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.