The Securities Act of 1933 (the “Securities Act”) requires that an offering of securities be registered with the Securities and Exchange Commission (the “SEC”) unless an exemption is available. Rule 506(b) of Regulation D is the most common “private placement” exemption that businesses use to raise money while avoiding securities registration.
Rule 506(b) allows issuers to raise an unlimited amount of money from an unlimited number of accredited investors, and up to 35 non-accredited investors so long as the non-accredited investors are “sophisticated.” If the issuer raises money from non-accredited investors, it must also provide detailed disclosure documents to all investors participating in the offering, potentially including audited financial statements.
As a condition of relying on the Rule 506(b) exemption, issuers are prohibited from engaging in general solicitation or advertising to promote the offering. Generally speaking, general advertising and solicitation occurs if the issuer publicizes the offering to anyone with whom the issuer does not have a “pre-existing, substantive relationship.” For example, if the issuer publishes an advertisement in a widely-circulated newspaper, trade journal, or Internet posting—or if the issuer draws prospective investors to a presentation or meeting via such a publication— the issuer has very likely engaged in general advertising and general solicitation. On the other hand, sending an email about the offering to 20 close friends probably does not constitute general advertising or solicitation. The question gets trickier when the issuer publicizes an offering such that information about the offering reaches people with whom the issuer has some relationship, but whom the issuer has not known well or for long.
According to SEC guidance, 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 SEC response to Question 256.29, Aug. 6, 2015.) 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. (See SEC response to Question 256.31, Aug. 6, 2015.) The SEC has noted that there are circumstances under which an issuer, or a person acting on the issuer’s behalf, can communicate information about an offering to persons with whom the issuer does not have a pre-existing, substantive relationship without having that information being deemed a general solicitation. For example:
The staff 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. For example, we acknowledge 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. 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. (See SEC response to Question 256.27, Aug. 6, 2015.)
Finally, SEC staff have stated that:
in the absence of a prior business relationship or a recognized legal duty to offerees, we believe 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. (See SEC response to Question 256.32, Aug. 6, 2015.)
So, what does this all mean?
If you are thinking of conducting a private placement in reliance on Rule 506(b) of Regulation D, be very careful of how and to whom you market that offering. Engaging in general advertising or solicitation surrounding the offering will cause you to blow the exemption, which will likely mean you are in violation of federal (and state) securities laws.
If you are finding that you cannot locate enough willing investors without broadening your reach, consider conducting an offering under a different exemption, such as Rule 506(c). (Though be wary of integrating multiple offerings… more on that in another post.) Like Rule 506(b), Rule 506(c) allows issuers to raise an unlimited amount of money from an unlimited number of accredited investors. Unlike Rule 506(b), Rule 506(c) permits general advertising and solicitation so long as the issuer proactively ensures that all investors ultimately purchasing securities are accredited.
More information on other potential options for raising money through a securities offering is available here.
Brian Edstrom is a Shareholder and Attorney at Avisen Legal, P.A. He brings to Avisen clients the ability to “speak regulator,” having spent several years working for federal and state regulators in Washington D.C. and Saint Paul, MN before entering private practice. Brian assists clients in all aspects of working with securities regulators, whether it be to obtain a license or registration, prepare for an audit, or respond to an enforcement investigation. Brian also regularly advises clients on their general business needs, particularly surrounding raising money through securities offerings.