Last week the Securities and Exchange Commission (SEC) responded to a “no-action” letter (RE: Citizen VC, Inc.) concerning the establishment of “substantive relationships” with previously unknown potential investors and what constitutes “general solicitation” in the context of a private securities offering. The SEC also issued several new Compliance and Disclosure Interpretations (C&DIs) last week centered around the same topic. While the majority of this guidance is more applicable to traditional 506(b) offerings (i.e. non-crowdfunded offerings), the new guidance is still applicable to many current offerings (particularly those done by private investment/VC/PE funds).

“No-Action” Letter:

The “no-action” letter issued by the SEC concerns the proposed offering strategy of Citizen VC, Inc. (“CitizenVC”). Essentially, CitizenVC is proposing to set up, what looks like, a traditional crowdfunding style offering structure. By that I mean that CitizenVC proposes to: (a) set up individual single purpose vehicle (“SPV”) limited liability companies whose sole purpose will be to invest in a particular project/company; and (b) use an internet portal to allow investors to purchase equity interests in such SPV companies. The catch is that CitizenVC expressly states in its letter that it “does not intend to rely on the exemption from registration provided under Rule 506(c), and will not engage in any general solicitation or general advertising.”

Without getting into a detailed discussion of applicable regulations, a little background is in order. There has always been a prohibition against generally advertising, or generally soliciting interest in, private securities offerings (i.e. Rule 502(c)) which makes it difficult, if not impossible, to post an offering on an internet website. One exception to this prohibition, is that Issuers (And their agents) can pitch offerings to individuals/companies with who they have had a past substantive relationship and it will not be considered general solicitation. It should be noted that Rule 506(c) (i.e. Title II) was enacted specifically to provide an exemption to allow issuers to “broadly solicit and generally advertise” certain types of private securities offerings, including using the internet, without the need for establishing such substantive relationships. That being said, since CitizenVC is expressly choosing not to use the Rule 506(c) exemption, they have asked the SEC to bless their proposed strategy for establishing a substantive relationship with new users as they come to the site.

Under CitizenVC’s proposed strategy, a person coming to the site that wishes to see the “password protected” areas must first register and be accepted for membership, the first step of which is to complete a generic online accredited investor questionnaire. Once the person has completed the initial questionnaire, and it has been accepted by the company, CitizenVC will initiate the “relationship establishment period” during which CitizenVC will undertake various actions to connect with the person (both on and offline) to “evaluate the prospective investor’s sophistication, financial circumstances, and its ability to understand the nature and risks related to an investment.” Such activities include (among others):

• Contacting the potential investor electronically to make an introduction, answer questions they may have about the company, the website, etc.

• Having a representative call the potential investor to discuss their respective “experience and sophistication, investment goals and strategies, financial suitability, risk awareness, and other topics designed to assist CitizenVC in understanding the investor’s sophistication”

• utilizing third party credit reporting services to confirm the potential investor’s identity and obtain credit/financial information of such potential investor;

• encouraging the potential investor to ask questions about the website, the company, its investment strategy, etc.;

• notifying potential investors that the minimum required investment will be $50,000;

• and “generally fostering interactions both online and offline between the prospective investor and CitizenVC.”

As stated “[a]ll of the foregoing activities and interactions are specifically designed to create and strengthen a real, substantive relationship between CitizenVC and the prospective investor, and to verify and ensure that the offering of Interests is suitable for
them.” Once the company has determined that the investor has sufficient financial sophistication, and the company believes it has taken sufficient measure to create a substantive relationship, the investor will be admitted as a member and given access to the offerings (and related offering materials) on the website.

In response to the “no-action” letter, the SEC issued the following response:

“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 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. …. 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”

While cryptic in their response, it appears that the SEC’s staff is agreeing with CitizenVC’s position that: (a) certain processes can be established for issuers to develop a substantive relationship with previously unknown investors; and (b) as a result, offerings of securities online (via a password protected area) to such approved investors will not violate the general solicitation provisions of Rule 502(c). The SEC’s staff did note however, that whether or not a substantive relationship has been created with any investor will ultimately depend on the specific facts and circumstances.

Compliance and Disclosure Interpretations (C&DIs):

In addition to their “no-action” letter response, the SEC also issued several C&DIs last week concerning general solicitation and related matters (See Question 256.23 through Question 256.33). While many of them are more fact specific, I believe the following should be noted:

Question 256.23 (in pertinent part): Does the use of an unrestricted, publicly available website to offer or sell securities constitute a general solicitation for purposes of Rule 502(c)?

Answer: Yes. As the Commission stated in Securities Act Release No. 7856 (Apr. 28, 2000), the use of an unrestricted, publicly available website constitutes a general solicitation and is not consistent with the prohibition on general solicitation and advertising in Rule 502(c) if the website contains an offer of securities. However, Rule 506(c) — which does not require compliance with Rule 502(c) — may be available to issuers when offering or selling securities through unrestricted, publicly available websites or other forms of general solicitation.

Comment: Clearly if you are relying on any exemption other than Rule 506(c) you cannot use an “unrestricted” website. Put another way, access to all offering materials must be restricted to those permitted to see them similar to the password protected areas discussed in the CitizenVC “no-action” letter. The question remains as to what restrictions, if any, are necessary to prevent unqualified (i.e. non-accredited) investors from accessing online offering information in connection with a Rule 506(c) offering.

Questions 256.24 & 256.25: What information can an issuer widely disseminate about itself without contravening Rule 502(c)? What is factual business information?

Answer: Information not involving an offer of securities may be disseminated widely without violating Rule 502(c). For example, factual business information that does not condition the public mind or arouse public interest in a securities offering is not an offer and may be disseminated widely. Information that involves an offer of securities through any form of general solicitation would contravene Rule 502(c). What constitutes factual business information depends on the facts and circumstances. Factual business information typically is limited to information about the issuer, its business, financial condition, products, services, or advertisement of such products or services, provided the information is not presented in such a manner as to constitute an offer of the issuer’s securities. Factual business information generally does not include predictions, projections, forecasts or opinions with respect to valuation of a security, nor for a continuously offered fund would it include information about past performance of the fund.

Comment: Given that the majority of investment/VC/PE funds are still raising capital under Rule 506(b) or other types of private placements, the second half of this answer is extremely important. I have seen a ton of pitch decks for private funds in my time and even if they don’t provide projections or forecasts related to a current investment (which they almost always do) those that have past performance success always highlight it. Under this comment, such pitch decks would not be considered “factual business information” and handing them out to potential investors could constitute general solicitation under Rule 502(c) (assuming no previous substantial relationship etc. with the receiver).

Question 256.30: Is there a minimum waiting period required for an issuer, or a person acting on its behalf, to establish a pre-existing, substantive relationship with a prospective offeree in order to demonstrate that a general solicitation is not involved?

Answer (emphasis added): No. While there is no minimum waiting period, the issuer must establish such a relationship prior to the 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. 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).

Comment: There is a timing nuance here that I think should be noted. The question is, once a substantive relationship is established, what offerings can that investor have access to? Put another way, once the investor is vetted would they have access to all of the offerings that are currently going on or only those offerings commenced after the relationship is established? From the emphasized language in the answer above it would seem the latter. However, a careful reading of the CitizenVC shows that they intended admitted members to have instant access to ongoing deals and the SEC staff was silent on that part of their proposal.