Substantive Preexisting Relationships in Rule 506(b) Offerings – What You Need to Know

Posted on Apr 9, 2024 by Kamden Crawford

When raising capital, establishing meaningful relationships with investors is essential for success. For private offerings under Rule 506(b) of Regulation D of the Securities Act, this concept is especially imperative. Rule 506(b) exempts issuers of private offerings from the extensive disclosure requirements in public offerings. Unlike Rule 506(c), which permits general solicitation, Rule 506(b) allows issuers to accept both accredited and sophisticated investors without independently verifying accreditation status. However, this exemption is contingent on issuers establishing a “substantive preexisting relationship” with all investors. This article aims to address common queries surrounding this requirement, including what constitutes a substantive preexisting relationship, when it must be established, how to establish it, and the consequences of failing to do so.

What constitutes a substantive relationship?

Issuer and investor relationships are “substantive” when the issuer has sufficient information to evaluate, and does, in fact evaluate a potential investor’s financial circumstances and sophistication, in determining their status as an accredited or sophisticated investor. The quality of the relationship between the issuer and investor is crucial in evaluating its substance. Self-certification alone is not enough to establish a substantive relationship. Furthermore, the relationship must exist independently from any investment discussions.

Unfortunately, there are not any strict guidelines on what is enough to constitute a substantive relationship. Gathering knowledge about a prospective investor’s financial position and their capacity to undertake the risks of investment helps substantiate the relationship. Investor questionnaires with questions targeting information on the financial position of prospective investors may help accomplish this. However, questionnaires are not enough by itself to establish a substantive relationship.

When is a substantive preexisting relationship established?

Substantive relationships with investors must be established before the offering commences. While some issuers assume that establishing these relationships just before accepting funds suffices, doing so exposes them to liability. The SEC mandates a passage of time between initiation of the relationship and offers to participate in the offering to avoid classification as a general solicitation.

Although no specific minimum duration exists, it’s advisable to ensure several months have elapsed between forming the relationship and initiating the offering. Requiring investors to complete a questionnaire may also assist in establishing the preexisting nature of the relationship.

How is a substantive preexisting relationship established?

While there is no concrete method to establish a substantive preexisting relationship, issuers can adopt measures to protect themselves. These include engaging with potential investors beyond investment discussions, understanding their business dealings, asking questions about a potential investor’s sophistication, actually evaluating investor’s sophistication and financial savviness, developing qualification standards and procedures, and adhering to a list of investor targets within the issuer’s personal network. In addition, issuers should maintain strict control over dissemination of offering materials and activities of representatives. Conversely, issuers should refrain from publicizing the offering via social media, speaking about a current offering at seminars and events with attendees outside their network, making generalized offers to investors and speaking with interested investors outside their network.

Determining the existence of a substantive preexisting relationship hinges on specific facts and circumstances. Despite lack of a one-size-fits-all approach, implementing or avoiding the above activities can serve as evidence thereof.

Consequences of Failing to Establish a Substantive Preexisting Relationship

Rule 506(b) strictly prohibits general solicitation and advertising. Consequently, failing to establish substantive preexisting relationships with investors in a Rule 506(b) offering subjects issuers to liability with the SEC and the loss of the securities exemption resulting in an illegal and unregistered offering of securities. Damages can include private causes of action, rescission rights, civil liability including fines and penalties, and criminal prosecution. Rights of rescission entitle investors to a return of capital plus interest and are the most common form of remedy.

To avoid liability, issuers of private offerings wishing to raise capital from outside their network should utilize a different exemption such as Rule 506(c). Issuers can also initially raise capital under Rule 506(b), then terminate the offering and commence a new offering with the same terms under Rule 506(c). With the complexities of the regulations, gray area of this subject, and challenges in the market, we understand that raising capital can be difficult. For inquiries or assistance, please do not hesitate to reach out.