Frequently real estate syndication/fund clients ask who they can and cannot raise capital from when conducting a securities offering using Regulation D, Rule 506(b), which is considered a “safe harbor” under Section 4(a)(2) of the Securities Act of 1933. It provides objective standards that a securities issuer can rely on to meet the requirements of the Section 4(a)(2) exemption. Under Rule 506(b), issuers are prohibited from engaging in general solicitation or advertising to market its securities. Communication by an issuer or person acting on the issuer’s behalf with a prospective investor with whom the issuer or the issuer’s agent has a preexisting, substantive relationship, will not constitute a general solicitation
So, what is general solicitation or general advertising?
The Securities and Exchange Commission (SEC) rules and regulations have not expressly 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:
- 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 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 recent guidance regarding the types of communications that would be viewed as constituting a general solicitation. The SEC staff has issued guidance through no-action letters and Compliance and Disclosure Interpretations (C&DIs), focusing on the nature and breadth of communications.
Preexisting, substantive relationship
A relationship is “preexisting” if it was formed prior to the commencement of the 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 clarified that whether a relationship is preexisting 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.”
Establishing a preexisting relationship
The SEC staff has stated there is no minimum waiting period required to demonstrate that a relationship is preexisting, rather, “the relationship must be established prior to the time the registered broker-dealer or investment adviser began participating in the offering.” However, the SEC staff has provided further clarifying guidance indicated that in certain circumstances a waiting period can alter this analysis:
“The staff, however, has allowed a limited accommodation for offerings by private funds that rely on the exclusions from the definition of ‘investment company’ set forth in Sections 3(c)(1) and 3(c)(7) of the Investment Company Act. This limited accommodation permits an individual who qualifies as an accredited or sophisticated investor to purchase, after the end of a waiting period, securities in private fund offerings that were posted on a website platform prior to the investor’s subscription to the platform, in view of the fact that private fund offerings are made on a semi-continuous basis (quarterly or annually). See the Lamp Technologies, Inc. letter (May 29, 1997). [August 6, 2015]”
The SEC staff has also determined that evidence of a preexisting relationship may also be established by the issuer requiring investors to undergo a vetting process or complete a time sensitive questionnaire.
Substantive relationship
A relationship would be 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 “quality of the relationship between the issuer (or its agent) and an investor is the critical factor in evaluating whether a substantive relationship exists.”
An investor self-certifying as to his/her/its status as an accredited investor is not a sufficient manner in which to establish that a relationship is substantive. However, an issuer adding a period of time to establish a relationship after an investor completes a generic questionnaire would allow the issuer to consider such relationship substantive.
Establishing a substantive relationship
Issuers can successfully demonstrate a substantive relationship with their investors by proving
that the nature of an issuer’s relationship with an investor is evidenced, in part, by the determination by the issuer at the time of the investor’s investment the investor met certain suitability standards and by the belief by the issuer that each of the prospective investor currently has such knowledge and experience in financial and business matters that he, she or it is capable of evaluating the merits and risks of the prospective investment.
For an internet offering, the SEC Staff has determined that an issuer 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.”
Bottom Line
Preexisting, substantive relationships are required for all investors in an offering conducted under Regulation D, Rule 506(b), regardless of an investor’s financial qualifications. A prequalification questionnaire is not sufficient on its own. The manager or sponsor of the real estate syndication/fund must have sufficient information regarding the investor about his, her or its financial sophistication, circumstances, and suitability, and all of that must be done before making an offer.