Regulation D is an exemption that allows issuers to sell securities without registering those securities. Two very common subparts of Regulation D are often used for real estate deals: 506(c) and 506(b).
506(c) allows the issuer to raise an unlimited amount of capital from an unlimited number of investors so long as each investor is accredited. In contrast, Regulation D Rule 506(b) is a safe harbor under the Securities Act, which allows a securities issuer to raise an unlimited amount of capital to an unlimited number of accredited investors and up to 35 sophisticated investors. However, the issuer cannot engage in general solicitation and instead can only sell securities to investors that the issuer has a “pre-existing substantial relationship” with all investors.
So, how deep must that relationship go? Do I have a pre-existing relationship with members of my bowling league? What about members of a private social media group I’m part of? What makes the relationship substantial? Well, the answer to that is a lawyer’s favorite answer: It depends.
Below are some scenarios where the SEC has said there is or is not a substantial relationship, and these can be used as a general guide. As always, it is important to ensure that you have an attorney reviewing your unique situation.
History of Reg D and Commission Interpretation of Pre-Existing Relationships
Reg D was adopted in 1982 after the Commission spent years fielding complaints that compliance was inordinately hurting small businesses.
A few months after Reg D was adopted, the Commission issued a letter regarding a general partner of a limited partnership who wanted to send a written offer to 300 former investors for a new deal. The SEC found that this type of communication was legal and that the relationship between the general partner and the former investors was pre-existing and substantive. The SEC stated:
“...the nature of this relationship is evidence, in part, by the determination by the general partner at the time of the original investment that the investors met certain suitability standards and by the belief by Woodtrails that each of the proposed offerees currently has such knowledge and experience in financial and business matters that he or she is capable of evaluating the merits and risks of the prospective investment.[1]”
This first letter establishes the basics of the pre-existing, substantive relationship: that the general partner had dealings with these investors before the offer was extended and that the general partner knew of these investors’ financial matters and business savvy from prior dealings.
The SEC has reiterated in all subsequent letters and on their website that pre-existing means pre-existing. There is no wiggle room in this interpretation. Any contact establishing a relationship MUST be before any offer is extended. It does not matter how sophisticated the client/investor is or how much knowledge the dealer/broker has regarding the client/investor. The broker/dealer must make contact with the client/investor before any offer is made.
SEC No-Action Letters
To understand how to navigate these complex rules, an issuer must first understand what no-action letters are, as those often provide most of the guidance that comes from the SEC.
A no-action letter is typically where an issuer plans to perform some action related to securities but they are not sure whether the action is compliant, so they write to the SEC explaining their plan and asking the SEC if it would take action based upon the proposed plan. If the SEC reviews the proposed action and deems it to be in compliance with regulations, the SEC may issue a no-action letter, meaning that based upon what was described, currently, the SEC would decline to pursue action.
SEC no-action letters apply only to the specific issuer, in the specific context that it was written and technically do not constitute precedent. This means that the SEC can change its mind and it specifically means that you cannot use that letter to justify and validate your actions. Nonetheless, viewing no-action letters can give an issuer insights as to how the SEC might characterize certain actions.
SEC Interpretation of Substantive Relationship in the ’80s
There are a few helpful no-action letters from the ’80s dealing with the pre-existing, substantive relationship requirement. All three examples deal with building a pre-existing substantive relationship through programs where potential investors were identified and mailed a questionnaire pre-offer to establish said relationship.
In EF Hutton & Co and Bateman Eichler, Hill Richards, Inc., the SEC found that the questionnaire mailed pre-offer did establish a pre-existing relationship, but that the pre-screening questionnaires were not detailed enough to establish a substantive relationship. The crux of the substantive relationship is that the issuer must know the financial circumstances and sophistication of the potential investor.
Conversely, in H.B. Shaine & Co., a broker/dealer had a similar pre-screening questionnaire process that the Commission did find established a substantive relationship. In this pre-screening process, the broker/dealer’s questionnaire was more detailed and was updated annually to provide an always updated potential client list.
Pre-existing Relationships Modernly
Modernly, the SEC describes a ‘substantive’ relationship as one in which the issuer (or 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.
Additionally, there is no specific waiting period to form a pre-existing, substantive relationship, but:
“...the issuer must establish such a relationship prior to commencement of the offering, or, if the relationship was established through either a registered broker-dealer or investment adviser, the relationship must be established prior to the time the registered broker-dealer or investment adviser began participating in the offering. 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. These limited accommodations permit 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).”
In a 2015 no-action letter to a broker/dealer’s question of whether their investors meet the pre-existing, substantive relationship standard, the SEC stated:
“We agree that 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. As the Division has stated before, a ‘substantive’ relationship is one in which the issuer (or 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, e.g., Batemen Eichler, Hill Richards. Inc (Dec. 3, 1985). We note your representation that CVC’s policies and procedures are designed to evaluate the prospective investor’s sophistication, financial circumstances and ability to understand the nature and risks of the securities to be offered. We also agree that there is no specific duration of time or particular short form accreditation questionnaire that can be relied upon solely to create such a relationship. Whether an issuer has sufficient information to evaluate, and does in fact evaluate, a prospective offeree’s financial circumstances and sophistication will depend on the facts and circumstances.”
So, What Does All of This Mean?
What is a substantial pre-existing relationship?
Unfortunately, the SEC does not give specific rules regarding what qualifies as enough information to establish a substantive relationship. Instead, the SEC states that this is a fact-intensive inquiry, meaning they look at each unique situation on a case-by-case basis. But here are some takeaways for you:
- Talk with your attorney so they can advise you based on the specific facts and circumstances of your scenario.
- Generally, you will need to have the relationship established prior to starting the offering.
- Gather enough information to evaluate the potential investor’s financial status, financial status, financial sophistication, and ability to determine the merits and risks of the offering.
- Actually evaluate the information and make a determination as to the level of the investors’ financial savviness.
- Build real, quality relationships that help you accurately evaluate their information.
[1] SEC No-Action Letter, FED. Sec. L. Rep (CCH) August 8, 1982
About the Author:
Nic McGrue is a tenured professor of law and the founder of Polymath Legal PC. At Polymath Legal PC, Nic helps real estate investors lawfully raise capital allowing them to generate passive income while creating generational wealth.
Disclaimer:
The views and opinions expressed in this blog post are provided for informational purposes only and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.
