On May 25, 2011, the Securities and Exchange Commission (“SEC”) proposed rules implementing Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) that would disqualify certain “bad actors” from relying upon the Regulation D, Rule 506 safe harbor under the Securities Act of 1933 for private placement. The SEC release (Release No. 33-9211) is available at http://www.sec.gov/rules/proposed/2011/33-9211.pdf.
Section 926 of Dodd-Frank mandates that the SEC adopt disqualification provisions applicable to Rule 506 offerings that are “substantially similar” to the disqualification provisions applicable to Regulation A offerings currently found in Rule 262, with the addition of new bases for disqualification mandated by the statute.
The disqualification provisions would be applicable to all “covered persons,” which include:
- the issuer;
- any predecessor of the issuer;
- any affiliated issuer1;
- 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 the 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 general partner, director, officer, or managing member of any such compensated solicitor.
The proposed rule would include the following types of disqualifying events:
- criminal convictions in connection with the purchase or sale of a security;
- court injunctions and restraining orders in connection with the purchase or sale of a security;
- final orders of certain state regulators (such as state securities, banking, and insurance regulators) and federal regulators;
- SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment advisers, and investment companies and their associated persons; suspension or expulsion from membership in, or suspension or bar from associating with a member of, a securities self-regulatory organization;
- SEC stop orders and orders suspending a Regulation A exemption; and
- U.S. Postal Service false representation orders.
- The disqualifying events, other than SEC disciplinary orders and suspensions or expulsions from self-regulatory organizations, would be subject to either a five year or a 10 year look-back period.
The rule, as proposed, could have a profound impact on capital raising by many hedge funds, private equity funds and other private investment funds, as well as many other issuers which rely on the Regulation D exemption for their U.S. offerings, and many of which are affiliated with entities that are subject to a disqualifying event or use placement agents that would cause disqualification under the proposed rule. It could also significantly impact the ability of many investment banks to act as placement agents for capital raising transactions. As proposed, the Rule 506 exemption would not be unavailable as a result of disqualifying events involving investment advisers to private funds, or the directors, officers, general partners, or managing members of such investment advisers merely as a result of their status as such. However, the SEC is soliciting public comment on whether such persons should also be covered.
The proposed rule would provide an exception from disqualification if an issuer can establish that it did not know and, in the exercise of reasonable care, could not have known, that a disqualification existed. In addition, issuers would be able to apply for waivers from disqualification in the same manner they can currently apply under Rule 262 of Regulation A.
It should be noted that, over strong objection from two dissenting Commissioners, the proposed rule would apply the disqualification provisions to events, including negotiated settlements, which occurred before the enactment of Dodd-Frank. The SEC has requested comment on whether it should provide for grandfathering or other accommodation for events that predate the enactment of Dodd-Frank, the proposing release or the effective date of the rule.
The SEC has also requested comment on whether it should, in the absence of a requirement in Dodd-Frank, extend the proposed disqualification provisions and apply them on a uniform basis to offerings made in reliance on Rules 504 and 505, Regulation A and Regulation E.
The comment period runs until July 14, 2011. Section 926 of Dodd-Frank requires the SEC to issue the disqualification rules not later than July 21, 2011. The proposed rule does not state when it would become effective.