The SEC has adopted provisions which prevent felons and other bad actors from relying on Rule 506 of Regulation D, the most frequently used private placement rule.
These changes are mandated by Section 926 of Dodd Frank, and are required to be substantially similar to Rule 262 under the Securities Act, which contains the disqualification provisions for Regulation A.
The new provisions will become effective on September 23, 2013. Click here to view the adopting release.
The bad actor changes prevent an issuer from using the private placement provisions of Rule 506, if the issuer, or specified persons or entities associated with the issuer (covered persons), are felons or other bad actors (Bad Actors). Rule 506 is the most popular private placement exemption. It preempts state regulation of the offering (other than notice filings and fraud claims) and as a result, its use simplifies the private placement process.
The Bad Actor provisions come into play when a covered person has a disqualifying event. These concepts are summarized below and explained in the detailed discussion.
In a very significant change from the existing rule and the proposed rule release, disqualifying events that took place in the past result in mandatory disclosure rather than an inability to use Rule 506. Only disqualifying events that take place after the effective date of the Bad Actor rules result in the inability to use Rule 506.
At the same time that the SEC adopted the Bad Actor provisions, it also adopted changes to Rule 506 which permit advertised private placements as long as all purchases are accredited investors and the issuer takes reasonable steps to verify accredited investor status. Click here for our explanation of these changes.
The SEC has also proposed several significant changes to Rule 506 to enhance investor protections.
The following are the persons or entities that are “covered persons” under the Bad Actor provisions:
- any director, executive officer or other officer of the issuer participating in the offering
- any general partner or managing member of the issuer
- any beneficial owner of 20% or more of the issuer’s outstanding voting equity securities, based on the total voting power
any investment manager of a pooled investment vehicle
- any director, executive officer or other officer participating in the offering, general partner or managing member of the investment manager of a pooled investment vehicle, 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 way at the time of sale
any paid solicitor
- any director, executive officer, other officer participating in the offering, general partner, or managing member of a paid solicitor
The following is a list of the types of events that are disqualifying. More information about these disqualifying events is contained in the detailed discussion.
- criminal convictions
- court injunctions and restraining orders
- final orders of certain regulators
- SEC disciplinary orders
- SEC cease and desist orders
- suspension or expulsion from membership in a self-regulatory organization (SRO) or association with an SRO member
- stop orders and orders suspending a Regulation A exemption
- U.S. Postal Service false representation orders
Reasonable Care Exception
The final rule includes an exception from disqualification where the issuer did not know, and in the exercise of reasonable care could not have known, about the disqualifying event relating to another covered person. Factual inquiry is required to support this exemption.
Waivers can be granted by the Director of the Division of Corporation Finance of the SEC, rather than requiring consideration by all SEC commissioners.
The Bad Actor provisions will apply to all private placements under Rule 506.
What Should Issuers Do Now?
Determine if Disclosure is Needed
Because the existence of disqualifying events before the effective date results in mandatory disclosure, issuers who are in the process of raising capital in a Rule 506 offering, or who may do so in the future, need to determine if any applicable covered persons have disqualifying events that will require disclosure in offering materials. If there are any events of this kind, the issuer should begin preparing the disclosure materials that will be needed.
Revise Due Diligence Procedures and Placement Agreements
Issuers should revise their due diligence procedures in connection with proposed Rule 506 offerings, and enhance disclosures in placement agent, finders or similar agreements, in an effort to ensure that no disqualifying events exist with respect covered persons, including the issuer’s or investment manager’s relevant principals, any promoters and any paid solicitors or their relevant principals.
Revise Subscription Documents
Issuers may also want to revise their subscription documents to capture information that would result in a disqualification if the purchaser becomes a 20% beneficial owner.
Work Out Procedures For Continuous Offerings
For private placements using Rule 506 that are ongoing after the effective date, it will be necessary for the issuer to have “update” procedures in place to make sure that the issuer has not been disqualified during the offering.
Detailed Description of Bad Actor Provisions
The new Bad Actor disqualification provisions prevent the use of Rule 506 if the issuer, or others associated with the issuer (such as directors, certain officers and significant shareholders) or the offering (such as underwriters and placement agents) have been convicted of, or are subject to court or administrative sanctions for, securities fraud or other violations of certain laws.
The Bad Actor disqualification comes into play when the issuer or certain persons or entities associated with the issuer or the offering have disqualifying events. These “covered persons” are as follows.
Predecessors of the Issuer
In addition to the issuer, predecessors of the issuer are also covered persons.
Directors, Executive Officers and Officers of the Issuer Participating in the Offering.
The SEC changed this item from its proposal that all officers be covered persons, to limit coverage to executive officers and officers who participate in the offering.
This change limits coverage to the situation where the risks are the most acute: when Bad Actors are personally involved in an offering or are performing policy making functions.
Managers of the Issuer
In many situations, the issuer is run by a manager or general partner, rather than a board of directors and officers. Accordingly, the covered persons include the general partner and managing member of the issuer.
20% Beneficial Owners
The final rule includes as covered persons beneficial owners of 20% or more of the issuer’s total outstanding voting equity securities, calculated on the basis of voting power.
This marks a change from the proposed rule release in which the SEC had proposed to cover 10% beneficial owners of any class of securities.
While no specific definition for the term “voting securities” was adopted, it is intended to be applied where the securityholder has or shares, either currently or on a contingent basis, the ability to control or significantly influence the management and policies of the issuer through the exercise of a voting right.
Securities that confer the right to elect or remove directors (or equivalent controlling persons of the issuer), or to approve significant transactions such as acquisitions, dispositions or financings, would be considered voting securities.
Securities that confer voting rights limited solely to approval of changes to the rights and preferences of their class would not be considered voting securities.
Investment Manager of Pooled Investment Vehicles
Investment managers of issuers that are pooled investment funds and their directors, executive officers, and other officers participating in the offering are covered persons.
Also included as covered persons are general partners and managing members of these types of investment managers, the directors and executive officers of such general partners and managing members and their other officers participating in the offering.
The category of promoter is broad, and captures all individuals and entities that have the relationship with the issuer or to the offering specified in Rule 405 of the Securities Act.
Rule 405 defines a promoter as any person – individual or legal entity – that either alone or with others, directly or indirectly takes the initiative in founding the business or enterprise of the issuer, or in connection with such founding or organization, directly or indirectly receives 10% or more of any class of issuer securities or 10% or more of the proceeds from the sale of any class of issuer securities (other than securities received solely as underwriting commission or solely in exchange for property).
This test includes activities “alone or together with others, directly or indirectly.”
Covered persons also include any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchases in connection with sales of securities in the offering (Paid Solicitor).
The rule changes also cover any director, executive officer or other officer of a Paid Solicitor participating in the offering, as well as the general partner or managing member of a Paid Solicitor.
Affiliated issuers are also covered persons under the new rule. However, the rule as adopted includes a provision under which events relating to certain affiliated issuers are not disqualifying if they predate the affiliation. Events that pre-date affiliation will not cause disqualification if, at the time of the event, the affiliated issuer:
- is not in control of the issuer, or
- under common control, together with the issuer, by a third party that controlled the affiliated issuer at the time of the event.
The SEC did not adopt specific exceptions for issuers that have had a change of control. The SEC expects this situation, under appropriate circumstances, to be dealt with in the waiver process.
Detailed Description of Disqualifying Events
The new rule provides for disqualification if a covered person has been convicted of any felony or misdemeanor:
- In connection with the purchase or sale of any security;
- Involving the making of any false filing with the SEC; or
- Arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities.
The rule includes look-back periods of five years for criminal convictions of issuers (including predecessors and affiliated issuers) and ten years for other covered persons. (These look-back provisions correspond to Rule 262.)
Court Injunctions and Restraining Orders
Under the new rule, an offering would be disqualified if any covered person is subject to any order, judgment or decree of any court of competent jurisdiction:
- That, at the time of such sale, 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;
- Involving the making of any false filing with the SEC; or
- Arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor or purchasers of securities.
There is a five year look-back for these types of events.
Final Regulatory Orders
Disqualification also results from certain orders of a state securities commission (or an agency or officer of a state performing like functions); a state authority that supervises or examines banks, savings associations, or credit unions; a state insurance commission (or an agency or officer of a state performing like functions); an appropriate federal banking agency; the CFTC; or the National Credit Union Administration.
Final orders of these regulators result in disqualification if at the time of such sale, they bar a covered person from:
- Association with an entity regulated by such regulator; or
- Engaging in savings association or credit union activities.
A final order of one of these regulators that is based on a violation of any law or regulation which prohibits fraudulent, manipulative, or deceptive conduct entered within ten years before such sale is also a disqualifying event.
This provision as adopted made a significant change from the proposed rule by adding the CFTC to the list of regulators whose regulatory bars and other final orders will trigger disqualification.
Under the rule as adopted, “bars” are orders issued by one of the specified regulators that have the effect of barring a person from association with certain regulated entities; from engaging in the business of securities, insurance or banking, or from engaging in savings association or credit union activities. An order that has one of these effects is a “bar” even if it does not use the word “bar.”
The final rule provides that an order must bar the person “at the time of sale” from one or more of the specified activities, making clear that a bar is disqualifying only for so long as it has continuing effect.
A person who is barred indefinitely, with the right to reassociate after a specified period, is disqualified until he or she is permitted to reassociate, if the bar has no continuing impact after reassociation. Persons who are subject to an indefinite bar who do not reassociate, but wish to participate in Rule 506 offerings, will need to seek a waiver.
“Final order” means a written directive or declaratory statement by a federal or state agency described in 506(d)(1)(iii) under applicable statutory authority that provides for notice and an opportunity for a hearing, which constitutes a final disposition or action by that federal or state agency.
Under this definition, ex parte orders issued under statutory authority that do not provide for notice and an opportunity for a hearing, do not trigger disqualification. There is no requirement that a final order be non-appealable.
SEC Disciplinary Orders
The final rule also disqualifies an offering if a covered person is subject to an SEC order (under certain provisions of the Exchange Act and the Investment Advisers Act which are described in the next paragraph), that, at the time of sale:
- suspends or revokes the person’s registration as a broker, dealer, municipal securities dealer or investment adviser;
- places limitations on the activities, functions or operations of the person; or
- bars the person from being associated with any entity or from participating in the offering of any penny stock.
Under the operative provisions, the SEC has the authority to impose a variety of sanctions against registered brokers, dealers, municipal securities dealers and investment advisers and their associated persons, including suspension or revocation of registration, censure, placing limitations on their activities, imposing civil money penalties and barring individuals from being associated with specified entities and from participating in the offering of penny stock.
SEC Cease and Desist Orders
The rule as adopted includes disqualification of an offering where a covered person is subject to an SEC order, which requires the person to cease and desist from committing or causing a violation or future violation of:
- any scienter based antifraud provision of the federal securities laws; or
- the registration requirements of the Securities Act.
This provision has a five-year look back.
Suspension or Expulsion From SRO Membership or Association with an SRO Member
An offering is also disqualified if a covered person is suspended or expelled from membership in, or suspended or barred from association with a member of, a registered national securities exchange, or a registered national or affiliated securities association, for any act or omission to act constituting conduct inconsistent with just and equitable principles of trade.
Stop Orders and Orders Suspending the Regulation A Exemption
Under the rule as adopted, an offering is disqualified if any covered person has filed (as a registrant or issuer), or was named as an underwriter in, any registration statement or Regulation A offering statement filed with the SEC within 5 years before the sale, which was the subject of a refusal order, stop order or order suspending the Regulation A exemption, or is at the time of sale, the subject of an investigation or proceeding to determine whether a stop order or suspension order should be issued.
U.S. Postal Service False Representation Orders
Under the final rule, an offering is disqualified if any covered person is subject to a United States Postal Service false representation order entered within five years before the sale, or is, at the time of the sale, subject to a temporary restraining order or preliminary injunction with respect to conduct alleged by the United States Postal Service to constitute a scheme or device for obtaining money or property through the mail or property through the mail or by means of false representations.
Reasonable Care Exception
The final rule includes an exception from disqualification 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 another covered person.
An issuer will not be able to establish that it has exercised reasonable care unless it made a factual inquiry into whether any disqualifications existed. The nature and scope of the inquiry necessary to exercise reasonable care will vary based on the circumstances of the issuer and the other offering participants.
The SEC did not provide specific guidance on the types of inquiry needed to establish reasonable care.
The SEC’s adopting release states that the SEC believes that issuers may have “in-depth” knowledge relating to their executive officers and officers participating in an offering and that, in such circumstances, further steps may not be required for these persons in a specific offering.
The adopting release also states that:
“Factual inquiry 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 the case of a registered broker-dealer acting as a placement agent in a Rule 506 offering, the adopting release states that it may be sufficient to make inquiry of the employing entity concerning the relevant set of covered officers and controlling persons, and to consult publicly available databases concerning past disciplinary history of the relevant persons.
In the case of continuous, delayed or long-lived offerings, the SEC expects that reasonable care will include updating the factual inquiry “on a reasonable basis.” The frequency and degree of updating depends on the circumstances relating to the issuer, the offering and offering participants. Periodic updating will generally be sufficient.
However, more frequent monitoring will be required in special circumstances, such as where a covered person is subject to a judicial or regulatory proceeding. It is expected that issuers will use a combination of the following for updating, depending on the circumstances.
- bring downs of representations, questionnaires and certifications;
- negative consent letters; and
periodic rechecking of public databases. Under the new provisions, the disqualification is on a sale by sale basis and a disqualifying event that takes place after a sale does not impact that past sale.
The rule as adopted includes waiver provisions. Waivers can be granted by the Director of the Division of Corporation Finance (rather than requiring consideration by all the SEC commissioners, which would have been required under the proposed rules).
The SEC did not provide guidance on the circumstances that would give rise to a waiver, or articulate standards for granting waivers. However, the adopting release does identify a number of circumstances that would, depending on the specific facts, be relevant to the evaluation of a waiver request, including:
- a change of control;
- a change in supervisory personnel;
- absence of notice and opportunity for a hearing; and
- relief from a permanent bar for a person who does not intend to apply to reassociate with a regulated entity.
Disqualification does not apply if the regulator issuing the relevant decision determines that Rule 506 disqualification is not necessary under the circumstances. In the absence of action by the state regulator, the SEC may grant a waiver on its own.
Disqualifying Events That Take Place before the Effective Date
Disqualification Applies Only to Triggering Events that Take Place After Effectiveness of the Rule Amendments
The amendments specify that disqualification will not arise as a result of triggering events that took place before the effective date of these changes.
Mandatory Disclosure is Required for Triggering Events that Predate the Effectiveness of the Rule Amendments
Instead of imposing disqualification for pre-existing triggering events, the new rule requires written disclosure of matters that would have triggered disqualification, except that they occurred before the effective date of the Bad Actor provisions.
The SEC expects that issuers will give reasonable prominence to this 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 the disclosure “a reasonable time” before sale, which is the same timing that currently applies to disclosures to non-accredited investors under Rule 502(b)(1).
If disclosure is required and not adequately provided to an investor, relief will not 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.
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. This “reasonable care” exception to the disclosure requirement is similar to the “reasonable care” exception to disqualification the SEC also adopted, and will preserve an issuer’s claim to reliance on Rule 506 if disclosure is required but the issuer can establish that it did not know and in the exercise of reasonable care could not have known of the matters required to be disclosed. The provision also includes an instruction, similar to the instruction for the reasonable care disqualification exception, clarifying that reasonable care requires factual inquiry.