Utah Bar Journal

The most commonly used registration exemptions are found in Regulation D promulgated under the Securities Act of 1933, as amended (the “Securities Act”). This article addresses the issue of offering securities in a private placement and outlines the prohibition against using “general solicitation or general advertising” set forth in the Securities Act and Regulation D.

BACKGROUND
All offerings of securities must be either (1) registered with the SEC or (2) exempt from registration, see Securities Act § 5; Regulation D. Since the registration process is time-consuming and expensive, most Utah businesses wish to ensure that any securities they offer are exempt from registration. See General Accounting Office, Report to the Chairman, Comm. On Small Bus., U.S. Senate, Small Business Efforts to Facilitate Equity Capital Formation at 23 (2000). An exemption from registration does not exempt an offering from the anti-fraud requirements or any other provision of the securities laws. See Securities Act Release No. 33-6389 (Mar. 8, 1982).

Regulation D includes three exemptions from Securities Act registration. Under Rule 504, an issuer may sell up to $1 million of securities to an unlimited number of persons. However, Rule 504 offerings are not permitted in Utah. The exemption under Rule 505 allows an issuer to sell up to $5 million of securities to an unlimited number of “accredited investors” (as defined herein) and up to thirty-five nonaccredited investors.

Rule 506 allows an issuer to sell an unlimited amount of securities to an unlimited number of “accredited investors” and up to 35 nonaccredited investors. The issuer must also reasonably believe that each nonaccredited purchaser either alone or with a purchaser representative has sufficient knowledge and experience to be capable of evaluating the merits and risks of the prospective investment in a Rule 506 offering. In addition, a Rule 506 offering allows an issuer to avoid having to comply with state registration and exemption requirements, other than notice filings. See Securities Act § 18(a)(1)(A); 18(b)(4)(D); Rule 506(a).

Rule 502 prohibits the use of a “general solicitation or general advertising” in a Rule 505 or Rule 506 offering of securities. See Rule 502(c). Neither “general solicitation” nor “general advertising” is defined in Regulation D or in the SEC release adopting Rule 506. This article will address the few interpretations of these terms that have come from the SEC.

ANALYSIS
The majority of this analysis will be based on SEC no-action letters. A no-action letter is a method of securing informal advice from the SEC on a specific proposed transaction. Generally, an attorney representing a party with a question prepares a letter to the SEC laying out the facts of the transaction. The SEC responds as to whether it is likely to bring legal action against such a transaction or whether it will take no action. No-action letters generally end with a disclaimer stating that the SEC’s position in the letter is based on the representations made in the initial letter to the SEC, and any different facts or conditions might require a different conclusion.

Advertisements
Examples in Rule 502(c)
Although the terms “general solicitation” and “general advertising” are not defined in Regulation D, the rules do clarify that at least the following actions qualify as a general solicitation: “any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio” or “any seminar or meeting whose attendees have been invited” by a general solicitation. See Rule 502(c). The SEC believes that whether a particular action is a general solicitation is generally an issue of facts and circumstances, and therefore typically declines to give specific guidance. See Interpretive Release on Regulation D, Securities Act Release No. 33-6455, 17 C.F.R. Pt. 231, 1983 SEC LEXIS 2288 (March 3, 1983).

Product Advertisements
The above examples refer to using radio advertisements and seminars in connection with an offering of securities. By the terms of the rule, they do not apply to advertisements for goods and services other than securities. However, the SEC believes that an issuer’s product promotion may be deemed a general solicitation or general advertising for the sale of securities, based on (1) the content of the advertisements and (2) the actual use of the advertisement in relation to the offering of securities. When enumerating these criteria, the SEC declined to issue guidance on this particular issue. See Printing Enters. Mgmt. Sci., Inc., 1983 SEC No-Act. LEXIS 2250 (Apr. 25, 1983). In addition, if the primary purpose of an advertisement is to sell securities and to condition the market for future sales, an advertisement may constitute an offer even if an issuer is not offering securities at the time. Again, the SEC declined to give further guidance about the meaning of “conditioning the market.” See Gerald F. Gerstenfeld, 1985 SEC No-Act. LEXIS 2790 (Dec. 3, 1985).

Generic Advertisements and Informational Seminars
The treatment of general advertisements for seminars giving purely “generic” industry information depends on the purpose for which the seminar is given. In the SEC’s review of an NASD disciplinary action, a registered representative of a broker-dealer advertised a seminar he was giving on hedge funds in a newspaper. The advertisement read, in part: “‘Today’s Hottest Investment’/Hedge Funds/WHAT THEY ARE/HOW TO INVEST.” Although the registered representative gave uncontradicted testimony that the information given in the seminar was “generic” in nature, prior to the seminar he had sent a letter to investors in his current hedge fund stating that the seminar was intended to attract new investors to such fund. The SEC held that the purpose of the advertisement was the relevant factor, not the content and deemed the advertisement and the seminar a general solicitation. See In the Matter of Brian Prendergast, 2001 SEC LEXIS 1533.

Offeree/Issuer Relationship
To date, the SEC has focused on the relationship between the issuer and the potential investor in determining whether a general solicitation has occurred. For a communication to a potential investor to not be considered a general solicitation, the SEC requires a pre-existing, substantive business relationship between the issuer and the potential investor. See, e.g., Woodtrails-Seattle, Ltd., 1982 SEC No-Act. LEXIS 2662 (Aug. 9, 1982); E.F. Hutton & Co., 1985 SEC No-Act. LEXIS 2917 (Dec. 3, 1985); and Bateman Eichler, Hill Richards, Inc., 1985 SEC No-Act. LEXIS 2918 (Dec. 3, 1985). If there is a pre-existing, substantive business relationship between the issuer and potential investor, the SEC allows an issuer to target and solicit interest such persons. See Woodtrails-Seattle, Ltd.

While the SEC asserts that “prior relationship is [not] the only way to show the absence of general solicitation,” the SEC has not issued any guidance on any other way to avoid a general solicitation. See Securities Act Release No. 33-6825 (Mar. 15, 1989).

Substantive and Pre-existing Relationship
The substantive aspect of the issuer-investor relationship focuses on the potential investor’s financial sophistication and ability to evaluate the risks and merits of the proposed offering. The issuer must be able to demonstrate that the potential investor was sufficiently sophisticated in financial matters to participate in the private offering. Targeting accredited investors exclusively would satisfy this “substantive” requirement because accredited investors, as defined by the Securities Act, are presumed to be sophisticated for Rule 506 purposes. See Rule 501(a); see also H.B. Shaine & Co., Inc., 1987 SEC No-Act. LEXIS 2004 (May 1, 1987). A “substantive” relationship may be created by a “satisfactory response by a prospective offeree to a questionnaire that provides…sufficient information to evaluate the respondent’s sophistication and financial situation.”

Please note that the guidance regarding the establishment of a “substantive” relationship through a questionnaire was specifically applied to a solicitation by a broker-dealer on behalf of an issuer, not to a solicitation by an issuer directly. Another no-action letter states that

the types of relationships with offerees that may be important in establishing that a general solicitation has not taken place are those that would enable the issuer (or a person acting on its behalf) to be aware of the financial circumstances or sophistication of the persons with whom the relationship exists or that are otherwise are of some substance and duration.

Mineral Lands Research & Mktg. Inc., 1985 SEC No-Act. LEXIS 2811 (Dec. 4, 1985) (emphasis added).

The potential investor’s sophistication alone, however, is not sufficient to prevent application of the prohibition. See Interpretive Release on Regulation D, Securities Act Release No. 33-6455, 17 C.F.R. Pt. 231, 1983 SEC LEXIS 2288 (March 3, 1983), Q. 60, (“The mere fact that a solicitation is directed only to accredited investors will not mean that the solicitation is in compliance with Rule 502(c).”). The relationship between the issuer and the potential investor must also satisfy the requirement that it be “pre-existing.” A relationship is pre-existing if it existed for some duration prior to the current private offering. See E.F. Hutton & Co., 1985 SEC No-Act. LEXIS 2917 (Dec. 3, 1985). A pre-existing relationship most likely exists with potential investors with whom the issuer has a business relationship that allows the issuer to reasonably be sure the potential investor is sufficiently sophisticated in financial matters to participate in the offering. Furthermore, a pre-existing relationship clearly exists with investors who have participated in previous offerings made by the issuer. For example, there is no general solicitation where a general partner that has sponsored previous limited partnerships contacts investors in such previous limited partnerships to invest in a new limited partnership, provided the general partner believes that each investor is capable of evaluating the merits and risks of the investment. See Woodtrails-Seattle, Ltd. Offering securities to potential investors that do not have a “substantive” and “pre-existing” relationship with the issuer runs the risk of violating the prohibition against general solicitations and advertising.

Creating a Substantive and Pre-Existing Relationship
Official guidance does little to address the manner in which an issuer may create a substantial and pre-existing relationship. However, the guidance applicable to broker-dealers discussed below may be applicable to issuers as well.

Offeree/Broker-Dealer Relationship
Since many issuers do not have pre-existing relationships with large numbers of investors, they often hire a broker-dealer that has such relationships. See Sjostrom, William K., Relaxing the Ban: It’s Time to Allow General Solicitation and Advertising in Exempt Offerings, 32 Fla. St. U.L. Rev. 1, 14-19 (2004). Certain SEC no-action letters provide guidance as to how a broker-dealer may develop a substantive and pre-existing relationship with potential investors where one does not currently exist, see e.g., E.F. Hutton & Co.; Bateman Eichler, Hill Richards, Inc., 1985 SEC No-Act. LEXIS 2918 (Dec. 3, 1985); H.B. Shaine & Co., Inc.; and IPONET, 1996 SEC No-Act. LEXIS 642 (July 26, 1996). These no-action letters demonstrate that a substantive and pre-existing relationship may be developed through the use of a suitability questionnaire designed to ascertain the financial sophistication of potential investors as long as there is a “cooling-off” period between the time of the questionnaire and the private offering. In other words, a questionnaire may be used to establish the substantive aspect of the relationship, and a cooling-off period that allows the potential investor to participate only in offerings that are to be in the future establishes the relationship to be pre-existing.

In the 1985 Bateman Eichler no-action letter, the SEC provided guidance on how a broker-dealer can tailor its actions to avoid a general solicitation. Bateman Eichler’s proposed program involved various account executives sending a monthly mailing to not more than fifty potential local investors, including a letter and a financial questionnaire. If the potential investor completed the questionnaire, the account executive would follow up to obtain additional information. Those completing the follow-up stage would then be offered securities in the areas in which the potential investor indicated interest. No offering materials would be sent for any offering ongoing at the time of the initial solicitation, and no offering materials would be sent for at least forty-five days after the initial mailing. The broker-dealer’s letter to the SEC indicated that this program, “much like seminars, speaking engagements and generic advertising of Bateman Eichler, would serve as the first step in establishing a business relationship with new clients.”

The SEC noted the following factors: (1) that the proposed solicitation would be generic in nature and would not make reference to any specific investment and (2) that the broker-dealer would implement procedures designed to insure that persons solicited are not offered any securities that were offered or contemplated for offering at the time of solicitation. See Bateman Eichler, Hill Richards, Inc., 1985 SEC No-Act. LEXIS 2918 (Dec. 3, 1985). The SEC ruled that the later offers of securities “would not be deemed made by a general solicitation as a result of the initial solicitation” provided that the broker-dealer received “sufficient information to evaluate the prospective offeree’s sophistication and financial circumstances.” Id. The SEC did not believe that Bateman Eichler’s questionnaire provided enough information to constitute a substantive relationship. However, in a later no-action letter, the SEC indicated that full responses to a certain questionnaire would establish a pre-existing substantive relationship. See H.B. Shaine & Co., Inc., 1987 SEC No-Act. LEXIS 2004 (May 1, 1987). Once the there is a substantive relationship, offering materials may be placed on a password-protected website. See IPONET, 1996 SEC No-Act. LEXIS 642 (July 26, 1996).

There are two key points to ensuring that a questionnaire creates a substantive relationship. First, the questionnaire must be sufficiently detailed to properly determine the potential investor’s level of sophistication in financial matters and financial circumstances. In other words, the questionnaire must be sufficient for the broker-dealer to determine the potential investor’s ability to evaluate the risks and merits of the private offering and that the potential investor’s financial condition is adequate.

Second, the questionnaire process must be timed in a way that allows the relationship to be pre-existing to any offering. In other words, the questionnaire process must allow, “that sufficient time will have elapsed between a respondent’s completion of the questionnaire and the completion or inception of any particular offering.” H.B. Shaine & Co., Inc. Under this requirement, a broker-dealer cannot establish a quick relationship with a potential investor immediately before commencing a private offering in a specific attempt to circumvent the rule. Such relationships can, however, be developed in anticipation of some future offering so long as such offerings were not initiated or under consideration during this pre-qualification review. The SEC stated

[I]t is important that there be sufficient time between establishment of the relationship and an offer so that the offer is not considered made by general solicitation or advertising. In the [SEC]’s view, if the relationship was established prior to the time [the broker/dealer or issuer] began participating in the Regulation D offering, an offer could be made to the person with whom the relationship was established without violating Rule 502(c).

E.F. Hutton & Co., 1985 SEC No-Act. LEXIS 2917 (Dec. 3, 1985).

Time Period Elapsing for Pre-existing Relationship
There is little guidance on the time period that must elapse between the first introduction to a prospective investor and the offering of a security. A court has held that a one-week period between an initial “cold call” and following up on the call with a securities offering is not sufficient to establish a relationship. See S.E.C v. Credit First Fund, LP, 2006 U.S. Dist LEXIS 96697 (C.D.Cal 2006). In the Bateman Eichler no-action letter, the SEC did not object to a 45-day waiting period between the initial contact with a potential investor and a securities offering, provided the securities offering had not been initiated at the time of the initial contact. In the context of a website listing hedge fund information which only accredited investors could access, the SEC did not object to a 30-day waiting period between the day the potential investor qualified for the website and the day the investor could invest in a fund listed on the site. In addition, since hedge funds raise money on a semi-continuous basis, the SEC allowed the offering to be ongoing at the time of the investor’s qualification. See Lamp Techs., Inc., 1997 SEC No-Act. LEXIS 638 (May 29, 1997).

Application of Broker-Dealer Rules to Issuers
The above questionnaire procedures were approved solely for licensed broker-dealers. It is not clear whether an issuer could itself prequalify investors using these procedures. The SEC declined to give no-action relief to an issuer contemplating building a database of accredited investors by sending a generic financial questionnaire to users of its services that the issuer believed were likely accredited investors. See Agristar Global Networks, Ltd., 2004 SEC No-Act. LEXIS 203 (February 9, 2004). In a 2000 Release, the SEC opined:

Generally, staff interpretations of whether a “pre-existing, substantive relationship” exists have been limited to procedures established by broker-dealers in connection with their customers. This is because traditional broker-dealer relationships require that a broker-dealer deal fairly with, and make suitable recommendations to, customers, and thus, implies that a substantive relationship exists between the broker-dealer and its customers. We have long stated, however, that the presence or absence of a general solicitation is always dependent on the facts and circumstances of each particular case. Thus, there may be facts and circumstances in which a third party, other than a registered broker-dealer, could establish a “pre-existing, substantive relationship” sufficient to avoid a “general solicitation.”

Securities Act Release No. 33-7856 (April 28, 2000), 2000 SEC LEXIS 847 (footnotes omitted).

Conclusion
The following general principles may be inferred from the analysis above with respect to avoiding a “general solicitation”:

• Advertisements and seminars. Advertising relating to a securities offering is never allowed. Advertising relating to an issuer’s goods or services is permissible as long as the primary purpose of the advertisement is not to condition the market for future sales of securities. Seminars giving general information may not be given if the purpose is to attract investors for an issuer’s securities.

• Substantive and pre-existing relationship. An issuer may offer securities to those with whom the issuer has a pre-existing and substantial relationship. To be pre-existing, at a minimum the relationship must have been established at least 30 days prior to the offering. To be substantial, an issuer’s relationship must be such that the issuer is fully aware of the financial circumstances or sophistication of the potential investor.

• Facts and circumstances. The determination of whether or not a general solicitation or general advertisement has been made will always be made on the particular facts and circumstances of an offering. Counsel should be very careful in advising clients as to the types of communications that are permitted in connection with an offering of securities.