The SEC has proposed new regulations under Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act that would disqualify certain “bad actors” from relying on Rule 506, the most widely used safe harbor for private placements. The proposed rules reflect the Dodd-Frank Act’s directive to the SEC to issue disqualification rules for Rule 506 offerings that are “substantially similar” to those for Regulation A offerings while expanding the list of disqualifying events to include certain actions taken by state securities regulators.
Persons covered by the disqualification rules. The SEC’s proposal designates the following as “Covered Persons,” the acts of whom could disqualify an issuer from relying on Rule 506:
- the issuer, any predecessor of the issuer, or an affiliated issuer;
- any director, officer, general partner or managing member of the issuer;
- any beneficial owner of 10% or more of any class of the issuer’s equity securities;
- any promoter connected with the issuer in any capacity at the time of sale;
- any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with sales of securities in the offering; and
- any director, officer, general partner, or managing member of any such compensated solicitor.
The investment adviser to a private fund is not named as a Covered Person. The SEC’s proposal solicits comment on whether the investment adviser to a private fund issuer should be made subject to the disqualification regime. However, several comments pointed out that without further tailoring by the SEC, the definition of “promoter” under Rule 405, which includes “any person who…directly or indirectly takes initiative in founding and organizing the business or enterprise of an issuer,” may be broad enough to encompass an investment adviser.
While the status of investment advisers under the proposal is uncertain, the release is clear that actions of placement agents and other intermediaries can disqualify a Rule 506 offering. When coupled with the broad definition of the term “officer” (defined under Rule 405 to include “a president, vice president, secretary, treasurer or principal financial officer, comptroller or principal accounting officer, and any person routinely performing corresponding functions with respect to any organization”), the proposed rule might cover large numbers of employees at institutions acting as placement agents, including employees that have not had any involvement with the relevant Rule 506 offering. The proposal therefore requested comment on whether the definition of “officer” should be restricted to those performing policy-making functions for a Covered Person, or whether disqualification should attach only to officers actually involved with the relevant offering.
Acts or events that trigger disqualification. The proposed rule would disqualify an offering from reliance on Rule 506 if a Covered Person is subject to any of the following:
- A felony or misdemeanor conviction within ten years of the proposed sale (i) in connection with the purchase or sale of any security, (ii) involving the making of any false filing with the SEC, or (iii) arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities.
- A court order, judgment or decree entered within five years of the proposed sale that, at the time of the sale, restrains or enjoins a Covered Person from engaging in any conduct or practice (i) in connection with the purchase or sale of any security, (ii) involving the making of any false filing with the SEC, or (iii) arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities.
- A final order of a federal or state securities, banking, or insurance regulator (i) that, at the time of the proposed sale, bars the Covered Person from associating with other entities under the supervision of the regulator or engaging in the business of securities, insurance, or banking, or (ii) that is based on a violation of any law or regulation that prohibits fraudulent, manipulative or deceptive conduct and was entered within ten years of the proposed sale.
- An SEC disciplinary order that, at the time of the proposed sale, (i) suspends or revokes a Covered Person’s registration as a broker, dealer, municipal securities dealer or investment adviser, (ii) places limits on the activities, functions or operations of a Covered Person, or (iii) bars the Covered Person from association with any entity or from participating in the offering of any penny stock.
- Suspension or bar from membership in, or suspension or bar from association with a member of, a national securities exchange or a national or affiliated securities association at the time of the proposed sale, for any action or inaction constituting conduct inconsistent with just and equitable principles of trade.
- Filing as registrant or issuer, or being named as an underwriter in, a Regulation A offering that, within five years of the proposed sale, has been the subject of a refusal order, stop order, or order suspending the Regulation A exemption.
- A U.S. Postal Service false representation order entered within five years of the proposed sale or certain preliminary injunctions sought by the U.S. Postal Service and in effect at the time of such sale.
Under the proposed rule, the foregoing would disqualify an offering from reliance on Rule 506 even where the event occurred prior to the enactment of the Dodd-Frank Act or to the date the new rules become effective. This retroactive effect may be particularly troublesome for issuers whose continued reliance on Rule 506 is threatened by disqualifying events attributed to a 10% owner of the issuer’s securities. Even where private funds have the authority in their offering documents to compulsorily redeem such an investor, this may not be a practical course of action.
Exemption for issuers that exercise reasonable care. The proposed rule includes an exemption from Rule 506 disqualification where the issuer can establish “that it did not know, and in the exercise of reasonable care could not have known” that a Covered Person had been the subject of a disqualifying event. The proposal goes on to state that an issuer seeking to avail itself of this exemption “will not be able to establish that it has exercised reasonable care unless it has made factual inquiry into whether any disqualifications exist” and that “[t]he nature and scope of the requisite inquiry will vary based on the circumstances of the issuer and the other offering participants.”
The proposal states that, in some instances, representations in agreements or other negative consent received from Covered Persons may be sufficient to prove that the issuer exercised reasonable care, but also warns that “[i]ssuers should also consider whether investigating publicly available databases is reasonable” and that in certain undefined circumstances, “further steps may be necessary.” While the Commission is likely to provide greater clarity on this exemption in its adopting release, comments to the proposal have expressed concern that the language used in the proposal could require issuers to engage in continuous, real-time monitoring for potential disqualifications with regard to all Covered Persons throughout the conduct of a Rule 506 offering.
Consequences of disqualification from reliance on Rule 506. Disqualification from reliance on the Rule 506 safe harbor does not automatically subject an offering to the requirements of a public offering. An issuer may still complete a private offering in reliance on Section 4(2) of the Securities Act, but because of the lack of bright-line rules under that section, such an offering is likely to be subject to substantial uncertainty. Furthermore, disqualification from the safe harbor may have the effect, under Section 18 of the Exchange Act, of eliminating the offering’s exemption from state securities offering requirements.
Given the potential consequences of disqualification, fund managers should consider developing procedures for determining whether Covered Persons of continuously offered funds, including affiliates, placement agents, and significant investors have been subject to disqualifying events.
Timeline for adoption of final rule. The comment period for the proposed rule closed on July 14th. The SEC’s timeline for implementing Dodd-Frank indicates the final rule will be adopted before the end of this year.