The United States Securities and Exchange Commission (“SEC”) was required, under Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”), to adopt rules disqualifying felons and other “bad actors” from certain securities offerings from reliance on Rule 506 of Regulation D. These changes can have a serious impact on how issuers raise capital in the United States but are designed to protect the investing public. The United States Securities Act of 1933, as amended (“Securities Act”), requires that any offer to sell securities must either be registered with the SEC or meet an exemption from registration. However, on September, 23, 2013, the United States Securities and Exchange Commission (“SEC”) implemented a final rule that prohibits these funds from relying on Rule 506 exemptions to raise capital if disqualified “bad actors” have a certain connection to the offering.
Understanding Rule 506 and “bad actor” disqualification
First, it is important to understand how efficacious Rule 506 is. Of the three exemptive rules for limited offerings under Regulation D, Rule 506 is by far the most widely utilized exemption and accounts for an estimated 90% to 95% of all Regulation D offerings (with 504 and 505 making up the remainder). This translates into the an overwhelming majority of capital raised in transactions under Regulation D. The Rule 506(b) exemption to registration allows an issuer to accept funds from an unlimited number of accredited investors and up to thirty-five (35) non-accredited investors subject to certain conditions including a prohibition on general solicitation. Rule 506(c) allows an issuer to offer accept funds from an unlimited number of accredited investors via general solicitation but only accredited investors and the issuer must take reasonable steps to verify that the purchasers are, in fact, accredited investors. The “bad actor” disqualification requirements prohibit securities offerings from relying on a registration exemption if the issuer or other relevant persons, including but not limited, to general partner(s), officer(s), sponsor(s), placement agent, or primary investor(s), have been either been convicted of or are subject to court or administrative sanctions for securities fraud or other violations of specified laws. As such, the new bad actor disqualification under Rule 506(d) now affects all of Rule 506 offerings and thus 90-95% of exemptions to registration under Regulation D.
Who is a “covered person?”
In order to understand who can be deemed a bad actor by Rule 506(d)’s disqualification provision, it is first required to understand who is a “covered person.” Understanding the categories that are covered persons by Rule 506(d) is important because issuers are required to conduct a factual inquiry to determine whether any covered person has had a disqualifying event. “Covered persons” 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 issuers 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;
- the fund’s investment manager and its principals for pooled investment fund issuers;
- persons compensated for soliciting investors, including their directors, general partners and managing members.
If a covered person has committed one of the “disqualifying acts” listed in Rule 506(d), then either this will disqualify an issuer from relying on Rule 506 to raise capital or this information will have to be disclosed in writing to investors.
It is important to note that promoters who are connected with the fund “in any capacity” at the time of fundraising are perhaps the broadest category of covered persons. The term “promoter” is defined in Rule 405 and states a promoter is:
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). Since the definition of promoter encompasses activities “alone or together with others, directly or indirectly” and therefore, the result does not change if there are other legal entities (including other promoters) in the chain between that person and the issuer. However, a “promoter” will only be disqualified if they are connected with the issuance “in any capacity” at the time of sale.
What is a “disqualifying act?”
We have discussed a great deal about who is covered and now we talk about what is covered. Rule 506(d) sets forth a wide variety of securities and fraud in connection with the (i) 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 related offenses and includes:
- certain criminal convictions involving the above;
- certain court injunctions and restraining orders involving the above;
- final orders of certain state and federal regulators;
- certain SEC disciplinary orders;
- certain SEC cease-and-desist orders;
- SEC stop orders and orders suspending the Regulation A exemption;
- suspension or expulsion from membership in a self-regulatory organization (SRO), such as FINRA, or from association with an SRO member;
- U.S. Postal Service false representation orders.
For many of the included disqualifying events there is a look-back period between five (5) to ten (10) years depending on the disqualifying act. For example, five (5) years for a court injunction and ten (10) years for a regulatory order by the SEC. The look-back period is calculated from the date of the disqualifying event and not the date of the underlying conduct. However, it should be noted that actions taken in jurisdictions other than the U.S is not considered a disqualification triggered under Rule 506(d) by the SEC.
How to disclose pre-existing events
Disqualification will not occur as a result of disqualifying events that occurred before September 23, 2013, the effective date of the Rule 506 amendments. This is under one very highly important condition, that the covered person’s actions are disclosed in writing to investors and that this written disclosure must be provided to investors a “reasonable time” before the sale of the securities in reliance of Rule 506. If the issuer does not provide the proper disclosure, the Rule 506 safe harbor will be unavailable unless the issuer is able to demonstrate that it did not know and that after exercising reasonable care, it could not have known that the act was required to be disclosed. To determining whether disclosure is required, 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 (as discussed above). And, it is also important to note, that a triggering event that occurs after effectiveness of the rule amendments will result in disqualification, even if the underlying conduct occurred before the effectiveness of the amendments. The SEC also expects that the issuers will give reasonable prominence to the disclosure to reveal any pre-existing bad actor events when presented to investors.
What are reasonable care exception and waivers?
Reasonable Care Exception. Rule 506(d) provides an exception from disqualification if 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. The exercise of reasonable care is not defined by the SEC but, at the very least and in light of the circumstances, the issuer must make a factual inquiry into whether a disqualification exists and the remaining facts and circumstances will vary case by case.
Waivers. In addition to the reasonable care exception, Rule 506(d) also permits an issuer to rely on Rule 506 even if a covered person has committed a disqualifying act if there has been (i) a waiver for good cause or (ii) a waiver based on determination of the issuing authority. A waiver for good cause provides for the ability to seek waivers from disqualification by the SEC. The waiver request is evaluated on a number of different circumstances and the specific facts behind the disqualification. Rule 506(d)(2) provides a waiver based on the determination of the issuing authority. This waiver means that disqualification will not arise if, before the relevant sale is made in reliance on Rule 506, the court or regulatory authority that entered the pertinent order, judgment, or decree advises in writing to the SEC that the disqualification under Rule 506 should not arise as a consequence of such order, judgment, or decree.
What are the exemptions from being “bad?”
It should be noted that the bad actor rule does not apply to all exemptions to registration. Regulation D is affected by the new bad actor provision and is generally used by issuers to raise capital from U.S. investors but there are other exemptions that non-U.S. and U.S. issuers may use instead of Regulation D, including Section 4(a)(2) of the Securities Act and Regulation S. Section 4(a)(2) is a statutory exemption for offerings that does not involve general solicitation and Regulation S provides a “safe harbor” from the restriction requirement of the Securities Act for certain offers or sales of securities outside the United States. This is important because these other registration exemptions not affected by the new bad actor disqualification. However, if a issuer is offering securities to U.S. investors it is beneficial to rely on the Rule 506 safe harbor of prohibition of bad actors because it provides a degree of certainty that the offering complies with the Securities Act and which would preempt state (or “blue sky”) registration requirements.
Further, the rule amendments affect only sales of securities made on or after September 23, 2013 and the sales of these securities are not affected even if such sales are part of an offering that continues after the effective date. The only sales that are affected by the Rule 506(d) bad actor disqualifications are those made after the effective date and will be subject to disqualification or mandatory disclosure. Further, disqualifying events that occur while an offering is underway will be not be affected if the disqualification was before the occurrence but, if the sale was made afterward, the issuer will not be entitled to rely on Rule 506 unless the disqualification is waived or removed, or the issuer is not aware of the triggering event.
What to do if you are an issuer
If you are an issuer that is looking to rely on a Rule 506 exemption to raise capital then should contact an experienced securities attorney to discuss the preventative steps, including identifying who is a “covered person,” what is a “disqualifying act,” or who is a “bad actor,” to help ensure your offering does not lose the exemption.
What to do if you are a covered person
Individuals who do not make proper disclosure or violate the bad actor provisions of Regulation D risk potential civil, regulatory, and criminal liability. If you are unsure about an individual status as a bad actor, it pays to consult a qualified attorney for a thorough analysis of the situation relative to the new rules.
This securities law blog post about going public is provided as a general informational service to clients and friends of Feinstein Law, PA and should not be construed as, and does not constitute, legal and compliance advice on any specific matter, nor does this message create an attorney-client relationship.
For more information concerning the rules and regulations affecting the going public direct transactions and direct public offerings please contact Feinstein Law, PA at (619) 990-7491 or by email at Todd@Feinsteinlawfirm.com or JDunsmoor@Feinsteinlawfirm.com. Please note that the prior results discussed herein do not guarantee similar outcomes. Todd Feinstein is admitted in Florida and Jonathan Dunsmoor is admitted in New York.
