Rep. Maxine Waters, D-Calif., chairwoman of the House Financial Services Committee, introduced a bill entitled the Bad Actor Disqualification Act of 2019 (the Disqualification Act). The Disqualification Act states that it is intended to increase transparency and accountability associated with the waiver process. We are concerned that the bill, if enacted, would result in an inefficient and expensive waiver process that would not serve the public interest, protect investors or promote market integrity. The Disqualification Act would impose a public comment overlay on an important enforcement-related process where the Securities and Exchange Commission (SEC or Commission) previously had discretion.

What is the waiver process? When companies or individuals resolve a case with the SEC or other governmental entity, the resolution of such matters can trigger certain disqualifications under the federal securities laws. Such disqualifications may, among other things, prohibit a company from raising capital pursuant to Rule 506 of Regulation D or utilizing the significant reforms in the securities offering and communication processes that the Commission adopted in 2005, including the ability to register securities for offer or sale under an automatic shelf registration statement, which becomes effective upon filing, and to file post-effective amendments to register additional or new types of securities.

Because the disqualification provisions are intentionally broad and triggered by a variety of conduct (including conduct that is merely negligent or in some cases imposed based on strict liability), the Commission recognizes that it can be fundamentally unfair to disqualify an entire company from engaging in a particular activity or utilizing a certain provision under the federal securities laws for underlying activity that might be very limited in scope. The federal securities laws provide for a process by which the Commission, and in some cases the Commission staff through delegated authority, can waive those disqualifications. If for example, a company violated the securities laws in connection with the sale of securities, it might be disqualified from using the safe harbor available to private offerings. The company would have to go to the Commission and argue why the disqualification should be lifted. In such cases, a waiver is not usually granted. Oftentimes, however, the conduct at issue in a Commission matter is completely unrelated to the resulting disqualification. For example, in the case of large institutions engaged in a broad range of activities (e.g., banking, broker-dealer, investment adviser, commodities, insurance) through numerous domestic and international affiliates, a company may be sanctioned for a technical rule violation related to a discrete activity but be disqualified from conducting a very wide range of activities. In these cases, the Commission has provided waivers after satisfying itself that the conduct is unrelated to the disqualified activity and that the company has addressed the conduct at issue through remedial actions. As a result, ongoing businesses where there was no violative conduct can continue without disruption. This bill would change that — not only risking capital formation but potentially putting numerous industry jobs at risk.    The Disqualification Act does not recognize this distinction. The effect of making waivers difficult or impossible to obtain would be to penalize innocent employees, shareholders, vendors and customers who were entirely innocent of the misconduct at issue. The cascading effect of such ramifications could also lead to market disruption if companies were forced to cease entire facets of their business.  

What would the bill require? The Disqualification Act would apply to requests for waivers from the disqualifications under the federal securities laws, including the well-known seasoned issuer (WKSI) disqualification, Rule 506 of Regulation D disqualification, Private Securities Litigation Reform Act of 1995 (“PSLRA) forward-looking statements disqualification, Regulation A disqualification, Regulation E disqualification and cash solicitation rule disqualification pursuant to Rule 206(4)-3 under the Investment Advisers Act of 1940 (Advisers Act). The Disqualification Act would also require the commission of a study regarding the waiver process for the Section 9(a) of the Investment Company Act of 1940 disqualification. The Disqualification Act would eliminate the Commission staff’s ability to grant waivers and instead would impose a three-step process to obtain a permanent waiver. First, a company would need to petition the Commission for a temporary waiver, which the Commission could grant “if the Commission determines that such person has demonstrated immediate irreparable injury.” The temporary waiver would be for a period of 180 days, and all temporary waiver requests (whether granted or not) would be published with an explanation from the Commission as to the rationale for granting or not granting the waiver. Second, the Commission would publish notice in the Federal Register “of the pendency of the waiver determination and ... afford the public and interested persons an opportunity to present their views [on the waiver application], including at a public hearing.” Third, the Commission would hold a public hearing during which it would consider granting a permanent waiver. The Commission would not be able to consider the “direct costs to the ineligible person associated with a denial” and would need to find that the waiver “(i) is in the public interest; (ii) is necessary for the protection of investors; and (iii) promotes market integrity” in order to grant the waiver.   The Disqualification Act would also prohibit the Commission staff from informing a waiver applicant of the “likelihood of a waiver being granted” or of the staff’s recommendation of a waiver and would require that the staff maintain a database of “ineligible persons.”

What would be the consequences of the bill? The main consequences of the proposed Disqualification Act would be to (1) take the waiver process out of the hands of those who are best situated to make the decisions regarding the waivers, (2) further politicize the waiver process, (3) use waivers as additional sanctions against companies, and (4) make settlements with the Commission less attractive to companies.

The waiver process should be handled by the Commission staff and Commissioners. The waiver process is currently handled by the Commission staff in the relevant SEC Divisions and the SEC Commissioners and Chair (Commissioners). The Commission staff review waiver applications, based on certain criteria, and make a determination as to whether a waiver should be granted in a particular instance. The Commission staff, with oversight by the Commission, are in the best position to determine whether a waiver should be granted, based on the facts and circumstances of a particular matter. Important in that consideration are the costs to a company of the disqualification; those costs include both the economic costs to a company as well as the loss of industry jobs, which can be quite significant.   Although the Commission staff can make a recommendation to the Commission, the Commissioners make the ultimate decision on a waiver application. In general, the Commissioners either call a waiver for a vote or permit the applicable Division to issue a waiver by delegated authority. Furthermore, certain waivers may only be granted by the Commission itself. It is not necessary or useful to introduce the concept of a public hearing and public comment into the waiver process. Those inside the Commission are closest to the waiver process, understand the most about the disqualification at issue and understand the most about the rationale for seeking the waiver. Introducing comments from the general public will only further politicize the process, add unnecessary expense and uncertainty to the companies seeking a waiver and require additional Commission resources, without any added benefit to the process.  

The waiver process has been politicized. As noted above, in recent years, the waiver process has been politicized and often criticized for favoring “the largest financial institutions on Wall Street,” and the Disqualification Act makes the same representations. However, such criticism is misleading. Certain waivers granted by the Commission relate to a disqualification that applies only to large institutions. Therefore, large institutions are the only applicants for the waivers. This naturally makes it appear as though large financial institutions receive most of the waivers, but it is because they are the only entities that need to seek that particular waiver. Furthermore, the Disqualification Act would make the waiver process so expensive for companies seeking a waiver that it may become impossible for smaller companies to even try to seek a waiver of those disqualifications that apply to all companies due to the added cost that would be associated with the process.

Disqualifications effectively would become additional enforcement sanctions. When an enforcement case is settled, it means that the Commission has already determined the appropriate remedies and sanctions — which may be severe — for the alleged conduct. Such remedies and sanctions may include restrictions from engaging in certain conduct related to the underlying enforcement action. The disqualifications under the federal securities laws were not intended to have an additional punitive effect against companies. Were the Disqualification Act adopted, the waiver process would become so difficult to navigate that the disqualifications would, in essence, become additional enforcement sanctions that impose restrictions on companies that may be ill-fitting by virtue of being unrelated to the conduct at issue.

The Disqualification Act would make companies less willing to enter into settlements with the Commission.Enacting the Disqualification Act would have a chilling effect on market participants’ willingness to settle cases with the Commission. In deciding to settle a case with the Commission, a company must be able to judge what the consequences of a settlement would mean to the company. Such consequences include any proposed sanctions in the order or consent judgment as well as any disqualifications triggered by such proposed settlement. A company could not enter into a proposed settlement with the Commission with uncertainty surrounding the potential disqualification of key business lines for a period of six months. Such uncertainty is harmful to a company, its clients and the markets as a whole.

Takeaways. The Disqualification Act is under discussion by the House Financial Services Committee and should be closely monitored by all companies subject to Commission jurisdiction, including both public companies and SEC-registered financial services firms — both small and large. If adopted, the Disqualification Act could be detrimental for companies, the Commission and the markets as a whole.