The Rule 506(b) Pre-Existing Relationship Requirement: A Practical Guide for Fund Managers

Introduction

Rule 506(b) remains the most popular exemption for private securities offerings in the United States, but it comes with a critical requirement that often trips up fund managers: the need to establish a “substantive pre-existing relationship” with investors before making any offer of securities. This requirement presents unique challenges in our digital age, where fund managers naturally want to leverage online platforms and networks to raise capital efficiently.

Understanding how to properly establish these relationships is crucial. Get it wrong, and you risk losing your exemption, exposing yourself to rescission rights, regulatory sanctions, and potential criminal liability. Get it right, and you can build a compliant fundraising process that scales with your business.

Understanding the Core Requirements

What Makes a Relationship “Substantive”?

According to SEC guidance, a substantive relationship exists when the issuer (or someone acting on its behalf) has sufficient information to evaluate—and actually does evaluate—a prospective investor’s:

• Financial circumstances
• Investment sophistication
• Status as an accredited or sophisticated investor

Critical point: Self-certification alone is insufficient. Simply having someone check a box claiming accredited investor status does not create a substantive relationship. You must have actual knowledge of the investor’s qualifications beyond their own assertions.

What Makes a Relationship “Pre-Existing”?

The relationship must be established before you commence the securities offering. The SEC has clarified that this depends on the quality of the relationship, not just its duration. While earlier guidance suggested 30 days might be sufficient, current interpretations focus more on the substantive nature of the interaction than any specific time period.

Key insight: You cannot mention or allude to any securities offering until after the relationship is established. This is where many issuers inadvertently violate Rule 506(b)—by discussing investment opportunities too early in the relationship.

The Stakes: Why Compliance Matters

Legal Risks of Non-Compliance

Failure to comply with Rule 506(b) requirements can result in severe consequences:

1. Loss of Exemption: Your entire offering may lose its exempt status, requiring registration or creating liability for illegal securities sales

2. Rescission Rights: Under Section 12(a)(1) of the Securities Act, investors can demand their money back plus interest

3. Regulatory Sanctions: SEC enforcement actions, civil penalties, and potential bars from future fundraising

4. Criminal Liability: In egregious cases, criminal prosecution is possible

The Infection Risk

Perhaps most concerning: non-compliance with respect to even one investor can “infect” the entire offering, potentially giving all investors rescission rights. This multiplier effect makes strict compliance essential.

Practical Strategies for Establishing Compliant Relationships

Building a Documented Process

The key to compliance is creating a systematic, documented process that demonstrates substantive evaluation of each prospective investor. Here’s a framework based on best practices and SEC guidance:

Step 1: Initial Contact and Information Gathering

• Collect basic information through a detailed questionnaire
• Include questions about investment experience, professional background, and financial qualifications
• Avoid any mention of specific investment opportunities

Step 2: Substantive Evaluation

• Review the submitted information thoroughly
• Conduct follow-up conversations (phone or video calls) to discuss:
  • Investment goals and strategy
  • Risk tolerance and investment timeline
  • Previous investment experience
  • Understanding of private securities risks
• Document all interactions and findings

Step 3: Verification and Documentation

• Consider additional verification steps such as:
  • LinkedIn profile review
  • Professional reference checks
  • Credit report review (with permission)
  • Third-party accreditation verification services
• Maintain detailed records of all verification efforts

Step 4: Internal Approval Process

• Designate a compliance officer or similar role to review relationships
• Create a formal approval process before granting access to offering materials
• Document the approval with timestamps and reasoning

The CitizenVC Model: A Case Study

In 2015, CitizenVC received a no-action letter from the SEC regarding their online process for establishing pre-existing relationships. While not a blanket approval, their approach provides valuable insights:

CitizenVC’s Process:

1. Gated Access: All offering materials were behind password-protected areas
2. Comprehensive Questionnaire: Detailed online forms collecting investor information
3. Multi-Touch Verification:
   • Phone calls to discuss background and investment goals
   • Email exchanges with educational materials
   • Credit report reviews
   • Encouragement to explore public educational content
4. Documented Approval: Only after satisfaction of all criteria was access granted

Key Takeaway: The order matters. Establish the relationship first, then—and only then—make any offer of securities.

Best Practices for Modern Fund Managers

1. Leverage Technology Wisely

• Use CRM systems to track and document all investor interactions
• Implement automated workflows that enforce proper sequencing
• Create audit trails showing when relationships were established

2. Train Your Team

• Ensure all team members understand the pre-existing relationship requirement
• Create scripts and guidelines for investor conversations
• Establish clear rules about when offering materials can be shared

3. Consider Alternative Approaches

• Rule 506(c): Allows general solicitation but requires verified accredited investor status
• Registered Investment Advisers: Can help establish relationships on your behalf
• Placement Agents: Registered broker-dealers can leverage their existing relationships

4. Document Everything

• Maintain detailed records of all investor interactions
• Create contemporaneous notes of phone calls and meetings
• Store all questionnaires and correspondence
• Implement retention policies that exceed statute of limitations periods

Sample Investor Questionnaire Elements

When building your investor questionnaire, consider including:

Professional Background:

• Current occupation and employer
• Years of professional experience
• Relevant industry expertise

Investment Experience:

• Types of alternative investments made previously
• Number and size of prior private investments
• Percentage of portfolio allocated to alternatives

Financial Qualifications:

• Method of accredited investor qualification
• Income ranges (if comfortable sharing)
• Net worth ranges (excluding primary residence)
• Sources of investment capital

Sophistication Indicators:

• Understanding of liquidity constraints
• Familiarity with private offering risks
• Investment decision-making process
• Use of advisors or consultants

Common Pitfalls to Avoid

1. Rushing the Process: Don’t let fundraising pressure compromise compliance
2. Over-Relying on Technology: Automated questionnaires alone aren’t sufficient
3. Inconsistent Application: Apply the same standards to all investors
4. Poor Documentation: Verbal assurances aren’t enough—document everything
5. Mixing Marketing and Relationship Building: Keep general marketing separate from 506(b) offerings

Conclusion

Establishing substantive pre-existing relationships under Rule 506(b) requires careful planning, consistent execution, and meticulous documentation. While the requirements may seem burdensome, they serve important investor protection purposes and, when properly implemented, can actually enhance your fundraising process by ensuring you’re connecting with qualified, appropriate investors.

The key is to view compliance not as an obstacle but as an opportunity to build meaningful relationships with potential investors. By implementing robust processes and maintaining detailed documentation, you can confidently navigate Rule 506(b) requirements while building a sustainable fundraising operation.

Remember: when in doubt, consult with experienced securities counsel. The cost of proper legal guidance is minimal compared to the potential consequences of non-compliance.

Disclaimer: This article is for informational purposes only and does not constitute legal advice. Securities law is complex and fact-specific. Always consult with qualified securities counsel before conducting any private securities offering.