if a company advertises with no intention to “offer or sell the securities of the issuer” then such advertising should not violate rule 502(c).

The first part of the analysis is Did Advertising or Solicitation to Offer or Sell Securities Occur?

In one example, Printing Enters. Management Science Inc. wanted to engage in promotional activities relating to the products and services that it offered. Since these promotional activities were to occur simultaneously with a private securities offering, the SEC was confronted with the question of whether these marketing activity were intended to facilitate the offer or sale of securities. (Printing Enters. Management Science, Inc., No Action Letter (issued Apr. 25, 1983)).The SEC declined to grant no-action relief stating that it could only evaluate whether the advertisement was in direct support of an offer or sale of securities by evaluating all the specific facts surrounding this promotion.

The SEC expanded the coverage of Rule 502(c) in its Gerstenfeld No-Action letter (Gerstenfeld, No-Action Letter, 1985 WL 55681 (Dec. 3, 1985)), explicitly prohibiting advertisements that occurred even when a private placement was not simultaneously occurring. In Gerstenfeld, a syndicator wished to place an advertisement generally stating that it sells securities, and inviting parties to contact the syndicator for further information. The SEC declined to recommend no-action.The staff concluded that the advertisement constituted a “general” advertisement and was designed to sell securities of entities that are, or will be, affiliated with the syndicator. It did not matter whether the syndicator was then in the process of selling partnership interests since the primary purpose of the advertisement is to sell securities and to condition the market for future sales.

In Alma Securities Corp. (August 2, 1982) the Staff took the position that tombstone advertisements published following the completion of a private placement could violate Rule 502(c) if they help solicit investors to invest in contemporaneous or future offerings. As stated by the staff, “where a sponsor or issuer conducts an ongoing program of private or limited offerings, tombstone announcements for the completion of each individual offering could be used to solicit investors to the program as a whole.”

The advertisement need not be one from the issuer. Third party advertisement can also cause problems. The SEC has declined to provide no-action relief regarding whether an advertisement would violate Rule 502(c) if the issuer did not sponsor the advertisement and it was published in an independent source (Oil and Gas Investor, No-Action Letter (Jan. 23, 1984)). The SEC declined to provide no-action relief to a question regarding whether an independent source could distribute reviews and analyses of various private offerings to a limited group of paid subscribers. (Tax Inv. Information Corp., No Action Letter, 1983 WL 29834 (Feb. 7, 1983)). The SEC seems to review these on a case by case basis.

Image is a Stock certificate for 10 shares of Birmingham Motors in the public domain, available on Wikimedia Commons.

Fund Raising Publicity

1903 stock certificate of the Baltimore and Ohio Railroad

Under the U.S. securities laws, it is important for private investment funds to avoid engaging in a “general solicitation” or “general advertising” prior to and during fund raising. The key to private investment funds and the private offering of interests in the funds is that they are “private.”

Assuring the private nature of an offering means that not only the issuer, but any party acting on its behalf, must refrain from generally soliciting potential purchaser. This means that a fund and its agents (which includes all management, personnel, placement agents,attorneys, accountants and other representatives) must be careful during the fund raising period not to make statements to the general public with regard to an investment in a fund.

Rule 502(c) of Regulation D states the limitation as “neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising, including, but not limited to, the following:

1. Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and

2. Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising. . . “

If a fund or its agents make statements that could be viewed as a “general advertising” or “general solicitation”, the SEC could impose a “cooling-off period.” This would typically mean a cessation of all fundraising and a moratorium on fund closings for a period of several months. A “general solicitation” could also trigger registration of the fund sponsor or the fund under the Advisers Act or the Investment Company Act.

The SEC has indicated that it believes that the following actions violate Rule 502(c):

1. Mass mailings

2. Speaking to the media about a solicitation when funding or investment matters are discussed, whether such speech is directed at current fundraising efforts or deemed to be an attempt to “condition the market” by making reference to the success or attractive return of previous investments.

3. Print, radio and television advertisements or solicitations regarding funding or investment matters

4. Tombstone advertising (an ad which does no more than give the barest of information) is held by SEC staff to “condition the market” for the securities and therefore constituted an offer even though the tombstone did not specifically mention the transaction in question.

Rule 502(c) prohibits general solicitation or general advertisement that occurs in connection with a Regulation D securities offering. This is to separate typical company advertising if a company advertises with no intention to “offer or sell the securities of the issuer” then such advertising should not violate rule 502(c).

The image is a 1903 stock certificate of the Baltimore and Ohio Railroad in the public domain and available on Wikimedia Commons.