The staff of the SEC released a Small Entity Compliance Guide discussing the application of the newly adopted regulations on the disqualification of felons and other "bad actors" from Regulation 506 offerings.

Generally, under the new regulations, an issuer may not rely on the Regulation 506 offering exemption if the issuer or any other person covered by Rule 506(d) has a relevant criminal conviction, regulatory or court order or other disqualifying event that occurred on or after September 23, 2013, the effective date of the rule amendments. Under Rule 506(e), for disqualifying events that occurred before September 23, 2013, issuers may still rely on Rule 506, but will have to comply with the disclosure provisions of Rule 506(e).

Persons Covered by the Rule

Persons and entities that are covered by Rule 506(d) (i.e., potential "bad actors") include:

  • the issuer, including its predecessors and affiliated issuers;
  • directors, general partners, and managing members of the issuer;
  • executive officers of the issuer, and other officers of the issuer that participate in the offering;
  • 20 percent beneficial owners of the issuer, calculated on the basis of total voting power;
  • promoters connected to the issuer;
  • for pooled investment fund issuers, the fund's investment manager and its principals; and
  • persons compensated for soliciting investors, including their directors, general partners and managing members

Some interesting guidance offered by the SEC includes the following:

  • "Executive officers" of an issuer follows the standard SEC definition. For other officers, to be considered "participating in the offering" would require more than transitory or incidental involvement, and could include activities such as participation or involvement in due diligence activities, involvement in the preparation of disclosure documents, and communication with the issuer, prospective investors or other offering participants.
  • 20 percent beneficial ownership is calculated on the basis of total voting power rather than on the basis of ownership of any single class of securities. Whether securities are "voting securities" depends on 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. As an example, the SEC would consider that 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, would be considered voting securities for purposes of the rule. Conversely, securities that confer voting rights limited solely to approval or changes to the rights and preferences of the class would not be considered voting securities for purposes of the rule.
  • The category of "promoter" is broad. Securities Act Rule 405 defines a promoter as any person—individual or legal entity— that either alone or with others, directly or indirectly takes initiative in founding the business or enterprise of the issuer, or, in connection with such founding or organization, 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 (other than securities received solely as underwriting commissions or solely in exchange for property).

The test considers activities "alone or together with others, directly or indirectly;" therefore, the result does not change if there are other legal entities (which may themselves be promoters) in the chain between that person and the issuer. " For issuers that are pooled investment funds, the rule covers investment advisers and other investment managers of the fund; the directors, general partners, managing members, executive officers and other officers participating in the offering of such investment managers; and the directors, executive officers and other officers participating in the offering of the investment managers' general partners or managing members.

  • Persons compensated for soliciting investors as well as their directors, general partners, managing members, executive officers and officers participating in the offering are subject to the rule. This category covers any persons compensated for soliciting investors but will typically involve broker-dealers and other intermediaries.

Disqualifying Events —"Bad Acts "

Under the final rule, disqualifying events that make a covered person a "bad actor" include:

  • Criminal convictions: Disqualification is triggered by criminal convictions in connection with: (i) the purchase or sale of a security, (ii) making a false filing with the SEC or (iii) the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities. The criminal conviction must have occurred within ten years of the proposed sale of securities, or five years in the case of the issuer and its predecessors and affiliated issuers.
  • Court injunctions and restraining orders: Disqualification is triggered by court injunctions and restraining orders in connection with: (i) the purchase or sale of a security, (ii) making a false filing with the SEC or (iii) the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities. Disqualification only applies for injunctions and restraining orders that are in effect at the time of the proposed sale of securities and were entered within the preceding five years. Injunctions and court orders that have expired or are otherwise no longer in effect are not disqualifying, even if they were issued within the five-year look-back period. For example, an injunction that was issued four years before the proposed offering but lifted before the offering occurred would not be disqualifying.
  • Final orders of certain state and federal regulators: Disqualification is triggered by final orders of state regulators of securities, insurance, banking, savings associations or credit unions; federal banking agencies; the Commodity Futures Trading Commission and the National Credit Union Administration that: (i) bar the covered 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 fraudulent, manipulative, or deceptive conduct and were issued within 10 years of the proposed sale of securities. Some matters to note:
    • A "final order" is a written directive or declaratory statement issued by one of the federal or state regulatory agencies listed above, under applicable statutory authority that provides for notice and an opportunity for hearing, which constitutes a final disposition or action by that federal or state agency. An order will be considered final even though it is subject to an appeal. An order does not have to be non-appealable to be a "final order" under the bad actor rules.
    • There are no procedural requirements beyond the basic requirement that notice and opportunity for hearing be provided for in the statutes, rules and regulations under which an order is issued. No hearing need have occurred. For example, a settlement is considered to have been made after an opportunity for hearing.
    • Bars are orders issued by one of the specified regulatory authorities that have the effect of barring a person from association with an entity, or engaging in the business, that is regulated by that authority. Any final order that has one of those effects is a bar, regardless of whether it uses the term "bar." A bar is disqualifying only for as long as it has continuing effect. For example, a person who was barred indefinitely, with the right to apply to reassociate after three years, would be disqualified until such time as he or she is permitted to reassociate, assuming that the bar had no continuing effect after reassociation.
    • The final rules do not provide a specific definition of "fraudulent, manipulative or deceptive conduct," and in particular do not limit it to matters involving knowing misconduct or scienter.
  • SEC disciplinary orders: Disqualification is triggered by SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment companies, and investment advisers and their associated persons under Section 15(b) or 15B(c) of the Securities Exchange Act, or Section 203(e) or (f) of the Investment Advisers Act that: (i) suspend or revoke the person's registration as a broker, dealer, municipal securities dealer or investment adviser, (ii) place limitations on the person's activities, functions or operations or (iii) bar the person from being associated with any entity or from participating in the offering of any penny stock. Disqualification continues only for as long as some act is prohibited or required to be performed pursuant to the order. As a result, censures and orders to pay civil money penalties, assuming the penalties are paid in accordance with the order, are not disqualifying, and a disqualification based on a suspension or limitation of activities expires when the suspension or limitation expires.
  • SEC cease-and-desist orders: SEC orders to cease and desist from violations and future violations of: (i) the scienterbased anti-fraud provisions of the federal securities laws, including, for example, Section 17(a)(1) of the Securities Act, Section 10(b) of the Securities Exchange Act and Rule 10b-5, Section 15(c)(1) of the Securities Exchange Act and Section 206(1) of the Investment Advisers Act or (ii) Section 5 of the Securities Act. Disqualification applies to cease-and-desist orders that were issued within five years before the proposed sale of securities and remain in effect.
  • SEC stop orders: An offering is disqualified if any covered person (as a registrant or issuer) has filed a registration statement or Regulation A offering statement that was the subject of an SEC refusal order, stop order or order suspending the Regulation A exemption within the last five years, or is the subject of a pending proceeding to determine whether such an order should be issued. Similarly, an offering is disqualified if any covered person (as an underwriter of the securities proposed to be issued) was, or was named as, an underwriter of securities under a registration statement or Regulation A offering statement that was the subject of an SEC refusal order, stop order or order suspending the Regulation A exemption within the last five years, or is the subject of a pending proceeding to determine whether such an order should be issued.
  • Suspension or expulsion from membership in an SRO or from association with an SRO member: Under the rule, an offering is disqualified if any covered person is suspended or expelled from membership in, or suspended or barred from association with a member of, a securities self-regulatory organization or "SRO" (i.e., a registered national securities exchange or national securities association, such as FINRA) for any act or omission to act constituting conduct inconsistent with just and equitable principles of trade.
  • U.S. Postal Service false representation orders: An offering is disqualified if the issuer or another covered person is subject to a U.S. Postal Service false representation order entered within the preceding five years, or to a temporary restraining order or preliminary injunction with respect to conduct alleged to have violated the false representation statute that applies to U.S. mail.

As noted above, many disqualifying events include a look-back period (for example, a court injunction that was issued within the last five years or a regulatory order that was issued within the last ten years). The look-back period is measured from the date of the disqualifying event—in the example, the issuance of the injunction or regulatory order—and not the date of the underlying conduct that led to the disqualifying event.

Reasonable Care Exception

The final rule provides an exception from disqualification when the issuer is able to demonstrate that it did not know and, in the exercise of reasonable care, could not have known that a covered person with a disqualifying event participated in the offering. According to the SEC, the steps an issuer should take to exercise reasonable care will vary according to particular facts and circumstances. The instruction to the rule states that an issuer will not be able to establish that it has exercised reasonable care unless it has made, in light of the circumstances, factual inquiry into whether any disqualification exists. In the adopting release, the SEC noted 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.

Waivers

The final rule provides for the ability to seek waivers from disqualification by the SEC for good cause shown. There are a number of circumstances that could, depending upon the specific facts, be relevant to the evaluation of a waiver request. The SEC suggests that interested persons view past applications and waivers granted under Regulation A that are available on-line. Staff in the Office of Small Business Policy is also available to discuss potential waiver concerns over the phone at (202) 551-3460.

Rule 506(d)(2) of Regulation D provides another way for issuers to request a waiver of disqualification. Disqualification will not arise if, before the relevant sale is made in reliance on Rule 506, the court or regulatory authority that entered the relevant order, judgment or decree advises in writing—whether in the relevant judgment, order or decree or separately to the SEC or its staff—that disqualification under Rule 506 should not arise as a consequence of such order, judgment or decree.

Disclosure of Pre -Existing Events

The effective date of the rule amendments was September 23, 2013; therefore matters that occurred before that date will not result in disqualification. However, matters that existed before the effective date of the rule and would otherwise be disqualifying are required to be disclosed in writing to investors. Issuers must furnish this written description to purchasers a reasonable time before the Rule 506 sale. Rule 506 is unavailable to an issuer that fails to provide the required disclosure, unless the issuer is able to demonstrate that it did not know and, in the exercise of reasonable care, could not have known that a disqualifying event was required to be disclosed. The rule looks to the timing of the triggering event (e.g., a criminal conviction or court or regulatory order) and not the timing of the underlying conduct. A triggering event that occurs after effectiveness of the rule amendments will result in disqualification, even if the underlying conduct occurred before effectiveness.

The SEC expects that issuers will give reasonable prominence to the disclosure to ensure that information about pre-existing bad actor events is appropriately presented in the total mix of information available to investors.

Transition Issues

The rules affect only sales of securities made on or after September 23, 2013. Sales of securities made before the effective date of the bad actor provisions will not be affected by the disqualification and disclosure requirements, even if such sales are part of an offering that continues after the effective date. Only sales made after the effective date of the amendments will be subject to disqualification and mandatory disclosure.

Sales made before the occurrence of the disqualifying event will not be affected by it, but sales made afterward will not be entitled to rely on Rule 506 unless the disqualification is waived or removed, or, if the issuer is not aware of a triggering event, the issuer may be able to rely on the reasonable care exception.

Disqualifying events that exist at the time the offering is commenced but are only discovered later trigger disqualification or a disclosure obligation. Sales will not be eligible for reliance on Rule 506, subject to the application of the reasonable care exception.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.