On July 10, 2013, the Securities and Exchange Commission (“SEC”) adopted amendments to Rule 506 of Regulation D under the Securities Act of 1933, as amended (the “Securities Act”) which add new Rule 506(d). Rule 506(d) will disqualify securities offerings involving certain “felons and other ‘bad actors'” from reliance on the Rule 506 offering exemption as mandated by Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act1. This memorandum describes the persons involved with an offering covered by Rule 506(d), the types of legal or regulatory matters covered by the disqualification provisions, and discusses the consequences to an issuer if a covered person is subject to a disqualifying event. Finally, this memorandum outlines the practical steps that issuers intending to rely on Rule 506 should consider to ensure compliance with the amended rules.
It is important to note that the new disqualification provisions apply to all Rule 5062 offerings (i.e., both offerings involving general solicitation and advertising as permitted under the SEC’s newly adopted Rule 506(c) and those involving no general solicitation or advertising as specified under the existing Rule 506(b) which will remain available).
A. Scope of “Bad Actor” Disqualification Provisions
Under the “bad actor” disqualification provisions, an issuer may not rely on the Rule 506 offering exemption if the issuer or certain other persons involved with the offering (“Covered Persons”) has a disqualifying event (a “Disqualifying Event”) after September 23, 2013 (the “Effective Date”), unless the disqualification is waived or otherwise remedied.3 Events occurring prior to the Effective Date that would be Disqualifying Events had they occurred after the Effective Date will not disqualify an issuer from relying on Rule 506, but must be disclosed in writing to offerees a reasonable time prior to sale. An issuer that is disqualified from relying on Rule 506 may, under certain circumstances, privately offer securities, but will be required to rely on more limited and burdensome exemptions from registration.4 Any issuer that made sales at a time when there were unknown Disqualifying Events may still rely on Rule 506 for those prior sales, if the issuer can establish that it did not know and, in the exercise of reasonable care, could not have known, that such Disqualifying Events existed.5
B. Definition of Covered Persons and Disqualifying Events
The following persons are Covered Persons:
(i) the issuer and any predecessor of the issuer or affiliated issuer;
(ii) any director, executive officer, other officer participating in the offering, general partner or managing member of the issuer;
(iii) any beneficial owner of 20% or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power;
(iv) any investment manager6 to an issuer that is a pooled investment fund7 and any director, executive officer, other officer participating in the offering, general partner or managing member of any such investment manager, as well as any director, executive officer or officer participating in the offering of any such general partner or managing member;
(v) any promoter connected with the issuer in any capacity at the time of the sale;
(vi) 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 (each such person, a “Compensated Solicitor”); and
(vii) any director, executive officer, other officer participating in the offering, general partner, or managing member of any Compensated Solicitor.
The following events are Disqualifying Events:
(i) criminal convictions8;
(ii) court injunctions and restraining orders9;
(iii) final orders of certain regulators;
(iv) commission disciplinary orders;
(v) certain SEC cease-and-desist orders;
(vi) suspension or expulsion from self-regulatory organization (“SRO”) membership or association with an SRO member;
(vii) stop orders and orders suspending exemptions under Regulation A of the Securities Act; and
(viii) U.S. Postal Service false representation orders.
Covered Persons Analysis
The Adopting Release provides further clarification with respect to the following categories of Covered Persons:
Officers
Only directors, executive officers or other officers10 who participate in the offering are Covered Persons. Whether an “other officer” participates in an offering will be a factual determination. In making such a determination, the SEC has indicated that participation in an offering is “more than transitory or incidental involvement” and may include involvement in due diligence activities, involvement in the preparation of disclosure documents and communication with the issuer, prospective investors or other offering participants (as applicable).
20% or Greater Beneficial Owners of Issuer Equity Securities
Beneficial owners of 20% or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power, are Covered Persons. The SEC has not adopted a definition of “voting securities” but indicated in the Adopting Release that the term should be applied based on factors such as whether securityholders have or share the ability, either currently or on a contingent basis, to control or significantly influence the management and policies of the issuer through the exercise of a voting right. The SEC explained in the Adopting Release, that it would consider securities that confer to securityholders the right to elect or remove the directors or equivalent controlling persons of the issuer, or to approve significant transactions such as acquisitions, dispositions or financings, to be voting securities for purposes of the rule. Conversely, the SEC stated that it would not consider securities that confer voting rights limited solely to approval of changes to the rights and preferences of a class voting securities for purposes of the rule. The 20% threshold is calculated on the basis of overall voting power as opposed to a share-based approach (i.e., the number of votes rather than the number of shares is relevant for the purposes of determining whether a beneficial owner meets this threshold).
Promoters
Promoters that are connected with the issuer in any capacity at the time of a sale of securities offered pursuant to Rule 506 are Covered Persons. The category of promoter is broad and captures all individuals and entities that have the relationships with the issuer or to the offering specified in Rule 405 under the Securities Act.11 Rule 405 provides, in pertinent part, that a promoter is any person who, either alone or with others:
(i) directly or indirectly takes initiative in founding or organizing the business or enterprise of an issuer; or
(ii) in connection with the founding or organization of the business or enterprise of an issuer, directly or indirectly receives 10% or more of any class of issuer securities or 10% or more of the proceeds from the sale of any class of issuer securities.
Detailed Description of Disqualifying Events
No exemption under Rule 506 will be available for a sale of securities if a Covered Person:
Criminal Convictions
Has been convicted, within ten years before such sale (or five years, in the case of issuers), of any felony or misdemeanor12:
(i) in connection with the purchase or sale of any security;
(ii) involving the making of any false filing with the SEC; or
(iii) arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities.
Court Injunctions and Restraining Orders
Is subject to any order, judgment or decree of any court of competent jurisdiction13 entered within five years before such sale that, at the time of such sale, restrains or enjoins such person from engaging or continuing to engage in any conduct or practice:
(i) in connection with the purchase or sale of any security;
(ii) involving the making of any false filing with the SEC; or
(iii) arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities.
For the purposes of this category, there are no specific due process requirements, requirements that all appeals have been exhausted or the time for appeal has expired as a condition for disqualification under the amendments.14 Persons “subject to” an order are only those persons specifically named in the order; persons who come within the scope of an order but who are not named will not be treated as “subject to” the order for purposes of disqualification under the amendments.
Final Orders of Certain Regulators
Is subject to a final order15 of a state securities commission (or an agency or officer of a state performing like functions); a state authority that supervises or examines banks, savings associations, or credit unions; a state insurance commission (or an agency or officer of a state performing like functions); an appropriate federal banking agency; the U.S. Commodity Futures Exchange Commission (“CFTC”); or the National Credit Union Administration that:
(i) at the time of such sale, bars16 the person from:
(1) association with an entity regulated by such commission, authority, agency, or officer;
(2) engaging in the business of securities, insurance or banking; or
(3) engaging in savings association or credit union activities;
(ii) constitutes a final order based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct entered within ten years before such sale.17
SEC Disciplinary Orders
Is subject to an order of the SEC entered pursuant to Section 15(b) or 15B(c) of the Exchange Act or Section 203(e) or (f) of the Advisers Act18 that, at the time of such sale:
(i) suspends or revokes such person’s registration as a broker, dealer, municipal securities dealer or investment adviser;
(ii) places limitations on the activities, functions or operations of such person; or
(iii) bars such person from being associated with any entity or from participating in the offering of any penny stock.
Certain SEC Cease-and-Desist Orders
Is subject to any order of the SEC entered within 5 years before such sale that, at the time of such sale, orders the person to cease and desist from committing or causing a violation or future violation of:
(i) any scienter-based anti-fraud provision of the federal securities laws19; or
(ii) Section 5 of the Securities Act.
Suspension or Expulsion from SRO Membership or Association with an SRO Member
Is suspended or expelled from membership in, or suspended or barred from association with a member of, a registered national securities exchange or a registered national or affiliated securities association for any act or omission to act constituting conduct inconsistent with just and equitable principles of trade.
Stop Orders and Orders Suspending the Regulation A Exemption
Has:
(i) filed, or was or was named as an underwriter in, any registration statement or Regulation A offering statement filed with the Commission that, within five years before such sale, was the subject of a refusal order, stop order, or order suspending the Regulation A exemption; or
(ii) is, at the time of such sale, the subject of an investigation or proceeding to determine whether a stop order or suspension should be issued.
U.S. Postal Service False Representation Orders
Is:
(i) subject to a U.S. Postal Service false representation order entered within five years before such sale; or
(ii) at the time of such sale, 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.
C. Transition Issues and Mandatory Disclosure
Issuers do not have a disclosure obligation under Rule 506(d) to purchasers with respect to sales made to such purchasers prior to the Effective Date (even if such sales were part of a continuing offering that began before the Effective Date). An issuer subject to mandatory disclosure must furnish to each purchaser, at a reasonable time prior to sale, a description in writing of any matters that would have triggered disqualification under the disqualification provisions if such matter had occurred after the Effective Date.20 The SEC has indicated that a failure to disclose or a failure to adequately disclose under this rule would be more than an “insignificant deviation” from the requirements of Regulation D, such that the issuer would lose its exemption under Rule 506.21
D. Next Steps
Immediate Steps
Issuers seeking to rely on Rule 506 as of or following the Effective Date should take the following steps as soon as possible:
(i) identify all potential Covered Persons;
(ii) determine whether any Covered Person has a Disqualifying Event (such as by distributing and obtaining questionnaires and certifications from each Covered Person regarding any Disqualifying Events); and
(iii) review agreements and contracts with Covered Persons and, where necessary, obtain representations, covenants and/or certifications regarding whether such Covered Persons have had a Disqualifying Event.
Suggested Additional Steps
In addition, issuers should consider taking the following steps:
(i) amend subscription agreements to require applicable investors to provide information about potential Disqualifying Events relating to such persons;
(ii) amend any agreements or contracts with potential Covered Persons (e.g., placement agent agreements, employment agreements and agreements with investors) to include appropriate representations, disclosure requirements and other relevant provisions;
(iii) implement compliance policies or procedures addressing the determination of whether a Covered Person has had a Disqualifying Event; and
(iv) amend operating agreements22 to provide the authority for prompt mandatory redemption or withdrawal in the event a beneficial owner could subject the issuer to disqualification.
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If you have any questions regarding the changes described above, please contact your attorney at Seward & Kissel LLP.
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1 See Disqualification of Felons and Other “Bad Actors” From Rule 506 Offerings, Securities Act Release No. 9414, 78 Fed. Reg. 44,729 (July 24, 2013) (the “Adopting Release”).
2 Rule 506 permits sales of an unlimited dollar amount of securities to be made without registration under the Securities Act to an unlimited number of accredited investors and up to 35 non-accredited sophisticated investors, provided that there is no general solicitation or advertising, appropriate resale restrictions are imposed, and certain other conditions are met. Rule 506 is the most widely used Regulation D exemption by both U.S. and non-U.S. issuers offering securities to U.S. investors. Rule 506 accounts for an estimated 90% to 95% of all Regulation D offerings, and the overwhelming majority of capital raised in transactions under Regulation D.
3 Issuers that are subject to disqualification may apply for a waiver, which may be granted upon a showing of good cause if the SEC determines that disqualification is not necessary, or, in the case of a final order (as discussed below), based on a determination of the issuing authority that disqualification is not necessary. Circumstances that may be relevant to a waiver request may include, but are not limited to, a change of control, change of supervisory personnel, absence of notice and opportunity for hearing and relief from a permanent bar for a person who does not intend to apply to reassociate with a regulated entity.
4 The limited exemptions include Rule 504 and Rule 505. Rule 504 and Rule 505 limit the amount of securities that may be offered to $1 million and $5 million respectively. Seeking these alternative exemptions on a state-by-state basis can be burdensome in terms of time and expense. These alternative offerings will also involve making significant additional filings on a state-by-state basis. Depending on the terms of the offering, some issuers may not be able to comply with certain states’ rules and would therefore not be able to offer or sell their securities in that state.
5 To establish that it has exercised reasonable care, an issuer must make, in light of the circumstances, factual inquiry into whether any disqualifications exist. For issuers that engage in continuous, delayed or long-lived offerings, reasonable care includes updating the factual inquiry on a reasonable basis, which may include 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.
6 The term “investment manager” encompasses both investment advisers (i.e., advisers with respect to securities) and other investment managers (advisers with respect to other assets such as commodities, real estate and certain derivatives). Sub-advisers are included in the term “investment manager”.
7 The term “pooled investment fund” is meant to be interpreted broadly and is not limited to funds relying on Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940, as amended.
8 The SEC indicated that actions taken by non-U.S.-based courts and regulators do not result in disqualification although issuers should consider whether disclosure would be necessary under general securities laws principles.
9 The SEC indicated that injunctions and orders issued by foreign courts do not result in disqualification although issuers should consider whether disclosure would be necessary under general securities laws principles.
10 The SEC uses the definition of “officers” under Rule 405 under the Securities Act, which defines the term “officer” as “a president, vice president, secretary, treasurer or principal financial officer, controller or principal accounting officer, and any person routinely performing corresponding functions with respect to any organization.”
11 Issuers should note that seed investors may be considered promoters under this broad definition.
12 The SEC indicated that actions taken by non-U.S.-based courts and regulators do not result in disqualification although issuers should consider whether disclosure would be necessary under general securities laws principles.
13 The SEC indicated that injunctions and orders issued by foreign courts do not result in disqualification although issuers should consider whether disclosure would be necessary under general securities laws principles.
14 The SEC declined to narrow the scope of court injunctions and restraining orders to exclude ex parte orders (i.e., an order that does not require the offending party to be present for adjudication) and indicated that a disqualifying event arising out of an ex parte order is best addressed through the waiver process (as described above).
15 A final order is a written directive or declaratory statement issued by a federal or state agency under statutory authority that provides for notice and an opportunity for hearing, which constitutes a final disposition or action. An order may be deemed final even if it is subject to appeal and a final order may be disqualifying even without a hearing, provided that the statutory authority provided for an opportunity for a hearing.
16 Bars are orders that have the effect of barring a person from association with certain regulated entities, from engaging in the business of securities, insurance or banking, or from engaging in savings association or credit union activities, regardless of whether the order uses the term “bar”. Additionally, a bar is disqualifying only for as long as it has continuing effect.
17 The SEC did not limit such conduct to scienter-based violations (i.e., the intent to violate a law or regulation).
18 Section 15(b) of the Exchange Act relates to registration as a broker or dealer; Section 15B(c) of the Exchange Act relates to registration as a municipal securities dealer and Sections 203(e) and (f) of the Advisers Act relate to registration as an investment adviser.
19 Anti-fraud provisions of the federal securities laws include, without limitation, Section 17(a)(1) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, Section 15(c)(1) of the Exchange Act, and Section 206(1) of the Advisers Act.
20 The disclosure requirement applies to all offerings under Rule 506, regardless of whether purchasers are accredited investors or whether the issuer is using general solicitation and advertising, and issuers should give reasonable prominence to such disclosures to ensure that such information is appropriately presented in the total mix of information available to investors. An issuer’s failure to furnish written disclosure in a timely manner will not disqualify the issuer from relying on Rule 506 if the issuer establishes that it did not know and, in the exercise of reasonable care, could not have known of the existence of the undisclosed matter.
21 Under Rule 508, an “insignificant deviation” from the requirements of Regulation D does not necessarily result in a loss of the exemption from registration, provided that the deviation does not pertain to a term, condition or requirement directly intended to protect an offeree or purchaser of securities. In the Adopting Release, the SEC makes clear that because the mandatory disclosure provisions are directly intended to benefit offerees or purchasers, an issuer’s failure to disclose would prevent the issuer from obtaining relief under Rule 508.
22 In the case of a pooled investment fund, the operating agreement would be the limited partnership agreement or other comparable governing document.
