I’ve devoted several blog posts to the multifarious problems engendered by the SEC’s new “bad actor” disqualification provisions. I’ve done so because Rule 506(d) is so poorly drafted that, like the annals of Volusius, its fate should be to provide loose wrappings for fish (“laxas scombris saepe dabunt tunicas“).
Under Rule 506(d), an issuer will be debarred from relying on Rule 506 if any of its directors is, or has been, subject to any of the numerous disqualifying events listed in the rule. The inability to offer and sell securities will affect both large and small issuers. For many small issuers, Rule 506 represents the most cost-efficient way to raise capital. Large companies use Rule 506 to effect Rule 144A and other offerings.
The idea that “bad actors” shouldn’t be involved in offerings has obvious appeal. However, in the case of directors, the ban overlooks one key fact. Issuers don’t necessarily control who gets elected to the board. For example, minority shareholders of most California corporations can invoke cumulative voting to elect one or more directors. Another problem arises when a director with a clean record suffers a misstep after being elected to the board. In California corporations, a board of directors generally cannot remove a director. The only exception being that Corporations Code Section 302 permits a board to declare vacant the office of a director who has been declared of unsound mind by an order of court or convicted of a felony. While certain felony convictions are included in the Rule 506(d) list of disqualifying events, there are many other events, such as certain misdemeanor convictions, that are not covered by Section 302.
Issuers might try to address these problems by requiring board candidates to disclose any disqualifying events. However, this wouldn’t prevent a candidate from being elected; nor would it provide any prophylaxis against post-election events. Corporations may also consider adding to their articles or bylaws director qualification provisions. See Cal. Corp. Code § 212(b)(4) and Director Qualification Requirements, Nominations & Proxy Access. If qualification requirements are continuing (i.e., a director must meet the requirements at all times), then how will the corporation monitor compliance (e.g., send out questionnaires before every meeting, rely on an “honor code”)?
SEC reporting issuers will also have to grapple with new disclosure questions. Questionnaires used in connection with preparing proxy statements generally have been limited to the events described in Item 401(f) of Regulation S-K. But, as I’ve pointed out, those events are not the same as the events listed in Rule 506(d).