On Dec. 4, 2013, the Division of Corporate Finance of the U.S. Securities and Exchange Commission supplemented its Compliance and Disclosure Interpretations (“C&DIs”)[1] to address some of the questions raised by private fund managers (and others) regarding the recently promulgated “bad actor” rules contained in new Rule 506(d).[2]

New Rule 506(d), which became effective on Sept. 23, 2013, disqualifies issuers that have committed or experienced (or who have a relationship with certain categories of persons who have committed or experienced) one or more of an enumerated list of bad acts and actions from relying on the exemption from registration under the Securities Act of 1933 provided by Regulation D. However, the final text of the rule raised a number of questions on how certain provisions of the bad actor rule would be interpreted in the context of private funds.

While the December 4 C&DIs do not answer all of the questions that private fund managers have about Rule 506(d), they resolve several points of confusion, including the following:

  • Resolving the “Affiliated Issuer” Question

Under Rule 506(d), an issuer is disqualified from relying on Regulation D if an “affiliated issuer” is a bad actor. There was considerable confusion and concern about whether the “affiliated issuer” concept captured situations such as separate private funds with a common adviser, private funds advised by another manager under a shared corporate parent or a portfolio company in which a private fund holds an interest.[3]

Question 260.16 provides a resolution that private fund managers will generally welcome, stating that under Rule 50(d), “affiliated issuer” is limited to an entity that is an affiliate (as defined in Rule 501(b) of Regulation D) of the issuer that is issuing securities in the same offering. Therefore, this C&DI, among other things, makes clear that portfolio companies are not “affiliated issuers.” (Managers were also reminded that “in the same offering” picks up the integration concept in Rule 502(a) of Regulation D and that they should, therefore, analyze that point in appropriate situations.)

  • The Division’s Interpretation of “Participation in an Offering”

Covered persons under Rule 506(d) include officers of — among others — compensated solicitors and private fund managers who are “participating in the offering” of privately placed securities. One C&DI, Question 260.19, seeks to resolve confusion over the applicability of “participation in an offering” to non-soliciting officers of a placement agent. The Division’s response confirms that it does not intend to employ a narrow construction of the scope of “participation” in an offering: it states that participation “is not limited to solicitation of investors . . . [it includes] participation or involvement in due diligence activities or the preparation of offering materials . . . providing structuring or other advice to the issuer in connection with the offering, and communicating with the issuer, prospective investors or other offering participants about the offering.” It does, however, provide a list of some activities that “would generally not be deemed to be participating in the offering” (e.g., opening brokerage accounts, wiring funds and bookkeeping activities).

  • Limited Guidance on “Reasonable Care”

Rule 506(d) introduced a “reasonable care” standard into an issuer-directed savings provision. In Question 260.23, the Division clarified that the following actions, if reasonable under the surrounding circumstances, would not necessarily constitute Rule 506(d) violations:

  1.     An inability to determine the existence of a disqualifying event;
  2.     An inability to determine that a particular person was a covered person; and
  3.     An initial (but ultimately incorrect) determination that a particular person was not a covered person.

However, no express guidance was provided in this C&DI on appropriate subsequent steps once the applicable error was discovered, although a non-exclusive list of options was included (e.g., obtaining waivers of disqualification, terminating the relationship with such a covered person, providing Rule 506(e) disclosures or other remedial steps).

  • Obtaining Bringdowns and Updating Disclosures

Question 260.14 confirms that “if an offering is continuous, delayed or long-lived, the issuer must update its [Rule 506(d)] factual inquiry periodically through bring-down of representations, questionnaires and certifications, negative consent letters, periodic re-checking of public databases, and other steps, depending on the circumstances.” The C&DI does not provide any further guidance or any safe harbor on frequency or extent.

  • Universal Placement Agent Disclosures

Question 260.26 makes it clear that the Division expects issuers to send Rule 506(e) disclosures on placement agent prior bad acts to all investors — not just to those introduced by the placement agent making the bad act disclosure.

  • The “Termination” Solution

Another C&DI confirms that timely termination of a disqualifying solicitation arrangement or termination or modification of an employment relationship can preserve an issuer’s prospective ability to rely on Regulation D. With respect to the termination of a placement agent, Question 260.15 also states that the terminated solicitor may “not receive compensation for the future sales.” In a related C&DI, Question 260.27, the Division makes clear that an issuer conducting a continuous offering is not required to provide Rule 506(e) disclosures with respect to compensated solicitors who are no longer involved with the offering.

  • No Foreign Bad Acts

Some of the “bad acts” listed in Rule 506(d) do not specifically identify geographic restrictions (e.g., the disqualification for a person “subject to any order, judgment or decree of any court of competent jurisdiction . . . [that] restrains or enjoins such person from engaging or continuing to engage in any conduct or practice in connection with the purchase or sale of any security . . .”). Question 260.20 provides confirmation that a Regulation D disqualification will not result from convictions, court orders, injunctions in a foreign court or regulatory orders issued by foreign regulatory authorities. (Note that this determination accords with pre-existing language in the SEC’s releases.)

  • Rule 105 Orders

Rule 105 is a non-scienter-based rule and Question 260.21 confirms that a cease and desist order under Rule 105 will not trigger a Regulation D disqualification, even though Rule 105 is itself promulgated under a scienter-based provision of law (i.e., Section 10(b) of the Securities Exchange Act).