Establishing Pre-existing and Substantive Relationship with Private Equity Investors in a Rule 506(b

Posted By: Byron Elliott, Esq. ICOR Blog & News,

Background. Rule 502(c) of the Securities Act of 1933 prohibits an issuer from offering or selling securities by any form of general solicitation or general advertising when conducting certain offerings exempt from registration under Regulation D. In 2012, Congress passed the JOBS Act, which directed the SEC to relax the prohibition against general solicitation and general advertising for certain offerings made in reliance on Rule 506 of the Securities Act. The amendments allow for private placements to be conducted in reliance on Rule 506(b) without general solicitation and general advertising and for certain exempt offerings to be conducted with general solicitation or general advertising in reliance on Rule 506(c). However, an issuer relying on the Rule 506(c) exemption and using general solicitation must limit sales to accredited investors and must take reasonable steps to verify that all investors are accredited. 


Definitions. Neither the JOBS Act nor SEC rules and regulations have explicitly defined the terms “general solicitation” or “general advertising.” However, Rule 502(c) provides some guidance by listing examples of communications that may be viewed as general solicitation and general advertising, including (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 meetings whose attendees have been invited by any general solicitation or general advertising.” Through a series of no-action letters, the SEC staff has provided guidance regarding the types of communications that would be viewed as constituting a general solicitation. The SEC staff considers the nature and breadth of a communication, based on factors such as the number of people who have received the communication, the relationship of those persons to the issuer or the issuer’s agent, the financial sophistication of such persons, and the physical form of the materials containing the communication. 


Pre-Existing Relationship. SEC staff guidance explains that a relationship is “pre-existing” if it was formed prior to the commencement of the issuer’s securities offering or was “established through either a registered broker-dealer or investment adviser prior to the registered broker-dealer’s or investment adviser’s participation in the offering.” The SEC staff further clarified that whether a relationship is pre-existing depends largely on whether there is “sufficient time between establishment of the relationship and the making of an offer so that the offer is not considered made by general solicitation or advertising.”


Establishment of a Pre-Existing Relationship. The SEC staff has noted there is no minimum waiting period required to demonstrate that a relationship is pre-existing, but, rather, “the relationship must be established prior to the time the registered broker-dealer or investment adviser began participating in the offering.” Many funds conduct continuous offerings, making it difficult to know exactly when an offering begins for all interested investors, so the SEC staff has established that the timing is determined on a per-investor basis. 


Substantive Relationship. A relationship is considered “substantive” if the issuer or its agent “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 SEC staff has indicated that the “quality of the relationship between the issuer (or its agent) and an investor” is the critical factor in evaluating whether a substantive relationship exists. 


Establishment of a Substantive Relationship. Implicit in broker-dealer interactions with customers lies an obligation to deal fairly with customers and to provide advice appropriate to the clients, which, according to the SEC staff, inherently “implies that a substantive relationship exists between a broker-dealer and customers.” Similarly, as a fiduciary, an investment adviser has the responsibility to adequately advise its clients. Likewise, the fiduciary duty necessitates an inquiry into that client’s financial situation and investment objectives that would satisfy the requirements of a pre-existing, substantive relationship. In contrast, for issuers who lack such an implicit duty, forming substantive relations with potential investors may be less organic and presumably more difficult. Issuers can successfully demonstrate a substantive relationship with their investors by proving that their investors meet specific suitability standards and that they had a good faith belief that each proposed offeree was sophisticated and able to evaluate the risks and merits of a potential investment. 


Do Written Material Distributed to Potential Investors Constitute General Solicitation? An offeror or its agents may distribute written materials to potential investors that are not intended to, and do not, have the effect of swaying investor decision-making with regard to an upcoming investment opportunity. The SEC staff noted that materials derived entirely from public record or even mainly from public research materials and public reports, and that omit substantive investment analysis and issuer information, could be spared the label of “general solicitation.” 


In contrast, the SEC staff has found that distributed printed materials that may influence the investment calculus of a potential investor may constitute “general solicitation.” These can be printed materials that don’t merely contain “data and calculations” but specifically provide “additional background on principals of the offering, the marketability of the investment, and any possible economic, corporate, tax or legal ramification” as a means of solicitation. Similarly, publishers may not set forth evaluations of an investment opportunity. Still, the boundary between “reciting public, factual information” and “providing a substantive evaluation” of an impending offering remains unclear. Where a publication has both provided factual information relating to an offering without an evaluation but employed suggestive information regarding the publication and the issuer, the SEC staff may be unable to ascertain whether dissemination of the material would constitute a general solicitation.  


A written communication that is delivered as part of a routine advertising campaign does not constitute general solicitation. Such exempt advertisements, including factual reports pertaining to the business or announcements of upcoming products and services, are routinely circulated as part of the ordinary course of business and will not constitute general advertising or general solicitation. Whether a written communication constitutes normal, permitted advertisement or general, prohibited advertisement depends heavily on the extent of offeror involvement in the distribution of the publication.  

Forms of Advertising that Constitutes Prohibited General Advertising. Advertisements communicated for the purpose of highlighting sales of securities or to solicit investors for a given offering constitute general advertising. Furthermore, communications about an offering shared with the general public without limitation, rather than to a targeted group of sophisticated investors, will likely constitute general advertising.  


Questionnaires. The SEC staff has permitted offerors and their agents to distribute generic print and electronic questionnaires for the purpose of verifying investor accreditation prior to the invitation of an investment opportunity. Generally, the SEC staff has declined to find questionnaires that have been generic in nature, without reference to specific private offerings or current investment offerings, distributed to professionals, businesspeople or those reasonably perceived to be sophisticated, and for the purpose of verifying investor accreditation, as general advertising. This conclusion likely would be different if the questionnaires were distributed by an issuer rather than by a broker-dealer, since it would be presumed that the issuer intends to conduct an offering. 


Cold-Calling. Usually, an offeror cannot engage in the “cold calling” of potential investors. Regardless of whether a pre-existing, substantive relationship has been established, any communication generally directed toward a large group of investors may be viewed as general advertising. An offeror may, however, engage in cold calling by limiting contact through a “targeted approach” or by contacting a certain group of recipients with a known interest, which can be reasonably viewed as accredited and sophisticated. 


Electronic Media and Internet. The use of electronic media or the internet to solicit investors will likely be considered general advertising unless certain precautionary measures are employed. The SEC staff has determined that an “offer conducted through an offeror’s unrestricted, publicly available website would constitute general advertising, even if the website required various forms of information from a prospective investor prior to displaying any offering materials.” The SEC staff has determined that websites that widely and publicly invite individuals to qualify as accredited investors may amount to general advertising. The SEC staff later echoed this sentiment and noted that a website that solely requires self-certification of accreditation will not be able to benefit from the Rule 506(b) safe harbor; rather, an offeror must “additionally implement policies that implement policies that ensure a comprehensive review of the accreditation and qualifications of any potential investor prior to any offering through a website or other electronic media outlets.” 


The SEC has afforded Private Equity Raisers an incredibly useful tool to raise capital from investors without having to file like a stock, bond or mutual fund, in the form of a Regulation D, Rule 506(b) of the Securities Act of 1933, however, it is imperative that new syndicators are mindful of the requisite conditions of using such an exemption.

For more information on how to legally and ethically raise money with private investors, feel free to contact our firm at