The SEC’s Division of Corporation Finance recently issued 14 Compliance and Disclosure Interpretations (CDIs) relating to the newly adopted “bad actor” disqualification provisions applicable to securities offerings conducted in reliance on Rule 506 of Regulation D under the Securities Act.

As discussed in our SEC Update of July 26, 2013, available here, the SEC earlier this year adopted amendments to Rule 506 to implement Section 926 of the Dodd-Frank Act directing the SEC to disqualify securities offerings involving “certain felons and other ‘bad actors’” from reliance on Rule 506. Under the disqualification provisions, which are contained in Rule 506(d), an issuer will not be permitted to engage in a Rule 506 offering if it or certain persons related to it or participating in the offering are convicted of certain felonies or misdemeanors or become subject to other “disqualifying events” on or after the effective date of the provisions (September 23, 2013). While a triggering event that occurred before that date will not disqualify an offering, the issuer will be required under Rule 506(e) to disclose the event to prospective investors before it sells securities.

Although the CDIs are not rules, regulations or statements of the Commission, they provide important guidance by the staff of the Division of Corporation Finance on how to apply the new disqualification provisions. The CDIs (which are organized as Questions 260.14 through 260.27 under the caption “Securities Act Rules”) present the staff’s views on how to determine in particular circumstances:

  • Which affiliates are “affiliated issuers” whose bad acts could disqualify an offering
  • When an issuer is required to make a disqualification determination
  • When an officer is deemed to be “participating” in an offering and therefore subject to a disqualification determination
  • Which types of events will trigger disqualification
  • When waivers of disqualification by the staff are unnecessary or will not be granted
  • How the “reasonable care” exception to disqualification will be interpreted
  • When disclosure of disqualifying events will be required under Rule 506(e)

The text of the CDIs is available here.

“Affiliated issuers”

Under Rule 506(d), the “covered persons” to which the disqualifications apply include the issuer and any predecessor of the issuer or “affiliated issuer.” The staff clarifies that an “affiliated issuer” for these purposes is an affiliate (as defined in Rule 501(b) of Regulation D) of the issuer that is itself issuing securities in the same offering, and therefore not every affiliate that has issued securities. The “same offering” under this guidance will include a nominally discrete offering that is subject to “integration” with other offerings under Rule 502(a) of Regulation D and hence treated as part of a single offering together with other offerings. (Question 260.16) This clarification should dispel the concern that portfolio companies controlled by private equity funds would be treated as affiliated issuers of the funds when the funds sell securities under Rule 506.

The staff refers to CDIs 130.01 and 130.02 under the caption “Securities Act Forms” for examples of co-issuer or multiple issuer offerings that would involve an affiliated issuer. Those offerings include (1) a master fund offering conducted through feeder funds created for the sole purpose of investing their proceeds in the master fund, (2) a debt offering with multiple guarantors, and (3) an offering that includes real estate limited partnerships as multiple issuers.

Disqualification determinations

Rule 506(d) does not specify when an issuer must conduct its bad actor due diligence. The SEC staff fills the gap by clarifying that an issuer must determine if it is subject to a bad actor disqualification any time it is offering or selling securities in reliance on Rule 506. Under this guidance, an issuer that is not currently engaged in an offering (such as a fund that is winding down and is closed to investment) need not determine whether Rule 506(d) applies unless and until it commences a Rule 506 offering. The staff indicates that an issuer may reasonably rely on a covered person’s agreement to provide notice of a bad actor triggering event in accordance with any of a variety of obligations, including contractual covenants, bylaw requirements, or an undertaking in a questionnaire or certification. (Question 260.14)

The staff advises in the same guidance that an issuer in a “continuous, delayed or long-lived” offering must “periodically” update its factual inquiry into whether any disqualifications exist. The updating measures will depend on the circumstances of the offering, but could include the bring-down of representations, questionnaires and certifications, negative consent letters, or periodic re-checking of public databases that would be expected to reflect information about disqualifying events.

The staff indicates that a disqualifying event affecting a placement agent that occurs during an offering will not prevent reliance on Rule 506 so long as certain conditions are satisfied. If a placement agent or one of its covered control persons (such as an executive officer or managing member) becomes subject to a disqualifying event while an offering is ongoing, the issuer may continue to rely on Rule 506 for future sales in that offering (1) if the placement agent is terminated and receives no compensation for future sales, or (2) if the disqualifying event affected only a covered control person of the placement agent, and the control person is terminated or no longer performs any roles with respect to the placement agent that would cause that person to be a covered person under the rule. (Question 260.15)

The staff notes that compensated solicitors are not limited to brokers, as defined in Exchange Act Section  3(a)(4), who are subject to registration under the Exchange Act. Instead, all persons who have been or will be paid remuneration for solicitation of purchasers are covered by Rule 506(d), regardless of whether they are, or are required to be, registered under the Exchange Act or are associated persons of registered broker-dealers. (Question 260.17)

“Participating” in an offering

Covered persons for purposes of the disqualification provisions include, in addition to directors and executive officers, any “officer participating in the offering” of an issuer or of any investment manager to, or general partner or managing member of, an issuer. In its Rule 506(d) adopting release, the SEC stated that, for an officer to be considered participating in an offering, the officer must have more than a “transitory or incidental involvement” in the offering. An officer soliciting investors in an offering generally would be deemed to be participating in the offering.

The staff provides the following additional gloss on the meaning of “participating”:

  • Officers who are involved in a Rule 506 offering only by virtue of their service on a compensated solicitor’s deal or transaction committee responsible for approving the solicitor’s participation in the offering would not be deemed to be participating in the offering. (Question 260.18)
  • Officers of a compensated solicitor might be deemed to be participating in an offering, even if they are not involved in the solicitation of investors for the offering, if they:
  • Participate or have other involvement in due diligence activities or in the preparation of offering materials (including analyst reports used to solicit investors)
  • Provide structuring or other advice to the issuer in connection with the offering
  • Communicate with the issuer, prospective investors or other offering participants about the offering

Officers who perform solely administrative functions with respect to an offering, such as opening brokerage accounts, wiring funds and engaging in bookkeeping activities, generally would not be deemed to be participating in the offering. (Question 260.19)

Disqualification triggers

The staff advises that disqualification under Rule 506(d) is not triggered by actions taken in jurisdictions other than the United States, such as convictions, court orders or injunctions in a foreign court, or regulatory orders issued by foreign regulatory authorities. (Question 260.20)

Disqualification is not triggered by all SEC orders to cease and desist from violations of the Commission’s rules promulgated under Exchange Act Section 10(b). Instead, disqualification as a result of such orders will occur only if the covered person is ordered to cease and desist from violations of scienter-based provisions of the federal securities laws, including scienter-based SEC rules. An order to cease and desist from violations of a non-scienter based rule (such as Rule 105 of Regulation M under the Exchange Act) would not trigger disqualification, even if the rule itself is promulgated under a scienter-based provision of law (such as Section 10(b)). (Question 260.21)

Waivers

Under Rule 506(d), the Director of the SEC’s Division of Corporation Finance has authority to waive disqualifications upon a showing of good cause. The SEC stated in its adopting release that a waiver would be appropriate, for example, upon a proper showing that there has been a change of control of the entity subject to a disqualifying event and that the persons responsible for the activities resulting in the event are no longer employed by the entity or no longer exercise influence over it.

The staff indicates that the waiver provisions of Rule 506(d)(2)(iii) are self-executing. Accordingly, if an order issued by a court or regulator provides, in accordance with Rule 506(d)(2)(iii), that disqualification from Rule 506 should not arise as a result of the order, it will not be necessary for the issuer to seek a waiver or to take any other action to confirm that bad actor disqualification will not apply as a result of the order. (Question 260.22)

The Director will not waive an issuer’s obligation to disclose past events that would have been disqualifying except for the fact that they occurred before September 23, 2013 (the effective date of Rule 506(d)). (Question 260.24)

Reasonable care exception

Rule 506(d) contains a “reasonable care” exception under which an issuer will not lose the benefit of the Rule 506 safe harbor, despite the existence of a disqualifying event, if the issuer can show that it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed.

The staff explains that this exception could apply when, despite its exercise of reasonable care, the issuer (1) was unable to determine the existence of a disqualifying event, (2) was unable to determine that a particular person was a covered person, or (3) initially reasonably determined that the person was not a covered person but later determined that the person should have been deemed a covered person. The staff notes that the issuer still will need to consider what remedial steps it should take throughout the course of a Rule 506 offering once it discovers a Rule 506(d) disqualifying event or a covered person. As indicated by the staff, the issuer may need to seek waivers of disqualification, terminate the relationship with covered persons, provide Rule 506(e) disclosure, or take other remedial steps to address the disqualification. (Question 260.23)

Disclosure of pre-effective disqualifying events

The staff provides the following guidance on the operation of Rule 506(e):

  • Rule 506(e) requires disclosure only of events that would have triggered disqualification at the time of the offering if Rule 506(d) had been applicable at that time. Because disqualification would not result from events that occurred outside the applicable disqualifying look-back period or orders that do not have continuing effect, Rule 506(e) would not require an issuer to disclose those events. (Question 260.25)
  • In an offering in which the issuer uses multiple placement agents or other compensated solicitors, the issuer is required to provide all prospective investors with the Rule 506(e) disclosure for all compensated solicitors who are involved with the offering at the time of sale and for all of their covered control persons. The issuer may not limit disclosure to specific prospective investors only with respect to the compensated solicitor that solicited those investors or with respect to that solicitor’s covered control persons. (Question 260.26)
  • Once a compensated solicitor ceases to be involved in a continuous offering, the issuer will not be required under Rule 506(e) to disclose to prospective investors disqualifying events affecting that solicitor. (Question 260.27)