|August 1, 2013|
Previously published on July 31, 2013
Over the past 30 years, the Rule 506 “safe harbor” has become one of the most commonly utilized exemptions from securities registration requirements. The Rule has provided a simple and straightforward exemption not only at the federal level, but also at the state level. The total volume of securities sold under Rule 506 in 2012 reportedly exceeded $898 billion.1 A useful exemption indeed.2
A companion exemption, Rule 505, has always included a set of disqualifications known as “bad boy” rules. So, too, has the Regulation A exemption. Bad boy rules generally have the effect of denying access to an exemption if the issuer or an affiliate, or anyone assisting with the offering, has been convicted of certain crimes or has been otherwise sanctioned for significant investment-related violations.
Rule 506 has not previously been subject to these kinds of disqualifications, but that will now change. In a Release issued on July 10, 2013, the Securities and Exchange Commission adopted final rules adding a set of bad boy provisions to Rule 506. These new requirements, codified in Rule 506(d) and (e), will go into effect on September 23, 2013.3 For those already familiar with the prior bad boy provisions, it is important to note that the new bad boy rules for Rule 506 are broader than those under Rule 505 and Regulation A.
AN ILLUSTRATION OF WHY THIS MATTERS: Let’s say a startup company decides to use a placement agent to help raise capital in a Rule 506 offering. And let’s say that, unbeknownst to the issuer, one managing member of that placement agent (even someone not involved in this offering) was sanctioned for an investment-related offense within the past five years. That fact alone might disqualify the issuer from using Rule 506, unless the issuer can prove that it did not know and in the exercise of reasonable care could not have known that the disqualification existed. The wording of Rule 506(d) is stark: “No exemption under [Rule 506] shall be available if . . . .”4 If the disqualification is discovered after the offering has been completed, and if the issuer did not happen to qualify for other exemptions from federal and state registration requirements, then the company, its founders, and its directors and executive officers could each be personally at risk to refund the price paid by investors who purchased securities in the defective offering.5
THE LESSON: This is an important new restriction. Companies that wish to rely on Rule 506 will need to identify all persons potentially covered by these bad boy rules, and should take affirmative steps to investigate whether any such individuals or entities have been hit with any covered sanction over the past ten years, or are currently subject to pending or threatened proceedings that could result in a covered sanction.
Who is a Covered Person?
Rule 506(d) includes each of the following as covered persons:
the issuer itself;
the issuer’s directors and executive officers (regardless of whether participating in the offering); all lesser officers who are participating in the offering; all beneficial owners of 20% or more of the issuer’s voting equity securities; and any promoters who are still connected with the issuer in any capacity;
the issuer’s predecessors and affiliated companies;
any individual or firm being paid to solicit any purchasers in connection with the offering; and
any general partner or managing member of a soliciting firm (regardless of whether he or she is participating in the offering); and any of the soliciting firm’s directors, executive officers or other officers who are participating in the offering.
In the case of issuers that are hedge funds or other pooled investment vehicles, “covered person” status also extends to:
the fund’s investment manager, and each general partner or managing member of the investment manager; and
any of the investment manager’s (or its general partner’s or managing member’s) directors, executive officers or other officers who are participating in the offering.
According to the SEC, participating means 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.”
What is a Covered Sanction?
Rule 506(d) contains a detailed list of sanctions, any of which if incurred by a covered person could disqualify the issuer from being eligible to rely on Rule 506 for the particular offering. A somewhat simplified list of covered sanctions (referred to by the SEC as “disqualifying events”) is as follows:
conviction for a securities-related felony or misdemeanor;
being the subject of any court-issued injunction or restraining order relating to a securities violation;
being the subject of any final order from a state securities regulator, federal or state banking regulator, state insurance regulator or the Commodity Futures Trading Commission which (i) arises from a violation of any law or regulation that prohibits fraudulent, manipulative or deceptive conduct or (ii) bars the person from employment with a securities firm or financial institution or from engaging in relevant regulated activities;
being the subject of an SEC order restricting business as a stockbroker, investment adviser, etc.;
being the subject of an SEC order prohibiting the person from violating antifraud rules or securities registration requirements;
being suspended from the New York Stock Exchange or FINRA6, or barred from associating with a registered broker-dealer, due to violations of applicable broker-dealer standards for just and equitable principles of trade;
being an issuer or named underwriter in any SEC-registered public offering or Regulation A offering that was the subject of a stop order or similar order, or that now is being investigated to determine if a stop order should issue; or
being subject to a U.S. Postal Service false representation order or a preliminary restraining order or preliminary injunction with respect to conduct alleged by the USPS to constitute mail fraud.
Due to the complexity and importance of the list of covered sanctions, issuers and their advisors should consult the specific wording of Rule 506(d) itself, rather than rely on a summary.
Look-Back Periods; Transition Period; Pre-Affiliation Events
Most of the covered sanctions have “look-back” periods of five or ten years before the date the security is sold in reliance on Rule 506. Many of those, however, are relevant only if still in effect at the time of the sale. The Appendix to this article shows the relevant time periods for the various covered sanctions.
As part of the transition to the new disqualification rules, otherwise-covered sanctions handed down before September 23, 2013 (the effective date of these bad boy rules) are excluded as disqualifying events. Instead, a separate provision (Rule 506(e)) requires the issuer to disclose in writing to each purchaser a description of any events that otherwise would have disqualified the offering under Rule 506. That disclosure must be furnished to each purchaser a reasonable time prior to sale, even if no other written disclosure is being made.7 Failure to meet this disclosure mandate will disqualify the issuer from relying on Rule 506, unless the reasonable care exception (discussed below) applies.
Also, in the case of affiliated issuers, disqualification will not result from events that predate the affiliation unless the affiliated entity is (i) currently in control of the issuer or (ii) currently under common control with the issuer through another person that controlled the affiliated entity at the time of the disqualifying events.
The Reasonable Care Exception
Rule 506(d) includes a reasonable care exception. Thus the issuer will not be subject to disqualification if the issuer bears the burden of proving that it did not know, and in the exercise of reasonable care could not have known, that a disqualification existed. The disclosure requirements of Rule 506(e) include the same exception. In either case, an issuer that does not make a factual inquiry will not be able to rely on this exception.
What constitutes “reasonable care” will vary according to the particular facts and circumstances. For example, the SEC states that for an issuer with in-depth knowledge of its own executive officers and other officers through the hiring process and in the course of employment, further inquiry might not be necessary. In other cases, a questionnaire and accompanying indemnity might suffice without independent verification, unless the issuer is on notice of information that arouses suspicion. An issuer that obtains assistance from a broker-dealer can (and should) use FINRA’s “broker check” site and examine that firm’s disciplinary history.
Rule 506(d) allows issuers to seek waivers of disqualification from the SEC upon a showing of good cause. The SEC will have broad discretion to decide whether to issue the requested waiver.8
In addition, if a potential disqualification arises from another regulator’s or court’s order, Rule 506(d) allows an exception if the same regulator or court advises in writing (whether contained in the relevant order or provided separately to the SEC or its staff) that the sanction imposed should not have the effect of a disqualification from Rule 506. This exception applies only for sales made later than the date that written advice is issued.
Certification on Form D
The SEC has revised the signature page of the Form D notice filing called for in Rule 506 offerings. The issuer will be required to certify that it is not disqualified in its reliance on the exemption being claimed.9
As noted above, the new bad boy rules become effective September 23, 2013. Covered sanctions that were issued before that date will not disqualify the offering under Rule 506 but will trigger special disclosure requirements to all persons who purchase the offered securities on or after that date.
1 To put this in perspective, the total amount of securities sold through registered public offerings in 2012 was $1.2 trillion. See http://www.sec.gov/divisions/riskfin/whitepapers/dera-unregistered-offerings-reg-d.pdf.
2 Rule 506(c) is about to become even more useful, due to new provisions that allow an issuer to use advertising and other forms of general solicitation in accredited-only offerings. (For details, see our article on this at www.verrilldana.com/NewSECRule.) The new bad boy rules will apply equally to offerings under Rule 506(c) (general solicitation allowed) and to offerings under the more traditional Rule 506(b) (no general solicitation).
3 See http://www.sec.gov/rules/final/2013/33-9414.pdf. The initial rule proposal was published in May 2011. Adoption of bad boy rules for Rule 506 was mandated by Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, enacted in July 2010.
4 In its Release, the SEC expressed the view that even relatively insignificant violations of the bad boy rules will result in a disqualification, unless waived by the SEC or unless the issuer meets the reasonable care exception.
5 Specifically, for violations of securities registration requirements under federal or state securities laws, the issuer is liable to repay the purchase price, with interest, and (often) to cover the investor’s legal fees. That liability extends, jointly and severally, to each “control person” of the issuer, except those who can establish that they did not know, and in the exercise of reasonable care could not have known, of the acts constituting the violation. The statute of limitations for this type of strict liability claim is typically two years, but could be longer under some states’ securities laws.
6 The Financial Industry Regulatory Authority, Inc. (successor to the National Association of Securities Dealers, Inc.) is a private, self-regulatory organization that oversees broker-dealers that are registered with the SEC.
7 Historically, Rule 506 has not required specific disclosures to purchasers who meet the “accredited investor” definition. Rule 506(e), however, requires written disclosure of relevant sanctions even to accredited investors. Note also that the SEC has proposed other mandatory written disclosures for Rule 506(c) offerings, involving general solicitation. See http://www.sec.gov/rules/proposed/2013/33-9416.pdf
8 However, the SEC waiver provision does not reach the disclosure mandate under Rule 506(e).
9 Form D already contains an analogous certification covering Rule 505 disqualifications. The individual who signs the form should indicate the capacity in which he or she is signing. Signatories should note that intentional misstatements or omissions of fact constitute federal criminal violations.