- Fundamentals
- Posts
- ⚖️ 506(b): Who can you raise money from?
⚖️ 506(b): Who can you raise money from?
How to Comply with the “Pre-existing, Substantive Relationship” Test
Michael Huseby & Chris Schuering
January 17, 2025
Happy Friday, Funds Family!
Our clients often ask us what they can (and can’t) do when raising money.
In particular, the Rule 506(b) exemption of Regulation D prohibits sponsors from engaging in the “general solicitation” of investors. That begs the question…what counts as a public solicitation?
But first…
/ SELF PROMOTION
If you’re a general partner (GP) raising an investment fund or syndication in private equity, private credit, real estate, or venture capital, we may be a good fit for you. We also represent limited partners (LPs) investing in funds and syndications.
Thanks for reading, now let’s jump into the article 😃
⚖️ A brief refresher on the Securities Act
Raising an investment fund requires compliance with a long list of state and federal rules and regulations. One of those is the federal Securities Act of 1933. Check out this previous article on the ⚖️Securities Act.
To comply with the Securities Act, you must either (i) register the securities you are offering or (ii) find an exemption. One common exemption for funds and syndications is Rule 506(b) of Regulation D.
Rule 506(b) is what is known as a “safe harbor” exemption. Among other things, the sponsors of an offering relying on Rule 506(b) are prohibited from engaging in the “general solicitation” of investors.
Note: If you do want to publicly solicit investors for your investment opportunity, you should use Rule 506(c), ⚖️described here in detail.
📢 What is a “General Solicitation” and How Do You Avoid It?
To rely on the Rule 506(b) exemption, you cannot engage in the general solicitation of investors.
⛔️ This means you cannot advertise the offering via methods like the following:
Newspaper
Magazine
Podcast
Social media
Conference
Television
Seminar
Cold LinkedIn messages
Cold emails
Large investor lists
Online ads
Billboard
Beyond that, you (and your counsel) must examine the facts and circumstances surrounding all of your communications to determine if they are “general solicitations.”
🔗 Regulation D only provides a few examples of what might be considered a general solicitation or general advertising, so we have to dig deeper to determine what is and is not allowed. SEC no-action letters and staff Compliance and Disclosure Interpretations (“C&DIs”) are helpful, and that is where we start. ⚖️
What is a No-Action Letter?
The process starts when a private party’s attorney sends a letter to the SEC outlining a set of facts. The letter concludes with a request asking the SEC to advise the private party if their proposed action complies with the law. Then the SEC responds, and a favorable response says something like “in light of these particular facts, the SEC would take no-action against you.”
No-action letters are fact-specific and cannot be relied upon by other parties, but they give us a good idea of what the SEC is thinking, so attorneys utilize them when we advise clients.
🤝 Do you have a pre-existing relationship?
In April of 2012, the federal Jumpstart Our Business Startups Act (the “JOBS Act”) became law, and some of the restrictions on fundraising were altered soon thereafter (for example, Reg D was revised to include the 506(c) safe harbor ✅ ).
After the implementation of the JOBS Act, SEC Staff wrote the following in a C&DI:
“The existence of … 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. See Securities Act Release No. 6825 (Mar. 15, 1989), at fn. 12. 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).”
(See SEC Division of Corporation Finance Compliance and Disclosure Interpretations, Securities Act Rules, at Question 256.26).
🧐 What is a Pre-Existing, Substantive Relationship?
Establishing a pre-existing, substantive relationship with a prospective investor before you begin your current fundraising efforts is one way to comply with the prohibition on general solicitations. The SEC’s analysis is always based on the facts and circumstances of each particular sponsor’s actions, but no-action letters shed some light on how managers might be able to comply.
Prong 1: “Pre-Existing”
First, the relationship with the investor must be pre-existing. You might ask, pre-existing to what? Great question. Must the relationship exist before the commencement of the securities offering in general or only before the time the offering is communicated to a particular investor?
Many lawyers subscribe to the conservative approach and suggest that the relationship must exist before the commencement of the offering, but we suggest you discuss your facts with your attorney. 🧑⚖️
In a C&DI citing a no-action letter, the SEC staff stated the following:
“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. See, e.g., the E.F. Hutton & Co. letter (Dec. 3, 1985). [August 6, 2015]”
(See SEC Division of Corporation Finance Compliance and Disclosure Interpretations, Securities Act Rules, at Question 256.29) (emphasis added).
However, further clarifying this guidance, staff has said that in certain limited circumstances, a waiting period can alter the analysis. ⏰
In a 2015 SEC C&DI, staff noted:
“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]”
(See SEC Division of Corporation Finance Compliance and Disclosure Interpretations, Securities Act Rules, at Question 256.30) (emphasis added).
Ultimately, there is no explicit minimum waiting period and no magic timeline that will satisfy the test's “pre-existing” element. It’s a murky analysis. 🌫️
Prong 2: “Substantive”
The second prong of the test requires that the sponsor’s relationship with the investor must be “substantive.” The easiest way to understand this element is to consider the SEC’s purpose with this test, which is to protect investors. The SEC wants to ensure investors have the sophistication to analyze the risk involved in a private offering and the financial means to take on that risk. 📊
In a 2015 no-action letter, the SEC stated the following:
“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.” See Citizen VC, Inc., SEC No-Action Letter, Division of Corporate Finance, (August 6, 2015).
In that letter, the Division said that the sponsor should obtain and evaluate sufficient information from the prospective investor to determine the investor’s “financial circumstances and sophistication, in determining his or her status as an accredited or sophisticated investor.” Id.
The SEC has further affirmed that there are no specific forms or questionnaires that, if used by the sponsor, satisfy the test. Further, in another C&DI, SEC staff specifically noted:
“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. [August 6, 2015].”
(See SEC Division of Corporation Finance Compliance and Disclosure Interpretations, Securities Act Rules, at Question 256.31).
Vetting prospective investors is the key. Sponsors should engage in the process and do the work before commencing the offering to satisfy the “substantive relationship” element of the test.
🌐 A note on websites
Be careful that your general marketing does not constitute a general solicitation. The SEC staff has stated, for example, that a sponsor’s website may generally include factual business information so long as it does not “condition the public mind or arouse public interest in a securities offering.” (See SEC Division of Corporation Finance Compliance and Disclosure Interpretations, Securities Act Rules, at Question 256.24).
⚠️ In other words, don’t mention your fund, the fact that you’re fundraising, or anything else that rhymes with investment fund.
/ WRAPPING THE CASE
 |
|
Thanks for reading, everyone.
Have a great weekend! 🙌
/ ABOUT THE CO-AUTHOR
Chris Schuering
Chris is an experienced attorney specializing in fund and SPV formation, mergers and acquisitions, and real estate transactions. Licensed since 1996, Chris brings nearly three decades of legal expertise to the table, guiding GPs with a focus on efficiency and excellence.
With a unique perspective gained from representing both GPs and LPs, Chris provides additional value to clients by understanding fund formation from both sides of the table. His extensive career includes time at Locke Lord LLP and other prominent firms.
Chris holds a B.B.A. from the University of Notre Dame (cum laude) and a J.D. from the University of Illinois College of Law (magna cum laude). He now resides in West Central Illinois with his wife and four children. Outside of work, Chris is dedicated to family life.
You can reach Chris directly with any questions or inquiries at [email protected].
/ JURY TRIAL
How did you like today's post? |
Have you enjoyed this newsletter? Don’t forget to share it with your GP, Co-GP, LPs, or anyone else you think might find it valuable!
You can also propose a topic that you would like us to cover! Just reply to this email or submit your suggestions 🔗 here.
⚠️ Note: This newsletter is for informational purposes only and nothing should be considered legal advice. For that, hire a lawyer! I am a lawyer, but not your lawyer (unless I actually am your lawyer because you’ve signed an engagement letter and we’re working together). This newsletter may be considered attorney advertising.
Reply