Note - This is an email chain between Jenny Kassan and other CfPA members discussing the challenges of Testing The Water, that has been edited for brevity. While it is chucked full of useful information, it doesn't constitute legal, financial or compliance advise. As always consulting with a qualified lawyer or SME. This post is for educational purposes only.  - Samson 

 

Subject: problem with Reg CF Testing the Waters 

From: Jenny Kassan

 
Oct 25, 2021, 10:07 PM

Hello!  I don’t know if anyone has discussed this in our group but there is a big problem with Reg CF testing the waters under Rule 206.

If someone decides to publicly advertise the fact that they are considering doing a Reg CF offering under Rule 206 and then later decides not to do a Reg CF offering and that that they want to do a private offering of securities under Rule 506(b) or Rule 504 instead, they will pretty much be precluded from doing so theoretically forever!

This is because of the integration rule that says

For an exempt offering prohibiting general solicitation, the issuer must have a reasonable belief, based on the facts and circumstances, with respect to each purchaser in the exempt offering prohibiting general solicitation, that the issuer (or any person acting on the issuer’s behalf) either:
(i) Did not solicit such purchaser through the use of general solicitation; or

(ii) Established a substantive relationship with such purchaser prior to the commencement of the exempt offering prohibiting general solicitation

 

So anyone who hears about your offering under Reg CF testing the waters would not be eligible to invest in your private offering.  There is no time limit on this!

The only way you could address this is to establish a substantive relationship with everyone who sees your public advertising before you solicit them in a private offering.

Of course this would be a very fact and circumstances intensive question as to whether you successfully established such a relationship.

And this doesn’t even address the blue sky challenges that would come up with a Rule 504 offering.

I spoke to someone at the SEC who agreed this was unfortunate.  I told him that we had submitted a letter requesting a time limit on this limitation in the integration rules and he said - I know - I wish they would have done that - hopefully they will do something about this in the future.

I would love to see if there is any way we could get the SEC to consider adding a rule that puts a time limit on this prohibition.

Let me know what you think!

Jenny Kassan
 
Jenny Kassan Consulting
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From: Jordan Fishfeld

Hey Jenny,

Just a thought, but doesn't section II create a method whereby the investor would be allowed.  Right now, if I want to do an offering under 506(b), I can't advertise the offering, and if I do, I must create a substantial and meaningful relationship with any of my investors.  This is how many of the 506(b) platforms operated, albeit close to the line.  If I were to test the waters, for Reg CF, does a blanket time limit turn that list of investors from generally solicited to my private investors, or does my effort in establishing a substantial relationship make them private?  

While I would agree we need clarity, from a client perspective, I would be comfortable advising that if they gain an investor's contact information through a general solicitation, they can use the historical methods of creating a substantial relationship to turn them into a valid private investor.  

 

From: Sara Hanks 

Agreed; I am not seeing how this is different from previous 506(b) practices.

 

From: Jordan Fishfeld

Hey Jenny,

 
Just a thought, but doesn't section II create a method whereby the investor would be allowed.  Right now, if I want to do an offering under 506(b), I can't advertise the offering, and if I do, I must create a substantial and meaningful relationship with any of my investors.  This is how many of the 506(b) platforms operated, albeit close to the line.  If I were to test the waters, for Reg CF, does a blanket time limit turn that list of investors from generally solicited to my private investors, or does my effort in establishing a substantial relationship make them private?  
 
While I would agree we need clarity, from a client perspective, I would be comfortable advising that if they gain an investor's contact information through a general solicitation, they can use the historical methods of creating a substantial relationship to turn them into a valid private investor.  

 

From: Jenny Kassan 

It seems like if you do a public announcement of a Reg CF testing the waters there is no limit on who might see it and you wouldn’t have a list of everyone who had seen it.  I’m not sure how you would go about creating substantial relationships with everyone who sees your TTW communication.  Also, couldn’t there be a dispute regarding whether a substantial relationship exists?

 

From: Sara Hanks

You would only need to form a substantive relationship (in the same way as usual in 506(b)) with the people who you want to invest in the 506(b). You wouldn’t need to revisit the communications made, compliantly, in the original CF TTW.

 

From: Jordan Fishfeld

 

Agreed.  

I do think the scrutiny of how that relationship is created might be higher compared to what a platform might need to do that hadn't advertised deal terms, but the academic analysis is the same. 

 

From: Sara Hank 

Although the deal terms would technically be with respect to the CF offering, right?

 

From: Jenny Kassan

Can you say what the same way as usual is for 506b?  

Also, what if the follow on offering was under Rule 504?

Thank you!

 

From: Sarah Hank 

Somewhere in my files I have a piece I co-authored that covers this, including I think discussion of the no-action letter that said the process didn’t necessarily have to take 30 days. Bear with me and I will find it.

I would imagine the same principles would apply to 504 but I have never done a 504…

 

From: Jenny Kassan 

Thank you Sara!

What bums me out is that they did away with the 6 month safe harbor in Reg D.  The way I interpreted that safe harbor was that even if you met investors through public solicitation using a public offering under Reg D (ie 506(c) or 504 with state compliance that allows public advertising), you could later switch to a private raise and solicit those same investors without an issue, as long as you had at least 6 months between the offerings.

 

From: Sara Hanks

I really don’t think you need the 6 months separation anymore though. Rule 152(a)(1) says that in those circumstances you can solicit the guys you found through the general solicitation exemption so long as you establish the substantive relationship with them before soliciting them under the non-GS exemption. I think the text in the adopting release accompanying n.79 is explicit on that point.

So all you need to do is establish the relationship (just for the guys you intend to offer to in the non-GS offering), which you would do the same way as you would have for 506(b) prior to the new rules, and if you do that you can even have GS offerings and non-GS offerings conducted at the same time.

I’m sending you separately the extract from the work I mentioned, and the Citizen VC letter, which is the one that said, in effect, you don’t need a 30-day period between initial contact with the potential 506(b) investor and the making of the investment, so long as the relationship is established, is also useful here.

 

From: Jenny Kassan 

Thank you for this!

But I am still a little bit skeptical!  Imagine this scenario:

I post on a public web site saying I am testing the waters for an offering of preferred stock in my company (could be Reg CF TTW or generic TTW).

100 people see the web site and sign up as interested or express interest via a message board.

One month later, I decide I am going to offer my preferred stock under Rule 506(b).

I take the list of 100 people that expressed interest on the public web site and I reach out to all of them and say “hey, thank you fo expressing interest in my offering.  I decided that I am not going to do that offering after all, but I would love to get to know you better!  Please tell me more about you.”

I gather some info about these folks including whether they are a accredited, where they live, their profession, etc.

One month later, I email all these people and say, “hey, guess what!  I am now offering my preferred stock via a private offering - would you like to invest?”

Are you saying this would not be a problem under the new rules?

Thank you so much for any insights Sara or anyone else has on this issue!

 

From: Jordan Fishfeld 

That now becomes a determination of facts and circumstances, and I think your fact-pattern does not rise to the level required.  If every day during that 30 day period you had coffee with every investors (obviously impossible, but stick with me) and you spoke about everything from investment thesis to family matters, that would do it for sure.  The line is somewhere in-between our two fact patterns and it is up to the platform to document the steps they took and the reasons they feel the relationship is now ripe for investment.

 

From: Sara Hanks

Two points to add here: first, if you set this sequence up deliberately, you’d fall foul of the anti avoidance rules. And secondly, the generic TTW almost never works in our industry. It doesn’t preempt state law. 

Sent from my iPhone. Please excuse typos and treat unintelligible autocorrects as found poetry. 

 

From: Jenny Kassan 

 Nov 13, 2021, 7:43 PM 

 

Thank you Sara and Jordan!  I prepared this summary - let me know if it sounds right.

Rule 241 (aka generic testing the waters) allows public or private solicitations of interest from potential investors.  There is no preemption of state law so this rule should not be used unless the solicitation is done in compliance with the rules for the state in which the offering is made and where investors are located.  Also, it is important to keep in mind the integration rule which is discussed below.

Rule 206 (aka regulation crowdfunding testing the waters) allows public or private solicitations of interest from potential investors in preparation for launching a Regulation Crowdfunding campaign.  This type of solicitation does not need to comply with state rules (state rules are preempted).  However, it is important to keep in mind the integration rule discussed below.

Integration Rule: If you meet a potential investor through a public solicitation, including solicitations conducted under Rule 241 or 206, you may not later solicit them to invest in a private offering UNLESS between the time you solicited them publicly and the time you ask them to invest in a private offering, you have developed a substantial relationship with them.  You cannot publicly solicit potential investors with the intention of later soliciting them for a private investment.

 

The End 

 

Note - Again, this is not legal or financial advice. You should at all time retain counsel or technical assistance to help you with your unique offering. The purpose of this post is only for educational purposes. 

 

And on that note, good luck! May the odds and the algorithms forever be in your favor. 

 

Samson