Pitfalls for Funding Platforms Continuing to Raise Capital over the Internet under Rule 506(b)

Even with the flexibility provided to Regulation D private placement offerings by Title II of the JumpStart Our Business Startups (JOBS) Act, U.S. Securities and Exchange Commission (SEC) data has consistently shown that most Regulation D offerings continue to raise capital under traditional Rule 506(b).  Rule 506(b), unlike its newer counterpart Rule 506(c), does not permit general solicitation. 

General solicitation under Rule 502(c) of Regulation D is general advertising of a securities offering, including any article, notice or other published communication.  A Rule 506(b) private placement offering must remain private, something difficult to conceptualize as many of these offerings are available now only over the internet. 

Thus, we see internet funding platforms that raise capital under Rule 506(b) attempt to map out an investment process that reconciles the import of historic and more recent SEC no action guidance.  Their investment processes include limitations on who may see investments on the site and when, and what is necessary to construct a pre-existing, substantive relationship.

While 506(b) does have some advantages over Rule 506(c), including that it does not require a verification of investor accreditation and it permits investment by a limited number of sophisticated albeit not accredited investors, reliance by Funding Platforms on Rule 506(b) carries with it significant risks.  These risks have increased given SEC enforcement investigations focusing on the availability of the Rule 506(b) exemption when evaluating a funding platform’s investment processes.  The obvious conclusion here is that general solicitation eliminates the Rule 506(b) exemption and renders the securities offering illegal.  Even inadvertent or minor general solicitation eliminates this exemption.  If there was any question on the point, it was put to rest in the KCD Financial case decided by the SEC earlier this year. 

In the Matter of KCD Financial Inc. , SEC Release No. 34-80340; File No. 3-17512 (March 29, 2017),  registered broker-dealer KCD Financial requested SEC review of a FINRA Disciplinary Action finding that it engaged in a unregistered securities offering in contravention of Section 5 of the Securities Act of 1933, among other findings.  The securities raise was for a fund investing in distressed properties under Rule 506(b) of Regulation D.  In addition to targeting potential investors to whom there was a prior business relationship, the issuer distributed a press release about the offering that resulted in two newspaper articles appearing on the topic (which later were added to the issuer’s website).  As these activities were identified as problematic, KCD Financial took precautions to preserve the Rule 506(b) exemption by limiting investors to only those who had a pre-existing business relationship, and rejecting other investors until KCD confirmed they did not see the press articles.  At least one investor who had learned about the offering through a newspaper article was not permitted to invest.   Despite KCD’s precautions and the fact that all investors who invested in the fund had a prior business (pre-existing, substantive) relationship, the SEC nonetheless affirmed FINRA’s findings holding that general solicitation rendered the Rule 506(b) exemption unavailable.  The SEC determined that the fact that there was general solicitation to other offerees who did not invest was sufficient to establish the violation of Section 5 of the Securities Act.    

In addition to providing a strong argument to convert to a Rule 506(c) model, this SEC’s decision provides a basis to consider current funding platform practices and pitfalls.  SEC guidance has been consistent that one way to show regulators there was no general solicitation is by establishing a pre-existing, substantive relationship with an investor (this is one but not the only way to do so — another is by showing that the activities do not constitute an “offer” of securities).  In establishing the substantive relationship, the SEC focuses on the investor’s financial knowledge and goals and the issuer’s (or its agent’s) efforts to understand same.  The SEC Division of Corporate Finance Compliance and Disclosure Interpretations make clear that “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.”  (Question 256.31) Similarly, “a ‘pre-existing’ relationship is one that the issuer has formed with an offeree prior to the commencement of the securities offering.” (Question 256.29) Establishing each of these requirements is necessary, especially where the introduction between investor and issuer first occurs on a funding platform’s website where a securities offering is listed.  Here are some pitfalls and common mistakes to avoid:    

  1. Platforms and issuers may misunderstand the breadth of general solicitation.  General solicitation under Rule 506(b) blows the securities exemption and renders the securities offering illegal.  Simple mistakes include sharing details of, or permitting investment in, a securities offering before or during the establishment of the substantive relationship.  Competing against properly establishing the substantive relationship is the business urgency to allow an investor to invest before he or she loses interest.  Unfortunately, failure to property establish the relationship will eliminate the availability of the exemption.
  2. The SEC has stated that “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.” (See SEC Corporate Finance Compliance and Disclosure Interpretations Question 254.31).  Adding some confusion here as to what specifically is required to form the relationship is SEC no action guidance including Lamp Technologies, Inc. (accredited investor questionnaire alone resulted in no action relief, but SEC took no position on whether the information was sufficient to show an investor was accredited) and Citizens VC, Inc. (suggesting a ‘substantive’ relationship requires more and is established only where 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  status as an accredited or sophisticated investor”).  When designing an investor onboarding process, it is best to err on the side of doing more rather than less to ensure that it accomplishes the objective of properly establishing the relationship.  This of course includes sufficient probing of an investor to achieve a full understanding of the investor’s financial circumstances and sophistication.
  3. The Citizen VC, Inc. no action letter which notified the world that there is no specific length required for a cooling off period has unfortunately been misunderstood by many.  The absence of a requirement for a specific time period does not eliminate the historic and clear requirement that a pre-existing, substantive relationship be formed before a prospective investor may review a securities offering or invest.  The key take-away remains that the relationship must be formed before the sharing of an investment opportunity.  And the relationship must pre-exist the investment opportunity (except for a limited exception for private funds making a semi-continuous offering).

While all these rules are a bit more complicated than the summary I provide above, my purpose is to help funding platforms and issuers navigate the more common pitfalls.  The lesson of KCD Financial is that even where all investors have a pre-existing, substantive relationship with an issuer, this fact alone does not insulate the exemption from the bar against general solicitation.  Thus, internet platforms, and issuers utilizing these platforms, need to understand that the Rule 506(b) exemption requires both the formation of a pre-existing, substantive relationship and the absence of any general solicitation.  This relationship may be more difficult to establish, and general solicitation may be more unforgiving, than is commonly acknowledged.  Navigating these pitfalls is necessary to protect the legality of a securities offering.  An alternative approach remains to convert the funding platform’s investment process to the requirements of Rule 506(c), a choice that the SEC likely prefers.       


Scott Andersen is principal at finLawyer.com. He has also been Deputy Regional Chief Counsel at FINRA, Enforcement Director at FINRA and the NYSE, Co-Chief of the Securities Prosecutions Unit of the NY Attorney General’s office, and Asst. Attorney General for the State of NY. In these roles, he has investigated, prosecuted and supervised criminal, civil and regulatory enforcement actions for over nineteen years. He concentrates his practice on SEC, FINRA and state regulatory defense and securities regulatory counseling, as well as working with crowdfunding portals, funding platforms, broker-dealers and fintech providers on regulatory compliance matters.

The information and materials in this article are provided for general informational purposes only and are not intended to be legal advice. The issues discussed include complicated areas of law and legal advice should be obtained from a securities attorney about your specific circumstances.


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