Each year, thousands of businesses and investment funds raise billions of dollars in capital through unregistered offerings under Rule 506—the most widely used exemption under Regulation D under the Securities Act of 1933, as amended. With a median offering size of $1.5 million, most Regulation D offerings are relatively small, but the aggregate amount of capital raised in these offerings rivals the registered public offering market.
Last year, as mandated by the Dodd-Frank Act, the SEC amended Rule 506 to prohibit issuers from relying on that exemption if the issuer or another covered person has been convicted of, or is subject to judicial or regulatory sanctions for, certain violations of law. This amendment, known as the “Bad Actor” rule, became effective September 23, 2013. A year following the effective date, a few key practice points can be gleaned from our experience.
Overview of the Bad Actor Rule
The “Bad Actor” rule is codified as new paragraphs (d) and (e) to Rule 506. Rule 506(d)(1) provides that the exemptions in Rule 506(b) and Rule 506(c) are not available if a covered person has had a disqualifying event. For this purpose, “covered persons” include, in addition to the issuer, any of the following:
- Directors, general partners, and managing members of the issuer;
- Executive officers of the issuer, and other officers participating in the offering;
- 20 percent beneficial owners of the issuer;
- Investment managers and principals of pooled investment funds; and
- Any person compensated for soliciting investors (as well as the general partners, directors, officers, and managing members of any compensated solicitor).
Events that trigger disqualification under the rule include:
- Criminal convictions relating to securities transactions, false filings with the SEC, or certain securities-related businesses;
- Court injunctions and restraining orders relating to securities transactions, false SEC filings, securities-related business activities, or obtaining money or property through the mail by means of false representations;
- Final orders of certain financial regulators that bar the covered person from associating with a regulated entity or engaging in certain financial business activities, or that are based on a violation of antifraud rules, or any postal service false representation order;
- SEC orders revoking the registration of a regulated person, limiting the activities of such a person, or imposing industry, collateral or penny stock bars;
- SEC cease-and-desist orders with respect to the scienter-based antifraud rules or violations of Section 5;
- Suspension or expulsion from a self-regulatory organization; and
- In the case of any registrant, issuer or underwriter named in any registration statement or Regulation A offering statement filed with the SEC, the issuance of a suspension or stop order with respect to such registration statement or offering statement, or any ongoing investigation relating to the same.
The look-back period is five years, except in the case of criminal convictions (for persons other than the issuer, its predecessors, and affiliated issuers) and certain regulatory orders based on antifraud violations, for which the look-back is ten years, and for certain SEC or SRO suspensions, revocations, bars, expulsions, and related orders, which result in disqualification so long as they remain in effect. If a covered person ceases to be subject to an order, judgment or decree that would other result in disqualification—for instance, if the order is vacated or dissolved—no disqualification will result.
These disqualification provisions only apply to events that occur on or after the rule’s September 23, 2013, effective date. However, under new Rule 506(e), any disqualifying event occurring prior to September 23, 2013, must be disclosed by the issuer to each purchaser in a Rule 506 transaction if that event would otherwise have resulted in disqualification pursuant to Rule 506(d)(1).
An issuer may seek a waiver of Rule 506(d)(1) from the SEC upon a showing of good cause that the disqualification is not necessary under the circumstances. Authority to grant such waivers has been delegated to the SEC’s Division of Corporation Finance. The SEC also retains authority to grant waivers under Rule 506(d), and has recently exercised that authority in connection with several settled SEC enforcement proceedings, as well as a criminal proceeding settled by the U.S. Department of Justice. Waiver requests should be submitted to, and will be evaluated by, Staff in the Division’s Office of Small Business Policy.
In addition, any court or regulatory authority that enters an order, judgment or decree that would otherwise trigger disqualification may itself exempt such action from Rule 506(d)(1) at any time prior to the relevant sale under Rule 506.
Neither the disqualification provisions of Rule 506(d)(1) nor the disclosure requirements of Rule 506(e) apply if the issuer can establish that it did not know, and in the exercise of reasonable care, could not have known, of the facts giving rise to such disqualification or disclosure obligation.
Key Practice Points
The provisions of Rule 506(d) are in many respects comparable to existing disqualification provisions in Rule 262 (Regulation A) and Rule 505 (an exemption under Section 3(b) of the Securities Act for certain offers and sales not exceeding $5,000,000)—although the universe of covered persons in Rule 506(d) is different from the earlier disqualification rules, and new state and federal regulatory orders have been added to the list of disqualifying events. However, Regulation A and Rule 505 are used relatively rarely compared to Rule 506, so the experiences of practitioners under those prior disqualification provisions may not be wholly relevant to understanding the impact of Rules 506(d) and 506(e). Given both the greater frequency and larger size of Rule 506 offerings, it is not surprising that Rule 506(d) has already had a substantial impact on securities practice with respect to unregistered offerings.
Here are three key takeaways from the first year of implementing the Bad Actor rule:
1. Factual Inquiry. Given the breadth of potential disqualification triggers under Rule 506(d)(1), a key provision of the rule for both issuers and investors is Rule 506(d)(2)(iv), which erases the disqualifying effect of an event if the issuer can establish that it did not know, and in the exercise of reasonable care could not have known, that a disqualification existed. Similar language excuses a failure to furnish, on a timely basis, information about an otherwise disqualifying event that occurred prior to the effective date of the rule. Both provisions are subject to the condition that the issuer has made a “factual inquiry” into whether any disqualifications exist.
The SEC has provided only limited guidance on the scope of inquiry required for an issuer to benefit from this “reasonable care” exception, rejecting a one-size-fits-all approach in light of the wide variety of Regulation D offerings and participants. Rather, the issuer’s objective should be to gather information that is complete and accurate as of the time of the relevant transactions, without imposing an unreasonable burden—either on itself or other participants. The steps required to meet this standard will vary based on the facts and circumstances concerning the issuer, other offering participants, and other factors. Practitioners should note that the requirement of a “factual inquiry” can also be found in the NASAA-approved Model Accredited Investor Exemption (MAIE), which has been adopted in some form by a majority of the states. The MAIE also requires the issuer to conduct a “factual inquiry” before asserting a reasonable care exception, but does not specifically identify the steps required.
To meet the requirements of the Bad Actor rule, the Rule 506 offering process has developed to require factual inquiry regarding the existence of any potential disqualification under the rule. This inquiry now customarily includes questionnaires or certifications, in many cases accompanied by contractual representations, covenants, and undertakings. In some cases, issuers have also enhanced or introduced background checks or other procedures in connection with their hiring processes to confirm that executive officers and other officers who participate in offerings are free of disqualifying events. Investors may also require specific representations and warranties from the issuer in purchase agreements to confirm that the issuer has appropriate procedures in place to satisfy its reasonable care obligations.
- Issuers in continuous or long-lived offerings, including pooled-investment vehicles, need to update their inquiry process on a periodic basis—but covered persons no longer relevant to the offering, such as former officers, directors and beneficial owners, and paid solicitors who have ceased their involvement in the transaction, do not need to be included in subsequent inquiries.
- Rule 508 of Regulation D provides that a failure to comply with a term, condition or requirement of Rule 506 or another Regulation D exemption will not result in the loss of the exemption if an issuer can demonstrate, among other things, that the failure was insignificant with respect to the offering as a whole and that a good faith and reasonable attempt was made to comply with all of the applicable terms of the exemption sought. However, the SEC has indicated that Rule 508 would not cover circumstances in which an offering was disqualified based on Rule 506(d), or excuse a failure to provide the disclosure required by Rule 506(e).
2. Waivers. The SEC’s Division of Corporation Finance has granted a waiver of disqualification five times since the effective date of the Bad Actor rule. Four additional waivers were granted directly by the Commission. In eight out of nine cases, the entity requesting relief was an affiliate of a regulated entity in the securities industry. Waivers granted under the Bad Actor rule are posted on the Division’s website, together with the formal waiver request. Reviewing these letters can highlight what the Staff is looking for when it evaluates such requests:
- None of the violations for which a waiver was granted relate directly to the offer or sale of securities by the applicant. Several applicants noted that the violations were not scienter-based.
- Seven of the applicants represented that the conduct giving rise to the disqualifying event was not pervasive in the applicant’s organization. A number of applicants also pointed to the passage of time since the relevant conduct.
- Seven of the applicants represented that since the conduct giving rise to the disqualifying event, the applicant had removed wrong-doers, instituted procedures and/or taken other steps to improve compliance and prevent the recurrence of such conduct.
- Eight of the applicants claimed that third parties would be adversely affected by the applicant’s disqualification.
- Two applicants pointed to the cooperation demonstrated by the applicant in connection with the Staff’s investigation relating to the disqualifying event.
- Two applicants claimed that, in light of the other sanctions or remedies imposed upon the applicant in connection with the disqualifying event, permitting such disqualification to stand would be unduly or disproportionately harsh.
Importantly, each of the applicants represented that, for a period of five years from the date of the disqualifying judgment, order or decree, it would furnish or cause to be furnished to each purchaser in any offering under Rule 506 otherwise subject to disqualification, a description of the judgment, order or decree, a reasonable time prior to sale. We understand that it is currently staff policy to require such an undertaking as a condition to any waiver of disqualification under the Bad Actor rule.
- The Bad Actor rule does not include any provision for waiver of the disclosure obligation under Rule 506(e), and the SEC Staff advises that such disclosure obligations are not waivable. This is consistent with the Staff’s position to require disclosure as a condition to any waiver of disqualification under Rule 506(d).
- Practitioners should contact the SEC's Office of Small Business Policy in the Division of Corporation Finance prior to submitting any waiver requests. The Staff is happy to provide guidance on the waiver process and will usually review a draft form of request and provide feedback. However, the Staff cannot grant waiver requests with respect to any disqualification until the disqualifying event has occurred. Nevertheless, it is often possible to have the waiver become effective at the same time as the injunction or administrative order settling a matter is issued. To be best positioned for a timely waiver, issuers negotiating a settlement that could constitute a disqualifying event should contact the SEC’s Office of Small Business Policy as soon as practicable to discuss the process.
3. Understanding the Form of Injunction. Disqualification under Rule 506(e) can be triggered by, among other things, any court order that restrains or enjoins a covered person from engaging in any conduct or practice in connection with the purchase or sale of any security. This category of disqualifying event includes the standard “obey-the-law” injunction sought by the SEC in both settled and non-settled actions in U.S. district court.
Traditionally, the “obey-the-law” injunction is broadly written to cover both direct and indirect conduct. A standard form of injunction sought by the Commission and entered in many districts for violations of the Securities Exchange Act is as follows:
IT IS HEREBY ORDERED, ADJUDGED, AND DECREED that Defendants and Defendants’ agents, servants, employees, attorneys, and all persons in active concert or participation with them who receive actual notice of this Final Judgment by personal service or otherwise are permanently restrained and enjoined from violating, directly or indirectly, Section ___ of the Securities Exchange Act of 1934, and Rule ___ promulgated thereunder, by using any means or instrumentality of interstate commerce, or of the mails, or of any facility of any national securities exchange, in connection with the purchase or sale of any security, to ….
By its terms, notice of the injunction may be given to, or served upon, various persons other than the named Defendants, who would then be “subject to” a court order that restrains them from engaging in a practice in connection with the purchase or sale of a security. Accordingly, participants in Regulation D offerings may wonder if this type of order may give rise to disqualification of an offering pursuant to Rule 506(d) if a covered person could be deemed to be an agent, servant, employee, attorney or other person in active concert or participation with the Defendant. If so, how could an issuer make the necessary factual inquiry with respect to such persons, to satisfy the reasonable care exception in Rule 506(d)(2)(iv), or Rule 506(e)?
However, these concerns are not necessary: the Commission interprets the disqualifying effects of injunctions and other court orders to apply only to the persons specifically named in the order. Consistent with prior SEC Staff practice in connection with Rules 262 and 505, other persons who are not specifically named but who come within the scope of an order (such as, for example, agents, attorneys and persons acting in concert with the named person) will not be treated as “subject to” the order for purposes of disqualification under Rule 506(d).