On December 4, 2013 and January 3, 2014, the SEC issued new Compliance and Disclosure Interpretations (C&DIs) clarifying the application of the “bad actor” disqualifications from Rule 506 offerings. Generally, under the new Rule 506(d), an issuer may not rely on the Rule 506 registration exemption if the issuer or any other person covered by Rule 506(d) has a relevant conviction, judgment, suspension or other disqualifying event that occurred on or after September 23, 2013 (the effective date of Rule 506(d)). Please see below a summary of some C&DIs issued by the SEC.
When is an issuer required to determine whether bad actor disqualification under Rule 506(d) applies? An issuer must determine if it is subject to “bad actor” disqualification any time it is offering or selling securities in reliance on Rule 506. After the initial inquiry, an issuer may reasonably rely on a covered person’s agreement to provide notice of a potential or actual bad actor triggering event pursuant to, for example, contractual covenants, bylaw requirements, or an under taking in a questionnaire or certification. However, if an offering is continuous, delayed or long-lived, the issuer must update its factual inquiry periodically through bring-down of representations, questionnaires, certifications, negative consent letters, periodic re-checking of public databases, and other steps, depending on the circumstances.
If a placement agent or one of its covered control persons becomes subject to a dis qualifying event while an offering is still ongoing, could the issuer continue to rely on Rule 506 for that offering? Yes, 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 still ongoing, the issuer could rely on Rule 506 for future sales in that offering if the engagement with the placement agent was terminated and the placement agent did not receive compensation for the future sales. If the triggering disqualifying event affected only the covered control persons of the placement agent, the issuer could continue to rely on Rule 506 for that offering if such persons were terminated or no longer performed roles with respect to the placement agent that would cause them to be covered persons for purposes of Rule 506(d).
What does it mean to participate in the offering? Participation in an offering is not limited to solicitation of investors. For example, participation in an offering includes participation or involvement in due diligence activities or the preparation of offering materials (including analyst reports used to solicit investors), providing structuring or other advice to the issuer in connection with the offering, and communicating with the issuer, prospective investors or other offering participants about the offering. However, to constitute “participation,” such activities must be more than transitory or incidental. Administrative functions, such as opening brokerage accounts, wiring funds, and bookkeeping activities, would generally not be deemed to be participating in the offering.
Is disqualification triggered by actions taken overseas? No, disqualification under Rule 506(d) is not triggered by convictions, court orders, or injunctions in a foreign court, or regulatory orders issued by foreign regulatory authorities.
When does the “reasonable care” exception apply? The reasonable care exception to the new rule applies whenever the issuer can establish that it did not know and, despite the exercise of reasonable care, could not have known that a disqualification existed under Rule 506(d). This may occur when, despite the exercise of reasonable care, the issuer was unable to determine the existence of a disqualifying event, was unable to determine that a particular person was a covered person, or initially reasonably determined that the person was not a covered person but subsequently learned that determination was incorrect. An issuer may need to seek waivers of dis qualification, terminate the relationship with covered persons, provide additional disclosure under Rule 506(e), or take other remedial steps to address the Rule 506(d) disqualification.
What does it mean to be a beneficial owner of at least 20% of voting equity securities? A shareholder that becomes a 20% beneficial owner of the issuer’s outstanding voting equity securities upon completion of a sale of securities is NOT a 20% beneficial owner at the time of such sale. However, it would be a covered person with respect to any sales of securities in the offering that were made while it was a 20% beneficial owner. The term “beneficial owner” under Rule 506(d) means any person who, directly or indirectly, through any contract, arrangement, understanding, relationship or otherwise, has or shares, or is deemed to have or share: (1) voting power, which includes the power to vote, or to direct the voting of, such security; and/or (2) investment power, which includes the power to dispose, or to direct the disposition of, such security. In addition, for purposes of determining 20% beneficial owners under Rule 506(d), it is necessary to “look through” entities to their controlling persons because beneficial ownership includes both direct and indirect interests (see Exchange Act Rule 13d-3).
If some of the shareholders have entered into a voting agreement under which each shareholder agrees to vote its shares of voting equity securities in favor of director candidates designated by one or more of the other parties, which effectively means that such shareholders have formed a group, then the group beneficially owns the shares beneficially owned by its members (see Exchange Act Rules 13d-3 and 13d-5(b)). In addition, the parties to the voting agreement that have or share the power to vote or direct the vote of shares beneficially owned by other parties to the agreement (through, for example, the receipt of an irrevocable proxy or the right to designate director nominees for whom the other parties have agreed to vote) will beneficially own such shares. Parties that do not have or share the power to vote or direct the vote of other parties’ shares would not beneficially own such shares solely as a result of entering into the voting agreement (see another new C&DI issued by the SEC on January 3, 2014). If the group is a 20% beneficial owner, then disqualification or disclosure obligations would arise from court orders, injunctions, regulatory orders or other triggering events against the group itself. If a party to the voting agreement becomes a 20% beneficial owner because shares of other parties are added to its beneficial ownership, disqualification or disclosure obligations would arise from triggering events against that party.
