This Client Update is the second segment in a three-part series on the new or proposed Securities and Exchange Commission rules governing private placements, mandated under the JOBS Act and the Dodd-Frank Act. This update focuses on the rules governing offerings that are associated with "bad actors." Part 1, available here, covered the new rules lifting the ban on general solicitation and general advertising in certain private placements of securities. Part 3 will cover the SEC's proposed changes to Form D, the notice filing made with the SEC in connection with private placements.
The Dodd-Frank Act required the SEC to adopt rules prohibiting securities offerings involving "felons and other 'bad actors'" from relying on Rule 506 of Regulation D, the most frequently used exemption from registration for private placements. Dodd-Frank mandated that the new 506 bad actor rules be "substantially similar" to the disqualification provisions of Regulation A, an existing offering exemption for smaller offerings.
Before this amendment, the rules governing Rule 506 offerings were silent on bad actors. The new bad actor disqualification now applies to the "old" Rule 506, which is now Rule 506(b), and governs offerings that do not include general solicitation, as well as the "new" Rule 506(c) offerings where issuers may generally solicit. The bad actor prohibition is codified in a new paragraph (d) of Rule 506, and is effective September 23, 2013.
"Bad Actor" Defined
A "bad actor" is a person, whether an entity or a natural person, that has committed any of a number of securities-related violations within a certain time period before the first sale in a Rule 506 offering takes place.
The list of disqualifying events is extensive. It includes:
- certain securities-related criminal convictions;
- certain securities-related judgments, orders, and decrees from a court;
- final orders from a number of entities, including securities commissions and bank examiners, as well as the National Credit Union Administration and the Commodity Futures Trading Commission;
- certain SEC orders;
- suspension or expulsion from self-regulatory organizations such as the New York Stock Exchange or Nasdaq; and
- U.S. Postal Service false representation orders.
Disqualification under the new rule is generally triggered if a person has had a disqualifying event within the past five or ten years. Any "covered person," which is discussed in more detail below, who has a disqualifying event within the relevant lookback period disqualifies the issuer from relying on Rule 506 for that particular offering.
"Covered Person" Defined
Equally extensive is the list of persons who fall under the new bad actor rule, or "covered persons." Issuers seeking to engage in a Rule 506 offering must make certain inquiries of all covered persons before the first sale in the offering takes place in order to ensure that no covered persons are bad actors. In general terms, issuers are required to conduct this inquiry of anyone who will be involved in the offering in a meaningful way, including directors; executive and certain other officers; general partners; managing members; large shareholders; promoters; and anyone who will be compensated in connection with the Rule 506 offering, such as placement agents. The bad actor inquiry also extends to directors, officers, general partners and managing members of compensated solicitors. Finally, if the issuer is a pooled investment fund, then the scope of required inquiry also extends to the investment manager of the issuer, as well as any directors, executive officers, officers participating in the offering, general partners and managing members of the investment manager. The following diagram illustrates the scope of the persons covered by the rule:
"Reasonable Care" Standard
Recognizing the difficulty of attaining absolute certainty that no bad actors are involved in an offering, the SEC adopted a standard under Rule 506(d) that applies if an issuer did not know about a bad actor and could not have known, even after exercising reasonable care. In that instance, the issuer has satisfied its obligations under the new bad actor rule. However, determining whether an issuer has taken reasonable care may be difficult because the SEC purposely left the description of "reasonableness" vague in order to allow for differences in the circumstances of issuers.
At a minimum, an issuer must make a factual inquiry into whether its offering is disqualified from Rule 506 due to bad actors. A factual inquiry could involve questionnaires, certifications, covenants, or contract terms between an issuer and any covered persons. The appropriateness of using any or all of the methods listed depends on the issuer, its relationship to the covered persons, the cost of compliance, and the potential risk associated with having a bad actor involved in the offering. The SEC specifically noted that issuers with continuous or long-lived offerings, for whom ongoing factual inquiries would be costly and disruptive, could update their factual inquiries periodically and satisfy the reasonable care standard, in the absence of any facts that would indicate that they should monitor one or more covered persons more closely.
Waivers Potentially Available
The Director of the Division of Corporation Finance at the SEC can grant a waiver of the Rule 506 disqualification for "good cause shown." The SEC has indicated that it may grant a waiver in certain circumstances, such as after a change in control, a change of supervisory personnel, or if the covered person did not receive notice and opportunity for a hearing before the disqualifying event. The authority issuing the disqualifying order can also sometimes grant a waiver. If, for example, a state regulator issuing an order that would disqualify someone from participating in a Rule 506 offering decides that Rule 506 disqualification is not necessary, the SEC noted that it will respect the regulator's decision.
Implementation of "Bad Actor" Rules
The new rule will only disqualify offerings if the triggering event occurs after September 23, 2013. However, issuers must still disclose whether any covered persons had disqualifying events that predate September 23, 2013. In that instance, issuers must disclose prior to the first sale whether there is anything in the history of any covered person that, had it occurred after September 23, 2013, would have disqualified the issuer from relying on Rule 506 under the bad actor rules. Again, issuers are excused from failure to disclose if they exercised reasonable care in investigating all covered persons.
Implications and Interpretations
The following practical considerations should be taken into account by companies before undertaking any Rule 506 private offering, whether or not that offering will involve general solicitation:
- There is no practical way to insulate an offering from a bad actor while still permitting that person continue in the role that triggers his or her status as a covered person, unless the SEC waiver process proves to be more efficient and flexible than anticipated. Issuers planning to rely on the Rule 506 exemption should work quickly to identify all current bad actors and remove them from any position that could compromise the exemption in advance of September 23, 2013.
- Issuers should create and circulate bad actor questionnaires to all covered persons, including proposed placement agents, and have all of those questionnaires returned and reviewed in advance of starting a Rule 506 offering. In addition, before starting a Rule 506 offering, issuers should check all publicly available information on all covered persons, including FINRA and SEC records, to ensure to the extent possible that the information presented in the covered person's questionnaire is accurate.
- Issuers should require all covered persons to certify to the issuer that all information in the bad actor questionnaire is correct. In addition, issuers should require covered persons to immediately report to the issuer any updates to any disqualifying event information, including pending matters and ongoing investigations.
- Even though the bad actor rule only applies to Rule 506 offerings, issuers should consider disclosing known bad actors in other offerings. For example, in an offering relying on the statutory exemption under Section 4(a)(2), the involvement of a bad actor could be "material" to investors considering participation in the offering even though the bad actor would not affect the availability of the statutory exemption.
- Issuers conducting continuous offerings under Rule 506, such as funds, should prepare themselves for a much more challenging compliance environment. These issuers will not only need to regularly re-send new bad actor questionnaires to covered persons, but will need to periodically re-examine publicly available information on all covered persons to ensure that none are bad actors.
The full text of the SEC release adopting the bad actor rule is available here .
Part three of this Client Update will explain the rules that the SEC has proposed alongside the adopted changes. These proposed rules would govern certain disclosure requirements related to Rule 506 offerings, and would amend Form D, which issuers must file with the SEC as part of any private placement seeking the benefit of the Regulation D safe harbor.
This client update is prepared for the general information of our clients and friends. It should not be regarded as legal advice. If you have questions regarding this client update, please contact your principal attorney at Tonkon Torp LLP, or Tom Palmer, Drea Schmidt, or Claire Brown of our Corporate Finance Practice Group.