Richard M. Leisner
In August 6, 2015, the SEC Division of Corporation Finance issued an interpretive letter to Citizen VC concerning exempt private offerings under Rule 506(b). In the following guest post, Richard M. Leisner takes a look at the SEC’s new interpretive guidance for these types of exempt offerings and suggests how best practices might evolve for permissible general solicitation activities in future Rule 506(b) private offerings that will not violate the prohibitions of Rule 502(c). Leisner is a shareholder with the Tampa office of Trenam Law. The article summarized below is scheduled for publication in Securities Regulation Law Journal, Summer 2016 Edition, a Thomson Reuters Publication. For more information about this publication please visit www.legalsolutions.thomsonreuters.com. This article also is posted on the Trenam Law website Legal Update available here.
I would like to thank Richie for his willingness to publish his article on this site as a guest post. I welcome guest post submissions from responsible authors on topic of interest to this site’s readers. Please contact me directly if you would like to submit a guest post. Here is Richie’s guest post.
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On August 6, 2015, without fanfare, the SEC Division of Corporation Finance issued an interpretative letter to Citizen VC[1] and posted several updates to the Division’s Compliance and Disclosure Interpretations (the “Companion C&DIs”[2]), all concerning the nuts and bolts of exempt private offerings, principally under Rule 506(b).[3] The first wave of professional commentary was uniformly positive, applauding the SEC for providing helpful guidance.
Citizen VC Overview
Some commentators have reported that the Citizen VC guidance significantly changed the overall compliance landscape for a key requirement of Rule 506(b) private offerings – that under the requirements of Rule 502(c) offers and sales must be made without the use of “general solicitation or general advertising.”[4] They see Citizen VC and the Companion C&DIs as a compliance roadmap for any issuer to contact an unlimited number of prospective investors via impersonal non-selective means (e.g., the internet) without jeopardizing Rule 506(b) compliance. When undertaken in accordance with the guidance in Citizen VC, such activities, they assert, will be deemed not to involve “general solicitation or general advertising” within the meaning of Rule 502(c).[5]
Others have a less expansive view about the general applicability of the Citizen VC and Companion C&DIs’ guidance to conventional issuers and companies other than registered broker-dealers or similar third-party financial intermediaries.
It is too soon to know the-long term compliance effects of Citizen VC and the Companion C&DIs. Today is a good time, however, for careful analysis of these recent SEC pronouncements and their underlying rationale and regulatory provenance.
With this analytical foundation, this article suggests how best practices for conventional issuers might evolve for permissible general solicitation activities in future Rule 506(b) private offerings that will not violate the prohibitions of Rule 502(c).[6]
Citizen VC and Companion C&DIs in Detail
Citizen VC’s counsel asked the Division of Corporation Finance to concur with counsel’s conclusion that certain planned policies and procedures in Rule 506(b) private offerings, conducted through a password-protected internet site were not impermissible general solicitation prohibited under Rule 502(c).[7] Counsel explained the policies and procedures were aimed at establishing substantive, pre-existing relationships with prospective investors.
The Division’s staff[8] did not respond directly to counsel’s request for concurrence. Instead, the staff’s response letter reviewed and commented favorably on certain of the statements and analyses in Citizen VC’s incoming letter. Reading the incoming request letter, and the staff’s response and the Companion C&DIs in pari materia tell Citizen VC’s plans and also reveal the staff’s views about several of the most important issues:
(1) The quality of the relationship between an issuer (or its agent) and an investor is the most important factor in determining if a “substantive” relationship exists;
(2) A “substantive relationship,” in the context of determining accredited investor status, is one in which the issuer (or its agent) has sufficient information to evaluate, and does evaluate, a prospective offeree’s financial circumstances and investment sophistication;[9]
(3) A “pre-existing substantive relationship” is one that is established before the commencement of the offering of securities;[10]
(4) Citizen VC’s proposed policies and procedures described in the incoming letter are designed to evaluate prospective investors’ investment sophistication, financial circumstances and ability to understand the nature and risks of the securities to be offered (but noting that whether such an evaluation has in fact occurred depends on the particular facts and circumstances);
(5) There is no specific minimum amount of time required before a substantive relationship may be established;[11]
(6) A single question self-accreditation document cannot be relied upon as the sole basis for establishing a substantive relationship;[12]
(7) No investment opportunity would be presented to a prospective investor from the time of initial contact though the process of establishing a substantive relationship (becoming a “Citizen VC Member”); and
(8) Any investment opportunity would only be presented after the prospective investor becomes a Citizen VC Member and any such investment would be in a particular company and not as an investment in a blind pool for a later-determined investment opportunity.
The simultaneous release of the Companion C&DIs reinforced several of the key Citizen VC principles and, in addition, addressed important general solicitation issues not specifically addressed in the facts of the Citizen VC request letter.[13]
Each of the important principles and concepts in Citizen VC and the Companion C&DIs had been expressed to some degree in prior no-action and interpretative letters or SEC releases, most of which had been issued decades before Citizen VC (collectively, as noted below, the “Legacy Interpretative Advice”).[14] Nevertheless, Citizen VC and the Companion C&DIs may be seen as a watershed in SEC staff interpretative advice regarding private offerings. In Citizen VC and the Companion C&DIs the staff provided helpful guidance in several important areas:
First, the staff confirmed the continuing vitality of certain key positions previously announced in the Legacy Interpretative Advice;
Second, the staff collected and re-introduced the most important of the principles from the Legacy Interpretative Advice in a single letter (along with the Companion C&DIs);
Third, the staff updated its views in the Legacy Interpretative Advice regarding impersonal, non-selective solicitations conducted via mass mailing and telephone cold calling, and applied such views to impersonal, non-selective solicitations conducted via the internet;
Fourth, the staff stated that, although it was difficult, it was possible that an entity other than a registered broker-dealer or similar third-party financial intermediary (i.e., a conventional issuer) could establish pre-existing substantive relationships with prospective investors without engaging in general solicitation in violation of Rule 502(c);[15]
Fifth, the staff confirmed that there was no minimum waiting period between the time that a pre-existing substantive relationship was successfully established and when an offer of securities could be made without violating the prohibition against general solicitation of Rule 502(c);[16]
Sixth, the staff reaffirmed its long-standing position that the ultimate determination about pre-existing substantive relationships and the existence (or non-existence) of general solicitation were both dependent on “all the facts and circumstances”; and
Seventh, the staff provided definitions of the elements comprising a “pre-existing substantive relationship”: When, before any offer[17] to sell securities is made, there is sufficient information to evaluate a prospective investor’s financial circumstances and investment sophistication (and such evaluation actually occurs); but, such a relationship may not be established solely by a prospective investor’s self-certification (i.e., just “checking a box”).[18]
Pre-Existing Relationships – Before Citizen VC
From the dawn of the federal securities laws, the relationship between the issuer and prospective investors has been seen as an important element – among all the facts and circumstances to be considered – in establishing compliance with the private offering exemption.[19] The issuer-investor relationship concept was further developed in the Legacy Interpretative Advice. It provides the regulatory provenance for the prior business or substantive relationship concept and its “no general solicitation” consequences discussed in Citizen VC and the Companion C&DIs.
It not clear how and when one of several important concepts in establishing an exempt private offering (the relationship between the issuer and prospective investors) was transformed to provide the basis for the staff’s current positions that: (1) impermissible general solicitation cannot occur if the appropriate substantive pre-existing relationship between the issuer and the prospective investor has been achieved and (2) impersonal general solicitation activities could be used to establish such relationships so long as no “offer” were made before establishing the relationship.
Neither the language of Regulation D nor its explanatory provisions that provide examples of improper general solicitation refers to the concepts of (1) “pre-existing substantive or business relationships” or (2) the “no general solicitation” conditional consequences once such relationships exist. There is no mention of any of these concepts in the 1982 Release adopting Regulation D or in the 1981 Proposing Release. To the knowledge of the author, published references to the concepts by the staff first occurred in 1982 in Woodtrails-Seattle, Ltd. (as a “pre-existing business relationship”) and were cited with approval in subsequently issued no-action letters and releases comprising the Legacy Interpretative Advice.
Regulation D was adopted in the spring of 1982. In 1983, the staff issued a detailed series of Q&A interpretations.[20] The staff stated that (1) general solicitation activities without any offer of an investment opportunity will not violate the restrictions of Rule 502(c) and (2) offers to sell securities to substantial numbers of persons with whom the issuer had a “pre-existing business relationship” also will not violate the restrictions of Rule 502(c). In the introduction to questions and answers about Rule 502(c), the staff put it this way:
The analysis of facts under Rule 502(c) can be divided into two separate inquiries. First, is the communication in question a general solicitation or general advertisement? Second, if it is, is it being used by the issuer or by someone on the issuer’s behalf to offer or sell the securities? If either question can be answered in the negative, then the issuer will not be in violation of Rule 502(c).
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In analyzing what constitutes a general solicitation [in Seattle-Woodtrails], the staff . . . underscored the existence and substance of the pre-existing business relationship between the general partner and those being solicited. The general partner represented that it believed each of the solicitees (sic) had such knowledge and experience in financial and business matters that he or she was capable of evaluating the merits and risks of the prospective investment. (Citation to Seattle-Woodtrails omitted).[21]
In the several decades following the Reg D 1983 Q&A Release, the SEC addressed general solicitation issues episodically in no-action and interpretative letters, formal releases and informal staff pronouncements (including materials identified as Legacy Interpretative Advice[22]). The 2000 Electronic Media Release provided a measure of clarity by collecting and summarizing the staff’s views on past releases and no-action letters. In this release, the staff announced the position that “general solicitation is not present” when the appropriate pre-existing business or substantive relationships exist between issuer and prospective investors.[23]
The collected components of the Legacy Interpretative Advice, while helpful, were still subject to a number of compliance uncertainties. In carefully reviewing the language in the staff’s periodic considerations of general solicitation issues that span more than 20 years, it is hardly surprising to find some inconsistencies. Word-search reviews of the documents comprising the Legacy Interpretative Advice reveal a variety of similar (but not identical) terms used to identify the appropriate relationships between issuers and prospective investors. A variety of adjectives are used, including, “existing, prior or pre-existing.” The adjectives modify nouns including “business relationship, business or personal relationship, substantive relationship, substantive business relationship and pre-existing substantive relationship.”
The author has found nothing in the Legacy Interpretative Advice to suggest that the varying terms were intended to have materially different meanings from the more clearly identified language – “pre-existing substantive relationship” – used in Citizen VC and the Companion C&DIs. However, the author found no consistent staff exposition in any of the Legacy Interpretative Advice documents of the criteria now detailed in Citizen VC and the Companion C&DIs as comprising the behavioral building blocks of “pre-existing substantive relationships.”
As noted above, in some instances in the Legacy Interpretative Advice, the appropriate relationship is identified as a “business relationship” (sometimes appearing along with the adjective “substantive”). However, neither Citizen VC nor any of the Companion C&DIs use the term “business” in conjunction with “relationship.”
Historically, the use in the Legacy Interpretative Advice of the term “business” in conjunction with the pre-existing relationship concept led many practitioners to be concerned that non-business relationships (e.g., churches, service or civic organizations or country clubs) might not provide a basis for establishing the appropriate relationships.
There is no pronouncement in either Citizen VC or the Companion C&DIs disavowing the requirement for the substantive relationships to be rooted in business relationships.[24] However, the total absence of the word “business” in conjunction with the definition of substantive relationship in these most recent pronouncements appears to have put the “business relationship” issue to rest. Accordingly, it should be safe for practitioners to advise that social, civic, religious and other “non-business” dealings are acceptable bases for establishing the appropriate substantive relationship with prospective investors.
Finally, it bears noting that financial wherewithal and investment sophistication of prospective investors – important elements in the current formulation of a pre-existing substantive relationship – were not consistently identified by the staff in the Legacy Interpretative Advice as important issues to establish the required relationships.
Some commentators have opined that Citizen VC and the Companion C&DIs are “nothing new” – not much more than modest (but welcomed) clarifications of well-established concepts and staff positions.
In the author’s opinion, such sanguine observations fail to consider, as discussed above, the important differences between the language and logic of the Legacy Interpretative Advice and Citizen VC and the Companion C&DIs. These most recent pronouncements use greater precision in both their terminology and substantive elements than are present in the Legacy Interpretative Advice. In addition, the absence of the need for the relationship to be a “business relationship” and the addition of the need to determine appropriate financial wherewithal and investment sophistication is each a significant change. Finally, and possibly of greatest importance, the staff has issued a favorable interpretative letter to an entity other than a registered broker-dealer or investment adviser.
Pre-existing Substantive Relationships – Today
Citizen VC and the Companion C&DIs cleared away several of the past uncertainties and inconsistencies in the Legacy Interpretative Advice. To start with, the staff consistently used the term “pre-existing substantive relationship.” In addition, as noted above, the term “business” had been removed from the formulation.
More significantly, the staff provided specific definitions for the key terms “substantive” and “pre-existing,” each as used to modify the term “relationship”:
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.[25]
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). (emphasis added)[26]
Today’s formulation of the “pre-existing substantive relationship” concept is the linchpin for the future application of the concepts and principles in Citizen VC and the Companion C&DIs. Conduct inside such a relationship benefits from an interpretative vaccination against being treated as impermissible general solicitation.
Activities undertaken to properly establish these relationships that are free from any “offer” to sell securities may use impersonal communications (e.g., open internet solicitations, mass mailings or cold calling campaigns). Indeed, such communications may be directed to an unlimited number of prospective investors who are total strangers to the issuer without running afoul of the general solicitation prohibition of Rule 502(c).
As noted above, this regulatory vaccination against the presence of impermissible general solicitation is subject to two important provisos – First, the relationship cannot be established by self-certification alone (checking the box).[27] Second, the conduct establishing the relationship cannot involve an “offer” to sell securities. Neither of these provisos, as noted above, was viewed as a significant impediment by counsel to Citizen VC and experienced practitioners are likely to have similar views.
In any event, after the establishment of the appropriate pre-existing substantive relationship, Rule 502(c) places no limit on the number of properly qualified prospective investors that may be contacted or the means by which communications are had with them. In these circumstances, the conduct in question is “not general solicitation” prohibited by Rule 502(c).
Questions have been raised about the requirement that the substantive relationship has to be established “prior to the commencement of the offering,” and in the case of broker-dealers, before “participating” in the offering.[28] There is no reference in Citizen VC regarding the timing of the establishment the substantive relationship with prospective investors and the “commencement” of a particular offering. There is no guidance in the Companion C&DIs about the operation of the phrases “commencement of the offering” and “prior to participating” in the offering vis-à-vis the establishment of substantive relationships. To date, there has been no formal staff guidance regarding these phrases. The concept of what particular conduct constitutes “commencement” is important in several securities law contexts, such as in IPOs, secondary offerings, rights offerings and tender offers (the consideration of which are beyond the scope of this article).
In the context of Rule 506(b) offerings, has an offering “commenced” if no prospective investor is offered an opportunity to invest but the contours of the offering have been determined and exist on the password-protected pages of a secure website? If this inquiry is answered affirmatively, compliance would have the effect of lengthening the offering process. The investor qualification process would have to be completed as to all prospective investors before establishing the terms of the subject offering and beginning to communicate with qualified prospective investors about investing in the offering. This interpretation would make the mechanics of Rule 506(b) offerings akin to a merry-go-round ride at the county fair: riders were allowed to get on the ride before the music started and the ride began to spin; once the ride began to spin, no additional riders were permitted.
Alternatively, the concept of “commencement” could be considered on a one-at-a-time basis for each prospective investor and be determined co-extensively with whether an “offer” has been made. Applying this interpretation, an offering would be seen as “commencing” for each prospective investor only when the elements of an offer are present. [29]
Current uncertainties concerning the operation of “commencement of the offering” and “participation in the offering” await further development.
Numbers, Numbers, Numbers
Neither Citizen VC nor any of the Companion C&DIs focused on “actual numbers.” There is no discussion of how many prospective investors might be contacted to begin with, how many might begin the qualification process or the actual number that might ultimately be presented with investment opportunities. The same is generally true for the Legacy Interpretative Advice no-action letters. The reason for this lack of concern with “numbers” is simple: In each situation, the conduct in question was believed not to involve impermissible general solicitation, allowing solicitation of an unlimited number of prospective investors.
Particularly before Citizen VC, most conventional issuers and their advisers seeking to raise capital in Rule 506(b) all accredited investor private transactions found themselves in a regulatory environment that did not allow them to take advantage of the general solicitation relief afforded in the Legacy Interpretative Advice to registered broker-dealers. As a result, conventional issuers had to be concerned with “actual numbers.”[30]
Before the adoption of Regulation D, private offering exemption compliance applied investor qualification criteria to offerees as well as investors. This requirement necessitated keeping track of each individual offeree to confirm satisfaction of the applicable qualifications (e.g., wealth and investment sophistication). Regulation D removed all offeree qualification criteria and allowed contact to be made with an unlimited number of offerees, subject to one “small” caveat – that no form of general solicitation be used in connection with the offer or sale of securities.
Despite the fact that offerees do not “count” under Regulation D generally, and in particular, in an all accredited investor offering under Rule 506(b), the prohibition against general solicitation compels conventional issuers to have a continuing concern with “numbers.”
Offerees “count” in determining if there has been impermissible general solicitation, assuming that each offeree has been solicited to consider purchasing the securities that are the subject of the offering. Even if offerees no longer had to be qualified as to financial wherewithal or investment sophistication, contacting “too many” offerees risked being found to constitute impermissible general solicitation under Rule 502(c). Concerns with “numbers” among practitioners did not abate even if offerees were contacted one-at-a-time or even if there was relative certainty that every member of a large group of offerees was an accredited investor (such as an annual meeting of the partners of a national accounting firm).[31] How many would be too many, of course, would depend on the particular facts and circumstances. Careful practitioners advise that the number would almost certainly be smaller if the prospective investors were not personally known to the issuer or if impersonal means of solicitation were used (i.e., mass mailings, cold calls or internet emails).
From the earliest days of using Regulation D in 1982, experienced counsel had little difficulty reminding clients to avoid the activities well understood to involve impermissible general solicitation, such as open meetings attended by large numbers of unqualified prospective investors or advertisements in newspapers, on TV or in other mass media and, of course, after the mid-1990s, impersonal internet-based solicitations.[32]
From the prospective issuer’s point of view, advising against conduct certain to violate Rule 502(c) often leaves unanswered issuer clients’ typical “numbers” questions:
In specific numbers, many prospective investors may be contacted without engaging in general solicitation prohibited by Rule 502(c)? If 10 personal friends are OK, but 300 acquaintances are too many, how about 30 relatively close friends? How about 50 slightly less close friends?
Careful practitioners answer “Once you have more than 10 personal friends, it depends on all the facts and circumstances.”
Consider several typical “numbers” scenarios clients may ask about and think what your responses might be if you were this issuer’s counsel:
· Two dozen golfing buddies. How about the wealthy client who suggests one-on-one contacts with two dozen long-time golfing buddies who all belong to the same exclusive country club?
For a variety of reasons, most practitioners would be comfortable with the “numbers” in this golfing buddy hypothetical. The absolute number is not great; there is a relationship that pre-dates any securities offering; the prospective investors are likely to be as wealthy as the client and, based on what your client knows from years of informal discussions in the locker room, reasonably likely to be sophisticated when it comes to investments. A short conversation with the client about other “facts and circumstances” can be expected to increase counsel’s comfort level.
When clients modify fact scenarios, counsel is pushed toward “it depends on all the facts and circumstances” answers.
· 400 Country Club Members. What if the two dozen golfing buddies are expanded a bit to include all 400 members of the exclusive country club, most of whom the client says he knows “fairly well,” either socially or through business dealings?
· 1,000 Congregants. How about the 1,000+ members of the church or synagogue attended by the issuer’s CFO? Would it make any difference if the CFO was only a sometimes attendee, but the CFOs non-employee brother-in-law is a very active congregant and offers to take the client’s senior officers to meet all the most important opinion leading congregants?
· 1,000 Best Customers. What about the 1,000 best customers of the client’s chain of 150 women’s high-end retail clothing stores? Would it make any difference if the client’s business was manufacturing and directly selling large bulldozers and other earth-moving devices, each costing several hundred thousand dollars?
· This is not an offer. Would it make any difference if, in each of the foregoing scenarios, the client made sure that all face-to-face discussions with prospective investors omitted specifics about price and terms for the securities and simply asked if prospective investors were interested in finding out more about the client’s business? What if all written communications (internet emails) omitted any reference to the nature of the securities, size of the offering, price, etc. and included a bold legend to the effect that the communications were not an offer to sell securities and offers could only be made after the prospective investor met certain criteria?
Many businesspeople believe none of the examples noted above involve “real” general solicitation. The author has been told by more than one client, “It’s not as if I am taking out an ad in The Wall Street Journal offering to sell common stock in my company for $10 per share.”
Careful counsel, for Rule 502(c) purposes, might find “issues” with each of the hypothetical scenarios outlined above that dealt with more “numbers” than the initial two dozen golfing buddies hypothetical. In responding, counsel would want to develop more facts and circumstances. In this regard, careful attorneys are ever mindful that violation of the Rule 502(c) prohibition on general solicitation destroys the exemption for all investors in the affected offering, not just the investors who were improperly solicited. When in doubt, most securities attorneys advise against conduct in the “gray areas” of general solicitation.
Should it Matter Who Makes the Solicitation?
Before Citizen VC, the pre-existing business relationship pathways of permissible general solicitation, despite the obvious benefits and advantages, were not widely traveled by conventional issuers. The problem was not so much satisfying the elements to build the appropriate relationships but rather limitations on the entities that could travel the pathways.
Before Citizen VC, with rare exception, only registered broker-dealers, their affiliates or other similar financial professionals were recipients of favorable general solicitation no-action or interpretative letters.[33] The favorable Legacy Interpretative Advice no-action and interpretative letters were issued to broker-dealers or similar third-party financial professionals.[34] To the author’s knowledge, prior to Citizen VC no conventional issuer had received a favorable letter. [35] Informally, senior staffers echoed the negative responses received by conventional issuers and reinforced the logic for limiting favorable letters to registered broker-dealers and other financial professionals.
The activities of broker-dealers or similar intermediaries were seen by the staff as a buffer between prospective investors and the issuers of securities. The SEC’s 2000 Electronic Media Release commented on permissible activities in conducting Regulation D private offerings.[36] After first noting that “a general solicitation is not present when there is a pre-existing, substantive relationship between an issuer, or its broker-dealer, and the offerees,” the SEC focused on the special role played by financial intermediaries:
“[T]raditional broker-dealer relationships require that a broker-dealer deal fairly with, and make suitable recommendations to, customers, and, thus, implies that a substantive relationship exists between the broker-dealer and its customers.” [37]
For registered broker-dealers, part of their normal dealings with customers would be gathering facts regarding prospective customers’ financial wherewithal and investment sophistication.[38] From the staff’s perspective, such required regulatory broker-dealer factual inquiries could be undertaken without making an “offer” to sell securities to the customer. Conventional issuers were not subject to these regulatory obligations.
Following the guidance in the first several favorable no-action letters in the Legacy Interpretative Advice, broker-dealers refined their use of impersonal non-selective general solicitation activities such as “cold-calling” and impersonal direct mail campaigns to solicit prospective investors to establish substantive relationships.
The author has received many “cold calls” from broker-dealers pursuing this scenario. The broker introduces herself (or himself) and almost immediately announces “I don’t want to sell you anything; I just want to find out a bit more about you and your investment objectives.”
After the initial contact, the broker-dealer could use additional telephone calls and mail exchanges (and after the mid-1990s, the internet and email) to obtain information about the financial wherewithal and investment sophistication of the prospective investor, thereby successfully establishing the substantive (business) relationship before making an offer to sell securities. After the establishment of the substantive (business) relationship, future securities offering communications with prospective investors would not be treated as general solicitation prohibited by Rule 502(c).
In 1997 and 1998, the Division of Investment Management, joined by the Division of Corporation Finance, provided favorable no-action letters to Lamp Technologies, a data processing and web site developer involved in the investment fund industry that was not registered as a broker-dealer.[39] Lamp Technologies planned to use a password-protected internet site to provide information about private investment funds to prospective investors in such funds. The prospective investors were to be prequalified as accredited investors before being granted access to the website. The staff agreed that the proposed activities would not constitute impermissible general solicitation prohibited by Rule 502(c).
Two years later, the SEC issued the 2000 Electronic Media Release on April 28, 2000, providing staff guidance on the interaction of the internet and other new technologies with the federal securities laws. The Release comprises 28 single-spaced pages of 10 pt. type. Although fewer than two pages are devoted to private offerings, several of the Legacy Interpretative Advice letters are mentioned in the text or footnotes, including the Lamp Technologies letters.
The several years between the Lamp Technologies letters and the 2000 Electronic Media Release afforded the staff a prescient opportunity to consider the possibility of extending to other non-broker-dealers the procedures endorsed in the Lamp Technologies letters.[40] Instead, in criticizing unprotected websites purporting to comply with the requirements noted in favorable no-action letters (including Lamp Technologies), the staff emphatically limited the application of the Lamp Technologies letters to their particular circumstances:
We understand that securities lawyers may have interpreted staff responses to Lamp Technologies, Inc. as extending the “pre-existing, substantive relationship” doctrine to solicitations conducted by third parties other than a registered broker-dealer. . . . We disagree. In the Lamp Technologies no-action letters, the staff of the Divisions of Investment Management and [the Division of] Corporation Finance recognized a separate means to satisfy the “no general solicitation” requirement solely in the context of offerings by private hedge funds that are excluded from regulation as investment companies pursuant to Sections 3(c)(1) and 3(c)(7) of the Investment Company Act. (Citations to statutes and Lamp Technologies letters omitted.)[41]
Standing in bizarre juxtaposition to its narrow reading of the Lamp Technologies letters, the staff offered its views about the ability of non-broker-dealers to successfully create pre-existing substantive relationships without engaging in prohibited general solicitation:
We have long stated . . . that the presence or absence of a general solicitation is always dependent on the facts and circumstances of each particular case. Thus, there may be facts and circumstances in which a third-party, other than a registered broker-dealer, could establish a “pre-existing, substantive relationship” sufficient to avoid a “general solicitation.” (footnotes omitted)[42]
Regrettably, the staff did not offer any examples of what “facts and circumstances” would allow a non-broker-dealer to successfully create a pre-existing substantive relationship. In these circumstances, as far as careful securities lawyers were concerned, there was little practical value in the staff’s theoretical insistence that non-broker-dealers could successfully establish pre-existing substantive relationships with prospective investors.
For careful securities lawyers advising conventional issuers, the staff’s positions vis-à-vis the Lamp Technologies letters meant that all but the most limited communications programs might be deemed to run afoul of the general solicitation prohibitions of Rule 502(c). Certainly, it would be too risky to advise a conventional issuer that it could solicit prospective investors following the procedures the staff approved for registered broker-dealers and Lamp Technologies.
In May 2003, the staff was presented with an opportunity to consider the proposed interactions of a conventional issuer with prospective investors. Counsel to Agristar Global Networks, Ltd. requested a no-action letter and related interpretative advice regarding certain proposed activities.[43] In view of the similarities to those outlined by Citizen VC nearly a dozen years later, the details of the Agristar incoming letters are worthy of careful consideration.
Agristar planned to offer satellite-based communications systems for farmers and ranchers. Agristar had access to an extensive database of information about the prospective service subscribers developed over several decades that included current detailed financial and other pertinent business information on approximately two million ranches and farms. In addition, Agristar had substantive business relationships with the database entities, many dating back more than 20 years. Agristar proposed soliciting the “top 1%” of entities in the database to complete detailed generic questionnaires aimed at determining the recipients’ accredited investor status. Based on the database information and years of experience with the database entities, Agristar believed even before sending out the generic questionnaires it had a reasonable basis to believe that the “top 1% entities” would be accredited investors. The questionnaires would not be accompanied by any offer to sell specific securities and there would be no solicitation of an offer to buy securities.
Counsel to Agristar referred to the Legacy Interpretative Advice that had permitted the broad distribution of investor questionnaires not accompanied by an offer regarding a specific investment.[44] Counsel to Agristar augmented the information in its initial request with an additional letter in September 2003. In February 2004, without substantive explanation, the staff declined to issue the requested no-action letter or interpretative advice.
There has been no formal staff explanation for the differing results obtained in the Citizen VC and Agristar letters. The planned policies and procedures of both companies seem to be similar to one another. If anything, it appears that Agristar’s plans to pre-select prospective investors to be solicited were significantly more selective than Citizen VC’s plans to first interact with prospective investors with an open public website.
As noted above, one persuasive explanation for concluding that broker-dealers could gather information about prospective investors without engaging in prohibited general solicitation was that gathering information about customers was a normal and FINRA (nee NASD) mandated part of broker-dealers’ day-to-day business. Citizen VC and Agristar, however, were alike in that neither had any regulatory obligations independent of complying with Rule 502(c) to gather information about prospective investors. Accordingly, this historical explanation was not available to differentiate the results in Citizen VC from those in Agristar.
Should their differing businesses alone account for differing SEC advice? Citizen VC planned to be an active participant in the financial services industry. In contrast, Agristar was a conventional issuer with an ongoing business separate from any participation in the financial services industry.
Which Communications are “Not Offers”?
As noted above, one explanation for differentiating treatment of financial services intermediaries from that accorded to conventional issuers was that such intermediaries could solicit information from prospective investors without making an “offer” to sell securities. Broker-dealers and investment advisers had regulatory obligations to become informed about the net worth, investment objectives and investment sophistication of their clients, who were also their prospective investors. In contrast, according to this explanation, most conventional issuers would have “no reason” to communicate with prospective investors other than to offer the issuer’s securities for sale.[45]
In the author’s opinion, this logic is subject to two fatal flaws: First, it omits any opportunity to take into account “all the facts and circumstances” that may be present in the activities of a particular conventional issuer and, in so doing, assumes its own conclusion that an “offer” must be part of any issuer contact. [46] Second, it ignores the fact that the “only reason” the financial intermediary (or broker-dealer) is communicating with prospective investors is just the same as that ascribed to the conventional issuer – to sell a security to investors at some time in the reasonably foreseeable future.
If the SEC sincerely wishes to fairly implement the agency’s oft-repeated “all the facts and circumstances” standard, the ultimate objective of limited initial communications with prospective investors is but one fact to consider.[47] The ultimate objective to sell a security – whether the sale is later made indirectly through a broker-dealer or directly through a conventional issuer – should not reasonably compel a conclusion that communications free from the indicia of an “offer” must nevertheless be seen as impermissible “offers” made in violation of Rule 502(c).
In the author’s opinion, under Citizen VC and the Companion C&DIs, a careful conventional issuer should be able to use impersonal means of mass communication with prospective investors without making an “offer” in violation of Rule 502(c). The issuer’s initial communications with prospective investors would omit any details about the nature of the security that might be offered in the future and instead concentrate on the initial steps in establishing the required substantive relationship.
Current and Future Best Practices for Conventional Issuers
To date, the staff has not endorsed the logic supporting the use by conventional issuers of “no offer” communications outlined above. As a result, conventional issuers and their advisers today are likely to conclude it is too risky to use Citizen VC and the Companion C&DIs as a template for general solicitation of prospective investors as a first step to establishing substantive relationships. However, the author expects that, over time, the uncertainties of the current environment for permissible general solicitation by conventional issuers will give way to more certain and more liberal best practices.
There are several likely sources for such improvements. First, the Division of Corporation Finance could issue a favorable no-action or interpretative letter to a conventional issuer. While it is true that, in the several decades since the adoption of Regulation D, no conventional issuer received a favorable letter, there is, nevertheless, a basis for a bit of optimism.[48]
The staff has repeatedly said that facts and circumstances (not status as a broker-dealer) determine whether favorable no-action and interpretative letters were issued. In this regard, the absence of broker-dealer registration did not disqualify Citizen VC from receiving the same favorable staff advice as had registered broker-dealers in the Legacy Interpretative Advice.[49] This favorable result in Citizen VC must be seen as both a significant change in the regulatory environment and also as a harbinger of a possibly favorable result in the future for a conventional issuer with the “right facts and circumstances.” Perhaps the favorable results will be forthcoming if the staff is now presented with facts and circumstances similar to those in Agristar.
Another source for more liberal compliance best practices for conventional issuers would be one or more court decisions requiring the staff to take a less restrictive view of what behavior was an impermissible “offer” or constituted impermissible general solicitation.[50]
Finally, it is inevitable that custom and practice will experience gradual changes (sometimes pejoratively referred to as “exemption creep”). Compliance practices that might raise concerns today could be well accepted in general use in a decade.[51]
The discussion that follows below suggests certain hypothetical future best practices that might emerge through one or more of the change agents discussed above. The author cautions readers that neither the staff nor any court has endorsed the procedures reviewed below as the “right facts and circumstance” to avoid characterization as impermissible general solicitation in violation of Rule 502(c).
The “exemption creep” process may begin by conventional issuers and their advisers modeling interaction with prospective investors based on the content and mechanics of Citizen VC letter and website, the relevant Companion C&DIs and the Legacy Interpretative Advice.
An issuer could start with its publicly available web page and include a generic invitation to individuals and companies who might be “interested in finding out more about our company” and asking them to “tell the company more about you.” Interested visitors would fill out a general questionnaire that would be the first of several steps needed to establish the appropriate substantive relationship.
The crucial webpage design objective would be avoiding any content that might be seen as an “offer” to sell securities. The content of the Citizen VC website may prove helpful in avoiding any “offer.”
Given how well known Citizen VC has become since August 2015, it seems a fairly safe assumption that its publicly available web pages do not constitute impermissible “offers” of securities. If the public web page content did constitute “offers,” it is highly likely there would have been a well-publicized staff public comment or other public event.[52] Therefore, the content on Citizen VC’s publicly available web pages provides a useful disclosure template for conventional issuers desiring to interest prospective investors but avoid making any “offers.”
Consider the following excerpts from Citizen VC website at http://citizen.vc/.
On the home page:
Startup investment, simplified
citizen.vc gives accredited investors direct access to private offerings from Silicon Valley’s most promising startups
Under the “Invest” tab:
An alternative to traditional VC funds
Our Investment Criteria: We identify and cultivate opportunities exclusively in late- and growth-stage companies, C Round or later, with a 2-4 year time horizon to a liquidity event.
Additional investment criteria include underwrite opportunities that can at a minimum yield a 3x or better, an outstanding management teams, and a fertile marketplace for the company to deploy the investment for growth.
We source our own deal flow
We discretely source our own deals and only the best make it through our filter. Companies seeking to raise capital on our platform disclose all the due diligence information available to insiders, the larger institutional investors and venture capital firms.
Under the “Invest” and then “Our Platform” tabs:
Investing with citizen.vc
Citizen.VC clients enjoy exclusive access to investment opportunities through a proprietary web-based platform. With the Citizen.VC platform investors track available opportunities, transact and monitor each of their investments. Citizen.vc is run by investment professionals for investment professionals
On the “Invest” and then “Qualify” tabs:
Only approved investors qualify to invest with us. If you would like to be considered for approval please fill out our questionnaire.
U.S. securities laws limit the types of investors who can invest with us. This questionnaire will help us determine whether you meet suitability requirements for future investments. Any information you provide here will be kept in strict confidence, but we reserve the right to present your completed questionnaire to parties that we, in our sole discretion, deem necessary in order to complete an investment on your behalf, or, if requested by a governmental or legal authority or required by any laws applicable to us.
Please click below to access our questionnaire: [53]
For a hypothetical conventional issuer’s website, the initial online invitation (and the website content) would include a clear “no offer” disclaimer similar to that used by Citizen VC. Nothing on the conventional issuer’s website or in communications taking place before the establishment of the substantive relationship would disclose any significant information about any planned offering.[54]
After processing the initial generic questionnaire, the follow up process could again model itself on the procedures outlined in Citizen VC and could include personal interviews via telephone and more detailed digital questionnaires. Among other things, such questionnaires would elicit detailed information about financial wherewithal (e.g., annual income, net worth, and investment portfolio makeup and liquidity) and investment objectives, experience and sophistication.[55]
The portions of the web pages that might include information about any planned or ongoing securities offering would be password-protected and passwords would be issued to prospective investors only after they had established the necessary substantive relationship with the issuer.
Although not deemed in the Companion C&DIs as mandatory, the hypothetical conventional issuer will be advised to impose a “cooling off” period of at least 30 days between the time when the substantive relationship is established and an “offer” is communicated to a prospective investor. Such a hiatus would harmonize with the assertion that no “offers” were involved in the initial communications and subsequent interchanges establishing the substantive relationship.
Only time will tell if the foregoing hypothetical best practices for conventional issuers based on the logic underlying Citizen VC become tomorrow’s generally accepted custom and practice for permissible general solicitation in Rule 506(b) offerings.
* * * * *
Epilogue: Why Not Use Rule 506(c)?
Substantial time and effort will be needed to comply with the foregoing hypothetical conventional issuer Rule 506(b) permissible general solicitation best practices. A fair reaction might be to suggest modifying the planned offering to qualify for compliance with Rule 506(c). Under Rule 506(c), unrestricted general solicitation is permitted.
There are several reasons why practitioners may prefer Rule 506(b). First, there are several decades of experience with Rule 506(b) transactions on which to draw. In contrast, Rule 506(c) has been available only since September 2013. In this regard, outside of safe-harbor procedures promulgated by the staff, many practitioners have not yet developed a comfort level with the steps needed to satisfy the Rule 506(c) compliance requirement to “take reasonable steps to verify” accredited status for all purchasers. Under Rule 506(b) accredited investor status is established under Rule 501(a) in either of two less challenging ways: (1) the prospective investor actually meets one or more accredited investor requirements or (2) there is a “reasonable belief” that the prospective investor meets such requirements.
If, for some reason, the Rule 506(c) exemption is lost, the admitted presence of “general solicitation” will make it very difficult if not impossible to qualify for a “fall back” federal exemption under the statutory private placement securities registration exemption of Section (4)(a)(2) of the Securities Act of 1933. General solicitation is simply incompatible with the federal statutory private placement registration exemption. If, however, a Rule 506(b) offering exemption is lost, in the author’s opinion, it will be a much less daunting task to qualify for the federal statutory private placement exemption, even if the non-compliance is alleged to have involved impermissible general solicitation.
There are no state securities registration exemptions that parallel Rule 506(c) and allow for general solicitation in exempt private offerings. Thus, for state securities law registration exemptions, practitioners in structuring Rule 506(c) transactions rely on the preemption of state securities law registration requirements provided by Section 18(b)(4) of the Securities Act of 1933. Similarly, the presence of general solicitation is incompatible with virtually every state securities law private placement exemption and the loss of federal preemption might make it impossible to satisfy applicable state securities registration exemptions, including some with which a Rule 506(b) offering could comply.
This article is scheduled for publication in Securities Regulation Law Journal, Summer 2016 Edition, a Thomson Reuters Publication. For more information about this publication please visit www.legalsolutions.thomsonreuters.com.
[1] Citizen VC (August 6, 2015). The SEC’s response letter is available at https://www.sec.gov/divisions/corpfin/cf-noaction/2015/citizen-vc-inc-080615-502.htm (last visited May 2, 2016); the incoming letter from the Boston office of Mintz Levin is available at https://www.sec.gov/divisions/corpfin/cf-noaction/2015/citizen-vc-inc-080615-502-incoming.pdf (last visited May 2, 2016).
[2] Securities Act Rules, Questions of General Applicability (Last Update August 6, 2015), Section 256 Rule 502(c) General Conditions to be Met et seq. (available at https://www.sec.gov/divisions/corpfin/guidance/securitiesactrules-interps.htm (last visited May 2, 2016), for convenience, the “Companion C&DIs.”
[3] Rule 506(b) has been the most popular Regulation D securities registration exemption, particularly Rule 506(b) offerings in which all investors are required to be accredited investors. Such Rule 506(b) offerings have several attractive features: they may be made without the need to comply with the mandated disclosure requirements of Rule 502(b), there is no limit on the number of accredited investor purchasers and such accredited investor purchasers are not required to meet any investor sophistication requirement. In addition, securities issued in transactions satisfying the requ