By Simon Riveles and Peter Tyson
On July 10, 2013, the Securities and Exchange Commission (SEC) adopted amendments to Rule 506 of the Securities Act of 1933 to disqualify securities offerings relying on the Rule 506 exemption that involve certain “felons and other ‘bad actors’”. The final amendments (the Final Rules) went into effect on September 23, 2013 (the Effective Date) and apply to all Rule 506 offerings made from that date forward, regardless of whether general solicitation is used.
According to the SEC’s Final Rules, if a felon or “bad actor” is involved with a Rule 506 offering, such offering will be disqualified from relying on the Rule 506 exemption. Whether a person involved with a Rule 506 offering is a “bad actor” for the purposes of disqualification is determined by certain “bad actor” triggering events, outlined in greater detail in a subsequent section. It should be noted, however, that “bad actor” triggering events occurring before the Effective Date will not cause disqualification, but will instead be subject to mandatory written disclosure within a reasonable time prior to the proposed sale of securities.
The SEC provides an exception from disqualification when the issuer can show it exhibited “reasonable care” in attempting to identify a previously unknown “bad actor.” However, in the Final Rules, the SEC did not define what would constitute “reasonable care,” stating instead that such a determination would be made on a case-by-case basis. Accordingly, private issuers and their intermediaries should focus on developing and maintaining robust compliance and due diligence procedures in order to identify potential felons and “bad actors”, and avoid disqualification from relying on Rule 506. Details regarding to whom “bad actor” triggering events apply, what “bad actor” triggering events are, and what private issuers should do moving forward are outlined below.
Covered Persons:
According to the SEC’s Final Rules, the disqualification provisions (i.e. “bad actor” triggering events) of Rule 506(d) will pertain to the following persons, also known as, “covered persons”:
- The issuer and any predecessor of the issuer;
- Any affiliated issuer;
- Any director, executive officer, other officer participating in the offering, general partners or managing members of the issuer;
- Any beneficial owners of 20% or more of the issuer’s outstanding voting equity securities, measured by voting power;
- Any promoter (as defined in Rule 405) connected with the issuer in any capacity at the time of the sale;
- Any investment manager of an issuer that is a pooled investment fund and any director or officer participating in the offering;
- Any persons that have been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with sales of securities in the offering; and
- Any director, executive officer, or other officer participating in the offering, general partner, or managing member of any such compensated solicitor.
“Bad Actor” Triggering Events:
Below is a table describing the various “bad actor” triggering events that cause disqualification from relying on Rule 506, including the relevant “look-back” periods, which provide the scope of each disqualifying event. As previously stated, the SEC’s Final Rules provide that “bad actor” triggering events that occur before the Effective Date will not cause disqualification, but will instead be subject to mandatory written disclosure within a reasonable time prior to the proposed sale of securities.
DISQUALIFYING EVENTS UNDER RULE 506(d) | |
Disqualifying Action | Look-Back Period |
1. Criminal Convictions: A covered person is disqualified if such covered person has been convicted of any felony or misdemeanor:
| 10 years from the proposed sale of securities for a covered person other than an issuer, its predecessor, or an affiliated issuer.5 years from the proposed sale of securities for issuers, their predecessors, and affiliated issuers. |
2. Court Injunctions and Restraining Orders: A covered person is disqualified if such covered person is subject to any court order, judgment, or decree:
| 5 years from the proposed sale of securities. |
3. Final Orders of Certain Regulators: A covered person is disqualified if such covered person is subject to a final order of a state securities, banking, or insurance regulating authority; an appropriate federal banking agency; the CFTC; or the National Credit Union Administration, that:
| 10 years from the proposed sale of securities for final orders based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct. |
4. Commission Disciplinary Orders: A covered person is disqualified if such covered person is subject to any SEC disciplinary order relating to brokers, dealers, municipal securities dealers, investment advisers, and investment companies that:
| A covered person is disqualified by a commission disciplinary order for a period of time equivalent to the duration of the suspension or limitation of activities ordered by the SEC. |
5. Certain Commission Cease-and-Desist Orders: A covered person is disqualified if such covered person is subject to any order of the Commission that orders the person to cease and desist from committing or causing a violation or future violation of:
| 5 years from the proposed sale of securities. |
| 6. Suspension or Expulsion from SRO Membership or Association with an SRO Member: A covered person is disqualified if such covered person 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. | A covered person is disqualified for an amount of time equivalent to the suspension or expulsion. |
| 7. Stop Orders and Orders Suspending the Regulation A Exemption: A covered person is disqualified if such covered person has 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. | 5 years from the proposed sale of securities.A covered person is also disqualified if, at the time of the proposed sale, the covered person is subject to an investigation or procedure to determine whether a stop or suspension order must be issued. |
| 8. U.S. Postal Service False Representation Orders: A covered person is disqualified if such covered person is subject to a U.S. Postal Service false representation order. | 5 years from the proposed sale of securities.A covered person is also disqualified if, at the time of the proposed sale, the covered person is subject to a temporary restraining order or preliminary injunction for conduct pertaining to obtaining money or property through the mail by means of false representation. |
Next Steps Private Funds Should Consider:
In order to identify potential felons and “bad actors”, and avoid a disqualification of a Rule 506 offering, Simon Riveles of Riveles Law Group emphasizes the need for private issuers to develop robust compliance and due diligence procedures. The following are some steps that private issuers and their intermediaries should take in order to comply with the SEC’s Final Rules regarding “bad actor” disqualification:
Identify all Covered Persons, including the full range of persons that could subject the issuer to disqualification (including placement agents and their personnel, entities affiliated with the investment manager, etc.);
- Procure and distribute questionnaires and obtain certifications from each Covered Person regarding any Disqualifying Events;
- Amend any agreements with potential Covered Persons (including placement agent agreements, employment agreements and agreements with investors) to include appropriate representations and disclosure requirements;
- Implement and document compliance policies or procedures addressing the determination of whether a Covered Person has had a Disqualifying Event; and
- Amend operating agreements to provide the authority for prompt mandatory redemption or withdrawal in the event a beneficial owner could subject the fund to disqualification.
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