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Rule 506(b): Developing Substantive Relationships in the Age of the Internet

On August 6th, 2015, the SEC responded to letter a from Citizen VC, Inc. (“Citizen VC”)[1] wherein Citizen VC posited a hypothetical on developing pre-existing substantive relationships entirely online for the purpose of complying with Rule 506(b).  The SEC responded to this hypothetical with a no-action letter stating that the SEC would not prosecute actions taken within Citizen VC’s stated framework.

Rule 506(b) offerings are private sales of securities without general solicitations or advertisements.  To comply with the rule, a substantive relationship must first be developed.  In the past, this was done almost entirely offline.  The procedure Citizen VC intends to employ to develop a substantive relationship to conduct Rule 506(b) offerings are almost exclusively online.  The steps Citizen VC laid out are as follows:

  1. Contacting the prospective investor offline by telephone to introduce representatives of the company and to discuss the prospective investor’s investing experience and sophistication, investment goals and strategies, financial suitability, risk awareness, and other topics designed to assist the company in understanding the investor’s sophistication;
  2. Sending an introductory email to the prospective investor;
  3. Contacting the prospective investor online to answer questions they may have about the company, the company’s website, and potential investments;
  4. Utilizing third party credit reporting services to confirm the prospective investor’s identity, and to gather additional financial information and credit history information to support the prospective investor’s suitability;
  5. Encouraging the prospective investor to explore the company’s website and ask questions about the company’s investment strategy, philosophy, and objectives, and;
  6. Generally fostering interactions both online and offline between the prospective investor and the company.
  7. Additionally, prospective investors will be advised that every special purpose vehicle offering will have a significant minimum capital investment requirement for each investor, which will be not less than $50,000 per individual investment, and in some offerings significantly higher.[1]

It is important to note that the website used is publically accessible, although content pertaining to special purpose vehicles, portfolio companies, investment offerings, and other offering materials is password protected and inaccessible without approval.  The publically accessible homepage is designed specifically so that it cannot be construed as a solicitation or an offering.

After Citizen VC determines that the prospective investor has sufficient knowledge and experience in financial and business matters to enable it to evaluate the merits and risks of the investment opportunities on the website, and that the company has taken all reasonable steps it believes necessary to create a substantive relationship with the prospective investor, only then will Citizen VC admit the prospective investor to the password protected areas of the website.

The SEC responded by saying that they “agree that the quality of a relationship between an issuer (or its agent) and an investor is the most fact in determining whether a  ‘substantive’ relationship exists”[1] and that a substantive relationship is established when an issuer has sufficient knowledge to evaluate a potential investor’s financial circumstances and sophistication to determine his or her status as an accredited investor.  The SEC also stated that there is no set timeframe in which a substantive relationship is established.  The relationship is one of quality, not duration.  Additionally, solely relying on a questionnaire to determine accredited status is insufficient and would not create a substantive relationship.

So long as a prospective member of the company’s website is not presented with any investment opportunity prior to the company assessing their status as an accredited investor, Citizen VC’s framework can be used to establish a substantive relationship.  The SEC punctuated their no-action letter by stating that any different facts or conditions than those listed by Citizen VC may result in a different decision by the SEC.  For now, it has been established that substantive relationships can be created online, but only in the narrow framework provided by Citizen VC.

[1] https://citizen.vc

[2] https://www.sec.gov/divisions/corpfin/cf-noaction/2015/citizen-vc-inc-080615-502-incoming.pdf

[3] https://www.scribd.com/fullscreen/274239111?access_key=key-oL2M5pqEXP1uKqhosOQc&allow_share=true&escape=false&view_mode=scroll
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Christopher Garitee
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