Have you been a “Bad Actor”? Maybe You Should Just Beg for Forgiveness.

Rule 506 under the Securities Act of 1933 is the most widely used exemption from the registration requirements of the Securities Act. The exemption is used by a wide range of issuers from small, start-up companies to the largest investment and hedge funds. Rule 506 generally permits issuers to sell an unlimited amount of securities to an unlimited number of accredited investors. However, pursuant to Section 926 of the Dodd-Frank Act, the SEC adopted Rule 506(d) disqualifying securities offerings involving certain felons and other “bad actors” from reliance on the Rule 506 exemption. Rule 506(d) became effective on September 23, 2013.  

Rule 506(d)(2)(ii) provides that the disqualification shall not apply “upon a showing of good cause . . . if the Commission determines that it is not necessary under the circumstances that an exemption be denied.” Similar disqualification provisions are applicable to offerings exempt from registration pursuant to Regulation A and Rule 505(b). However, neither Regulation A nor Rule 505 is relied upon nearly as often as Rule 506 because of the inherent limitations of those rules. Therefore, the impact of the bad actor disqualifications under Regulation A and Rule 505 has been somewhat limited. However, given the wide use of the Rule 506 exemption, we can expect many more issuers and others involved in securities offerings to request waivers.    

Since Rule 506(d) became effective, the SEC has granted exemptions to five issuers, four of which are financial institutions. In each case, the “bad act” which led to possible disqualification (I say possible because none of the entities requesting exemption actually admitted to disqualification) was an order or judgment entered with the consent or acquiescence of the financial institution.

Generally, each of the requests for exemption cited the following facts: the bad conduct did not involve the offer or sale of securities pursuant to Regulation A or Regulation D; steps have been taken to address the underlying conduct; and disqualification would have an adverse impact on third parties. In addition, each company requesting the exemption also committed to furnishing to each purchaser in certain exempt offerings disclosure of the “bad acts.”

In each case, the order or judgment giving rise to the disqualification, the letter from the financial institution requesting an exemption from Rule 506(d)’s disqualification provision and the letter from the SEC staff confirming that the exemption had been granted, all bear the same date. Most likely the granting of the exemption was part of the overall settlement of the matters that were the subject of the various orders. The four letters can be found here, here, here and here.

SEC Guidance on “Bad Actor” Disqualifications from Rule 506 Offerings

On 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) is subject to a bad actor triggering event at the time of each sale of securities.  Most of the new C&DIs focused on one category of such covered persons – a beneficial owner of 20% or more of the issuer’s outstanding voting equity securities.  Please see below a summary of such C&DIs.

  • A shareholder that becomes a 20% beneficial owner 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. 
  • 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. 

New SEC Guidance on “Bad Actor” Disqualifications from Rule 506 Offerings

On December 4, 2013, 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 a Rule 506 exemption from registering the offering under the Securities Act of 1933 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 undertaking 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 and 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 disqualifying 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 include 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 new rules 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 disqualification, 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.

No Rule 506 Offerings for Bad Boys: Felons and Other “Bad Actors”

On July 10, the SEC revamped the way private placements under Rule 506 of Regulation D can be conducted by permitting general solicitation and general advertising in offerings where all purchasers are accredited investors (see To Use or Not to Use General Solicitation and General Advertising in Private Placements?) and by disqualifying felons and other “bad actors” from all Rule 506 offerings (i.e., irrespective of whether the offering involves or does not involve general solicitation and general advertising).  New SEC “bad actor” rules, effective 60 days after publication in the Federal Register, implement Section 926 of the Dodd-Frank Act and were originally proposed two years ago (May 25, 2011).

Under new Rule 506(d), “Bad Actor” Disqualification, an issuer will not be able to rely on the Rule 506 exemption from registration under the Securities Act of 1933 if the issuer or any other “covered person” is or was involved in a disqualifying event.

Covered Persons

“Covered persons” under Rule 506(d) include:

  • the issuer, any predecessor of the issuer, or any affiliated issuer;
  • directors, executive officers, other officers participating in the offering, general partners or managing members of the issuer;
  • beneficial owners of 20% or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power;
  • promoters connected with the company at the time of such sale;
  • investment managers of a pooled investment fund;
  • persons compensated (directly or indirectly) for soliciting investors; and
  • directors, executive officers, or other officers participating in the offering, of any such investment manager or solicitor or general partner or managing member of such investment manager or solicitor.

Disqualifying Events

Rule 506(d) “disqualifying events” include the following:

  • criminal convictions, within ten years before the sale of securities (or five years, in the case of issuers, their predecessors and affiliated issuers) in connection with the purchase or sale of any security; involving the making of any false filing with the SEC; or arising out of the conduct of an underwriter, broker, dealer, or other financial intermediary;
  • court injunctions and restraining orders, entered within five years before such sale, in connection with the purchase or sale of any security; involving the making of any false filing with the SEC; or arising out of the conduct of an underwriter, broker, dealer, or other financial intermediary;
  • final orders of a state securities commission; a state authority that supervises or examines banks, savings associations, or credit unions; a state insurance commission; an appropriate federal banking agency; the U.S. Commodity Futures Trading Commission; or the National Credit Union Administration that: 

     (i)  bar the person from associating with a regulated entity; engaging in the business of  securities, insurance or banking; or engaging in savings association or credit union activities; or

     (ii)  are based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct entered within ten years before such sale;

  • SEC disciplinary orders suspending or revoking a person’s registration as a broker, dealer, municipal securities dealer or investment adviser; placing limitations on the activities of such person; or barring such person from being associated with any entity or from participating in the offering of any penny stock;
  • SEC cease and desist orders, entered within five years before such sale, that, orders the person to cease and desist from committing or causing a violation of any scienter-based anti-fraud provision of the federal securities laws (e.g., Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 or Section 5 of the Securities Act of 1933).
  • suspensions or expulsions from membership in, or suspension or a bar from association with a member of, a registered national securities exchange for any act or omission to act constituting conduct inconsistent with just and equitable principles of trade;
  • SEC stop orders in connection with a registration statement or orders suspending the Regulation A exemption, issued within five years before such sale; or investigation to determine whether a stop order or suspension order should be issued; or
  • U.S. Postal Service false representation orders, entered within five years before such sale, or being subject to a temporary restraining order or preliminary injunction with respect to conduct alleged by the U. S. Postal Service to constitute a scheme or device for obtaining money or property through the mail by means of false representations.

Exceptions

Rule 506(d) disqualification does not apply if:

  • the triggering event occurred before the effective date of the new rules;
  • the SEC waives the disqualification;
  • before the relevant sale, the court or regulatory authority that entered the relevant order, judgment or decree advises in writing that Rule 506(d) disqualification should not arise as a consequence of such order, judgment or decree; or
  • the company establishes that it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed.

 Disclosure of Pre-Existing Disqualifying Events

The company must furnish to each purchaser, a reasonable time prior to sale, a description in writing of any matters that would have triggered Rule 506(d) disqualification but occurred before the effective date of new rules.  The failure to furnish such information timely will not prevent a company from relying on Rule 506 exemption from registration if the company establishes that it did not know and, in the exercise of reasonable care, could not have known of the existence of the undisclosed matter or matters.

Reasonable Care

In connection with “reasonable care” requirements, a company will not be able to establish that it has exercised reasonable care unless it has made a factual inquiry into whether any disqualifications exist. The nature and scope of the factual inquiry will vary based on the facts and circumstances concerning, among other things, the company and the other offering participants.  For example, the SEC anticipates companies to have “an in-depth knowledge of their own executive officers and other officers participating in securities offerings gained through the hiring process and in the course of the employment relationship, and in such circumstances, further steps may not be required in connection with a particular offering.”

The SEC suggested that “factual inquiry by means of questionnaires or certifications, perhaps accompanied by contractual representations, covenants and undertakings, may be sufficient in some circumstances, particularly if there is no information or other indicators suggesting bad actor involvement.”  The SEC also clarified that for continuous, delayed or long-lived offerings, “reasonable care includes updating the factual inquiry on a reasonable basis,” which can be “managed through contractual covenants from covered persons to provide bring-down of representations, questionnaires and certifications, negative consent letters, periodic re-checking of public databases, and other steps, depending on the circumstances.”

Companies that are contemplating a Rule 506 private placement need to establish internal procedures for conducting a factual inquiry into whether “bad actors” may be involved in its offering.