<img height="1" width="1" style="display:none" src="https://www.facebook.com/tr?id=533208126839177&amp;ev=PageView&amp;noscript=1">

What Constitutes a Pre-existing Relationship in a 506(b) Offering?

Post on: June 29, 2018 | Chris Rohde | 0


Regulation D, Rule 506(b) provides safe harbor for issuers selling unregistered securities as long as the following requirements are met:

  • The offering must not be generally solicited
  • Unaccredited investors are limited to 35 per offering and are required to receive certain information if they are accepted
  • The issuer and its associates may not be bad actors
  • The issuer, investment advisor, or the broker-dealer must have a pre-existing, substantive relationship with any accredited investors

So, what qualifies as a pre-existing, substantive relationship for the purposes of 506(b)?

The SEC has provided answers to this question via several different methods, including no action letters, enforcement actions, and the SEC’s “Compliance Disclosures and Interpretations of Rule 506(b),” also known as the CD&Is. The most concise definitions of both the pre-existing and substantive requirements are contained in the responses to CD&I questions 256.29 and 256.31. Within these questions and answers the SEC lays out the basic guardrails for establishing pre-existing, substantive relationships with potential subscribers.

UNDERSTANDING REGULATION D | A definitive guide to Rules 506(b) and 506(c)

Pre-existing Relationship

The SEC defines a pre-existing relationship as “one that the issuer has formed with an offeree prior to the commencement of the securities offering…” Alternatively, this relationship may be established through either a registered broker-dealer or investment advisor, but, like the issuer, this relationship must pre-date their participation in the offering. While, this sounds self-explanatory, there is evidence that some issuers (and their advisors) are not paying attention to this requirement and are instead allowing subscribers access to offerings that pre-date the establishment of a relationship with that subscriber.

Here is why that matters: the existence of the pre-existing, substantive relationship rule prevents issuers from violating 506(b)’s bar on general solicitation.

Why are issuers’ and their associates not taking this requirement of the relationship with the subscriber pre-existing the offering seriously? This confusion may result from the existence of a limited exception to the pre-existing relationship requirement.

In the Lamp Technologies, Inc. No-Action Letter from 1997, the SEC allowed an individual who qualifies as an accredited or sophisticated investor to view offerings of securities in private fund offerings that were posted on a website platform prior to the investor’s subscription to the platform. This was only allowed after completing a generic questionnaire, payment of a subscription fee to the website, and a 30-day waiting period.

The letter specifies that this exception applies only to private fund offerings by investment companies exempt from registration under sections 3(c)(1) or 3(c)(7) of the Investment Company Act. The exception does not apply to 506(b).

One other significant fact is that these offerings were not offerings of Lamp’s own securities, but instead of third party private funds. This is different from the practice of some issuers today who will conduct a 506(b) offering of their own securities online, with or without a third party platform.

Substantive Relationship

This already confusing exception only became murkier with the release of the Citizen VC No Action letter in August of 2015. Prior to the Citizen VC letter, the accepted practice for complying with the Lamp letter was to require a 30-day cooling off period after a potential subscriber was introduced to an issuer or broker. Citizen VC, Inc., based on their own internal processes, requested clarification from the SEC on whether the cooling off period needed to be 30 days or if it is the quality of the relationship that matters. In response, the SEC made it clear that they view the quality of the relationship as far more important than the length of some cooling off period. While good intentioned, this clarification led us to many issuers “developing” pre-existing, substantive relationships effectively overnight. This is a grave misstep on the part of the industry. Issuers, and BDs, need to review the SEC’s guidance and pay attention to how relationships with potential subscribers are created.

The SEC defines a substantive relationship as “[a relationship] 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.” This means, the issuer, broker, or advisor needs to actually have knowledge of an investors sophistication or accreditation. As the SEC says in that same CD&I, “[s]elf-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.” Industry participants should take particular note of this point, as having a subscriber “check the box” is part of most, if not every, 506(b) subscription document. In addition to this attestation, issuers, brokers, or advisors should take extra steps to actually learn about the individuals with whom they engage, such as discussing finances, annual income, net worth, investment goals, and larger investment strategy.

Due to the nature of the information needed to establish a substantive relationship, the SEC makes clear that, “in the absence of a prior business relationship or a recognized legal duty to offerees, [they] believe it is likely more difficult for an issuer to establish a pre-existing, substantive relationship, especially…in an offering over the Internet.” For this reason, the SEC appears to be more comfortable with the relationship being with a broker or advisor, as those individuals do generally have knowledge of the financial wherewithal, investment experience, and investment goals of their clients.

So, is it impossible for an issuer to establish a substantive relationship with a potential subscriber? No, but issuers should take special care to put procedures in place to actually establish a substantive relationship with potential subscribers and not rely solely on attestations from the subscriber or a brief email exchange. Issuers must understand that this is the sale of private securities, not Tinder® for investments; You cannot simply swipe right to establish a relationship. It takes time and effort. Use the Citizen VC letter and the CD&Is as a guide, and focus on building qualitative relationships and instead of simply having investors check a box indicating that they are accredited. For a substantive relationship that did not exist prior to offering commencement, the issuer must ensure compliance with the Lamp No-Action Letter or it may violate the 506(b) exemption.


In order to be exempt from registration under 506(b) and not violate the prohibition on general solicitation, an issuer, or another party in an offering, must have a pre-existing, substantive relationship with the subscriber. The SEC has made it clear through various means that the establishment of such a relationship results from actual effort in getting to know an individual, not just checking some box or waiting a set amount of time. Issuers and their counsel should pay special attention to complying with this requirement, as violating the 506(b) exemption could, and likely will, lead to serious consequences such as rescission and potential enforcement action by the SEC, or a state regulator. Issuers unclear on whether or not they have enough investors with pre-existing, substantive relationships may want to consider the 506(c) exemption for their offering instead, freeing them up to utilize general solicitation.


Understanding Regulation D

A definitive guide to Rules 506(b) and 506(c)



Disclaimer: WealthForge provides this information to our clients and other friends for educational purposes only. It should not be construed or relied upon as legal advice.

Share on

About author

Chris Rohde

Chris serves as Associate Corporate Counsel at WealthForge where he advises on an array of areas, including both federal and state securities laws, broker-dealer law, general corporate law matters, and cybersecurity.
Find me on:

Related articles

Leave a reply