Overview

At an open meeting of the U.S. Securities and Exchange Commission on July 10, 2013, the SEC voted unanimously to adopt a new rule disqualifying felons and other “bad actors” from Rule 506 private securities offerings. Specifically, once the new rule becomes effective, issuers will no longer be able rely on Rule 506 of Regulation D if the issuer or any other person covered by the rule had a “disqualifying event,” such as a securities-related criminal conviction, an SEC cease-and-desist order or stop order, a securities-related court injunction or restraining order, or a suspension or expulsion from membership in a Self-Regulatory Organization, or SRO (such as FINRA), among others.

The rule is prospective and does not apply to disqualifying events preceding the effective date of the rule. However, pre-existing events that occurred during various specified time windows must be disclosed to investors.

Disqualifying events that occur while an offering is underway will be treated in a similar fashion. Offerings made before the occurrence of the disqualification trigger will not be affected by it, but the issuer will not be entitled to rely on Rule 506 for offerings made afterward unless the disqualification is waived or removed, or, if the issuer is not aware of a triggering event, the issuer can rely on the reasonable care exception.

The final rule will be effective 60 days following its publication in the Federal Register, estimated to be sometime in mid-September 2013. The new disqualification provisions will be codified as paragraph (d) of Rule 506. Disclosure of prior bad actor events will be codified as paragraph (e) of Rule 506.

Who is Covered by the Rule?

  • The issuer and any predecessor of the issuer or affiliated issuer;  
  • Any director, executive officer, other officer participating in the offering, general partner or managing member of the issuer;  
  • Any beneficial owner of 20% or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power;  
  • Any investment manager to an issuer that is a pooled investment fund and any director, executive officer, other officer participating in the offering, general partner or managing member of any such investment manager, as well as any director, executive officer or officer participating in the offering of any such general partner or managing member;  
  • Any promoter connected with the issuer in any capacity at the time of the sale;  
  • Any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with sales of securities in the offering (which the SEC refer to as a “compensated solicitor”); and  
  • Any director, executive officer, other officer participating in the offering, general partner, or managing member of any such compensated solicitor.

Events relating to an affiliated issuer that occurred before the affiliation arose will not be disqualifying to the issuer if the affiliated issuer is not in control of the issuer or under common control with the issuer at the time of such events.

Disqualifying Events

Under the new rule, the “disqualifying events” include the following:

  • Criminal convictions (within 10 years of the proposed sale of securities (or five years in the case of the issuer and its predecessors and affiliated issuers)) in connection with the purchase or sale of a security, making of a false filing with the SEC or arising out of the conduct of certain types of financial intermediaries.  
  • Court injunctions and restraining orders in connection with the purchase or sale of a security, making a false filing with the SEC, or arising out of the conduct of certain types of financial intermediaries. The injunction or restraining order must have occurred within five years of the proposed sale of securities.  
  • Final orders from the Commodity Futures Trading Commission, federal banking agencies, the National Credit Union Administration, or state regulators of securities, insurance, banking, savings associations, or credit unions that bar the issuer from associating with a regulated entity, engaging in the business of securities, insurance or banking, or engaging in savings association or credit union activities, or are based on fraudulent, manipulative, or deceptive conduct and are issued within 10 years of the proposed sale of securities.  
  • Certain SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment companies, and investment advisers and their associated persons.  
  • SEC cease-and-desist orders related to violations of certain anti-fraud provisions and registration requirements of the federal securities laws.  
  • SEC stop orders and orders suspending the Regulation A exemption issued within five years of the proposed sale of securities.  
  • Suspension or expulsion from membership in an SRO or from association with an SRO member.  
  • U.S. Postal Service false representation orders issued within five years before the proposed sale of securities.

Reasonable Care Exception

Overview

As proposed, the rule included an exception from disqualification for offerings where the issuer establishes that it did not know and, in the exercise of reasonable care, could not have known, that a disqualification existed because of the presence or participation of a bad actor. The SEC explained that an issuer would not be able to establish that it had exercised reasonable care, however, unless it had made a factual inquiry into whether any disqualifications existed.

The SEC stated in the adopting release for the new rule that “[w]e proposed the reasonable care exception to preserve the intended benefits of Rule 506 and avoid creating an undue burden on capital-raising activities, by reducing the risk that issuers could lose the benefit of Rule 506 as a result of disqualifications of which they were unaware.”

As adopted, the final rule states that the steps an issuer should take to exercise reasonable care will vary according to the particular facts and circumstances. The SEC has indicated that it expects issuers to have an “in-depth knowledge of their own executive officers and other officers participating in securities offerings gained through the hiring process and in the course of the employment relationship.” In these circumstances, the SEC has indicated further steps may not be required in connection with a particular offering. The SEC suggests factual inquiries by means of questionnaires or certifications, perhaps accompanied by contractual representations, covenants and undertakings, may be sufficient in some circumstances, particularly if there is no information or other indicators suggesting bad actor involvement.

In terms of timing, the SEC believes inquiries should be “reasonable in relation to the circumstances of the offering and the participants.” Accordingly, the objective for the issuer in a Rule 506 offering should be to gather information that is “complete and accurate as of the time of the relevant transactions.” The SEC expects that issuers will determine the appropriate dates to make a factual inquiry, based upon the particular facts and circumstances of the offering and the participants involved, to determine whether any offering participants are subject to disqualification before seeking to rely on the Rule 506 exemption.

Under the new rule, issuers should endeavor to make a factual inquiry of all offering participants. In some cases, however, it may be sufficient to rely upon publicly available databases concerning the past disciplinary history of the relevant persons. As an example, the SEC referenced public databases providing information about registered broker-dealers.

Finally, the SEC noted that if the investigation conducted by the issuer prompts it to question the truthfulness of the responses to its inquiries, the reasonable care exception would require further investigation to provide a reasonable level of assurance that no disqualifications apply.

Continuous and Long-Lived Offerings

The SEC also addressed the requirements in the event of continuous, delayed or long-lived offerings. The SEC stated that in these types of offerings, reasonable care requires updating the factual inquiry on a reasonable basis, while noting that the frequency and degree of updating will depend on the circumstances of the issuer, the offering and the participants involved.

The SEC said that in the absence of facts indicating that closer monitoring would be required (for example, notice that an offering participant is the subject of a proceeding or knowledge of the weaknesses in an organization’s screening procedures), the SEC would expect that periodic updating could be sufficient. The SEC believes that issuers should manage updating requirements through the use of contractual covenants from offering participants to provide the bring-down of representations, questionnaires and certifications, negative consent letters, periodic re-checking of public databases, and other steps, depending on the circumstances.

Waivers

Section 926 of the Dodd-Frank Act required the SEC to create disqualification provisions similar to those included in Regulation A. Under Reg. A, the SEC is permitted to grant a waiver from disqualification if it determines that the issuer has shown good cause that disqualification is not necessary.

Before the adoption of the new waiver rules for Rule 506 offerings, the Director of the Division of Corporation Finance of the SEC had delegated authority to grant disqualification waivers under Regulation A and Rule 505 only. However, commenters who addressed the issue generally supported the extension of this authority to Rule 506 offerings.

Waiver Based on Determination of Issuing Authority

The final rule provides that disqualification will not arise if, before the relevant sale is made in reliance on Rule 506, the court or regulatory authority that entered the relevant order, judgment or decree advises in writing, whether in the relevant judgment, order or decree or separately to the Commission or its staff, that disqualification under Rule 506 should not arise as a consequence of such order, judgment or decree. Even in the absence of such advice, the SEC may still exercise its discretion to grant waivers under Rule 506 in cases where it considers it appropriate to do so.

The SEC stated that it would be premature to adopt specific standards for granting waivers, but it lists a number of circumstances that it indicates could be relevant to the evaluation of a waiver request, including a change of control, change of supervisory personnel, absence of notice and opportunity for hearing, and relief from a permanent bar for a person who does not intend to apply to reassociate with a regulated entity. The SEC noted that this is not an exhaustive list, and other factors could also be relevant to consideration of waiver requests.

Transitional Issues and Disclosure of Pre-Existing Disqualifying Events

Disqualification Applies Only to Triggering Events that Occur After Effectiveness of the Rule Amendments

After reviewing approximately 20 comment letters on the issue of when the disqualification provisions should apply to offerings under Rule 506 (i.e., to offerings made before adoption of the new rules or only on a going-forward basis), the SEC determined that disqualification will not arise as a result of disqualifying events that occurred before the effective date of the rule amendments. The SEC will, however, require disclosure to investors regarding such events.

Mandatory Disclosure of Disqualifying Events that Pre-Date the Effectiveness of the Rule Amendments

In the proposing release, the SEC solicited comment on whether it should require disclosure, rather than disqualification, for bad actor triggering events that occurred before the effective date of the new rules.

The SEC ultimately decided against imposing disqualification for pre-existing triggering events. Rather, the rule amendments require written disclosure of matters that would have triggered disqualification, but for the fact that they occurred before the effective date of the new disqualification provisions.

In adopting these amendments, the SEC noted that “[i]n light of Congress’ concerns about the participation of certain felons and other bad actors in Rule 506 offerings, we believe this disclosure is important to put investors on notice of bad actor involvement in Rule 506 offerings …,” and that “as a result of the adoption of the new requirements implementing Section 926, investors may have the impression that all bad actors are now disqualified from participation in Rule 506 offerings. We expect that issuers will give reasonable prominence to the disclosure to ensure that information about pre-existing bad actor events is appropriately presented in the total mix of information available to investors.”

The disclosure requirement in new Rule 506(e) will apply to all offerings under Rule 506, regardless of whether purchasers are accredited investors. Issuers will be required to provide disclosure “a reasonable time prior to sale,” which is the same timing that currently applies to disclosures to non-accredited investors under Rule 502(b)(1).

Consequences of Failing to Disclose Participation of “Bad Actors” in Rule 506 Offerings

If disclosure is required and not adequately provided to an investor, the SEC does not believe that relief will be available under Rule 508, under which “insignificant deviations” from Regulation D requirements do not necessarily result in loss of the Securities Act exemption with regard to an offer or sale of securities to a particular individual or entity. Stated another way, failure to disclose the participation of bad actors may result in the loss of the Rule 506 offering exemption.

For Rule 508 to apply to an offer or sale of securities, the failure to comply with a Regulation D requirement must not pertain to a term, condition or requirement directly intended to protect that offeree or purchaser. Disclosure of pre-existing triggering events under new Rule 506(e) is intended to benefit all investors by alerting them to any bad actors associated with the issuer or the offering, and, therefore, this condition of Rule 508 cannot be met where the required disclosure is not provided.

Rule 506(e) does, however, provide that the failure to furnish required disclosure on a timely basis will not prevent an issuer from relying on Rule 506 if the issuer establishes that it did not know, and in the exercise of reasonable care could not have known, of the existence of the undisclosed matter or matters.

Amendment to Form D

The final rule amends Form D to include a certification in the signature block similar to the current certification by Rule 505 issuers, whereby issuers claiming a Rule 506 exemption will confirm that the offering is not disqualified from reliance on Rule 506 for one of the reasons stated in Rule 506(d).

Issuer Considerations

The new rule provides very limited circumstances under which participation of a bad actor in a Rule 506 offering would not cause an issuer to lose its Rule 506 registration exemption for private securities offerings. Because the consequences of the inadvertent participation of disqualifying persons in such an offering are so great, it is important for issuers relying on Rule 506 to establish appropriate due diligence procedures to ensure that no such persons participate in the offering.

While Rule 506 is a commonly relied upon registration exemption, private securities offerings may also be conducted pursuant to Section 4(a)(2) of the Securities Act of 1933. For offerings where Rule 506 would be unavailable based on disqualification under the new rule, an issuer may be able to rely on Section 4(a)(2) to avoid registration.

We would note, however, that although the new rule does not address Section 4(a)(2) offerings it may be prudent to consider the intent of the new rule with respect to Section 4(a)(2) offerings. We believe issuers relying on Section 4(a)(2) should strongly consider disclosing to potential investors any participation in an offering by a bad actor where the nature of the disqualifying event could be considered material information by investors.