Recently, the SEC adopted amendments to Regulation D under the Securities Act adding (1) new Rule 506(d), which disqualifies issuers from relying on Rule 506 if certain “bad actors” are involved in the offering, and (2) new Rule 506(c), which permits issuers to use “general solicitation and advertising,” subject to some conditions. Both rules become effective September 23, 2013. Funds that rely on Regulation D should consider compliance policy updates to ensure that they can comply with the conditions of these new rules.

Bad Actors — Disqualifying Events

Under Rule 506(d) generally, issuers may not rely on Rule 506 if the issuer or “covered persons” involved in the offering have a “disqualifying event” after September 23, 2013, unless the disqualification is waived by the SEC. If an event that occurred prior to September 23, 2013 would have been a disqualifying event had it occurred later, the issuer must disclose the disqualifying event to offerees, and this disclosure must occur within a reasonable time prior to the sale. If an issuer makes sales when there were unknown and undisclosed disqualifying events, the issuer can only rely on Rule 506 if the issuer can demonstrate that it did not know, and in the exercise of reasonable care could not have known, about the disqualifying events.

Amended Rule 506(d) lists the specific participants whose actions could disqualify an issuer from relying on Regulation D, and the specific disqualifying events. Before commencing a Regulation D offering, issuers must conduct internal due diligence to ensure that disqualifying events are disclosed. Issuers need to identify covered persons (including at service providers and among beneficial owners), identify disqualifying events, if any, and prepare mandatory disclosures, if required.

Issuers should also review service provider contracts, including employment agreements and placement agency agreements, to ensure that they contain appropriate provisions requiring notification to the issuer if a disqualifying event occurs. Issuers should also revise policies and procedures to require disclosures by officers, directors and employees and to require covered persons to certify annually that they have disclosed all disqualification events.

Employees, Officers and Directors

Only directors, executive officers or other officers who participate in the offering are covered persons for purposes of Rule 506(d). Whether an officer participates in an offering is based on all of the facts and circumstances, but generally, more than “transitory or incidental” activity is required. Engaging in due diligence activities, drafting or preparing disclosures documents and communicating with the issuer, prospective investors or other offering participants would constitute “participating in the offering.”

Issuers need to review their internal policies and procedures, and employment and compliance manuals, to request disclosure of disqualifying events, and add an annual certification requirement.

20% Shareholders

Covered persons include beneficial owners of 20% or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power (and not share ownership). For this purpose, securities that offer the ability to control or significantly influence management, such as by electing or removing directors or control persons of the issuer, or approving significant transactions such as acquisitions, dispositions or financings, would be “voting securities.” The ability to approve changes to rights and preferences does not by itself make the security a “voting security.”

Issuers should revise subscription documentation to include questions about potential disqualifying events and voting agreements among shareholders, and to include provisions requiring large beneficial holders to report disqualifying events. Some investors may be loathe to disclose these matters in responses to questionnaires. Issuers intending to rely on Regulation D should consider what due diligence, if any, should be conducted on major investors to uncover any events that could prevent the Regulation D reliance.

Private funds should consider whether to amend operating agreements to expand the fund’s ability to cause a mandatory redemption if a beneficial owner’s disqualification event could prevent the Fund from relying on Regulation D.

Promoters 

Covered persons include promoters that are connected with the issuer in any capacity at the time of a sale of securities offered pursuant to Rule 506. For purposes of Rule 506(d), promoters include any person who, alone or with others:

  • directly or indirectly takes initiative in founding or organizing the business or enterprise of an issuer; or 
  • in connection with the founding or organization of the business or enterprise of an issuer, 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. 

Issuers should also review and modify placement agreements to ensure they receive full and prompt disclosure of disqualifying events, and to add an annual certification requirement.

Timing 

For all of these inquiries, issuers need to ensure that they know of events that occurred prior to September 23, 2013 that would have been disqualifying events had they occurred after that date. For sales occurring after September 23, the issuer must disclose these events to prospective investors and this disclosure must be delivered a reasonable time before the sale. The disclosure must describe the matters that would have triggered disqualification if they had occurred after September 23. Failing to make this disclosure when an issuer is required to do so would not constitute an “insignificant deviation” for purposes of Rule 508, and the issuer would lose its ability to rely on Rule 506. 

Issuers that are aware of pre-2013 disqualifying events should consider and prepare the necessary pre-offering disclosure. 

General Solicitation/Advertising 

Rule 506(c) under the Securities Act was recently amended to permit issuers to use general solicitation or advertising. Under Rule 506(c) generally, issuers relying on Regulation D can engage in general solicitation and advertising of their offerings, so long as all investors in the offering are actually accredited, and the issuer has taken steps to reasonably determine that the investors are accredited. 

Issuers that intend to use general solicitation or advertising should amend their compliance policies and procedures: 

  • to specify the type of diligence that the issuer will perform to ensure that investors are accredited; 
  • to specify a review process for creating, using and retaining general solicitation or advertising materials; and 
  • to document the processes by which investor qualifications and any solicitation or advertising materials are reviewed. 

Fund advisers should be particularly aware of Rule 204(6)-8, which covers misstatements by advisers to pooled investment vehicles, and would apply to general solicitation or advertising materials.