• New Bad Actor Disqualification Events Trigger Disclosure Obligations and Possible Loss of Accredited Investor Exemption
  • October 11, 2013 | Authors: Thomas M. Rose; Shona Smith
  • Law Firms: Troutman Sanders LLP - Norfolk Office ; Troutman Sanders LLP - Atlanta Office
  • The SEC adopted final rule amendments related to certain new bad actor disqualification events, which became effective on September 23, 2013. These new bad actor disqualification events now trigger disclosure obligations to potential investors and the possible loss of the “accredited investor” exemption in Rule 506 of Regulation D for offers and sales of securities. It is important to note that if a disqualifying event occurred before the effective date of these amendments it would not result in the loss of the Rule 506 exemption. However, such event will require disclosure to potential investors prior to any sale being completed in reliance upon the Rule 506 exemption. All issuers conducting an offering in the United States and elsewhere in reliance upon Rule 506, and all broker-dealers receiving compensation in connection with such offerings (directly or indirectly), will be required to conduct the due diligence necessary with respect to themselves and their representative “covered persons” to confirm that such exemption is available prior to any offers and sales being made.

    Covered Persons

    The rule amendments add new Rule 506(d), which provides that the following “covered persons” could disqualify an issuer from relying on Rule 506 if they are the subject of a disqualifying event:

    • The issuer and any predecessor of the issuer or affiliated issuer;

    • Any director, executive officer, officer participating in the offering, general partner or managing member of the issuer;

    • Any beneficial owner of 20% or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power;

    • Any promoter connected with the issuer in any capacity at the time of the sale;

    • Any investment manager to an issuer that is a pooled investment fund 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;

    • 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 (a “compensated solicitor”); and

    • Any director, executive officer, other officer participating in the offering, general partner, or managing member of any such compensated solicitor.

    Whether an officer participates in an offering will be a question of fact, with participation requiring more than transitory or incidental involvement. Participation 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.

    The covered persons include any person that is paid (directly or indirectly) remuneration for soliciting purchasers in the offering. This will include broker-dealers acting as agents, underwriters or finders in an offering, and their personnel that are covered persons, as well as any other individual at a broker-dealer that may directly or indirectly receive remuneration for solicitation of purchasers. This will also include any members of a selling dealer group or any persons participating in any form of fee splitting with respect to the offering.

    Disqualifying Events

    The disqualification will apply if a covered person is subject to the following “disqualifying events”:

    • Criminal convictions within ten years before the sale of securities (or five years, in the case of issuers, their predecessors and affiliated issuers);

    • Court orders entered within five years before the sale of securities, that, at the time of such sale, restrains or enjoins such person from engaging or continuing to engage in such conduct or practice;

    in each case (A) in connection with the purchase or sale of any security; (B) involving the making of any false filing with the SEC; or (C) 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;

    • Final orders of certain state regulators (such as state securities, banking and insurance regulators) and certain federal regulators, if the order is based on fraudulent, manipulative or deceptive conduct within ten years before the sale of the securities for so long as such orders are in effect;

    • Certain SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment advisers and investment companies and their associated persons for so long as such orders are in effect;

    • SEC cease and desist orders within five years before the sale of securities for scienter-based anti-fraud violations and Section 5 registration violations;

    • Suspension or expulsion from membership in, or suspension or bar from associating with a member of, a securities self-regulatory organization for the duration of the suspension or expulsion;

    • SEC stop orders and orders suspending a Regulation A exemption issued within five years before such sale, or investigations in respect of such orders ongoing at the time of the sale; and

    • U.S. Postal Service false representation orders entered within five years before such sale, or 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.

    Reasonable Care Exception

    To clarify the issuer’s obligations under the new Rule 506(d), the rule amendments provide a “reasonable care” exception, under which an issuer would not lose the benefit of the Rule 506 safe harbor, despite the existence of a disqualifying event, if it can show that it did not know and, in the exercise of reasonable care, could not have known of the disqualification. To establish reasonable care, the issuer would be expected to conduct a factual inquiry with respect to the relevant covered persons, the nature and extent of which would depend on the facts and circumstances of the situation.

    Waivers

    The SEC may grant a waiver if it determines that the issuer has shown good cause that it is not necessary under the circumstances that the registration exemption be denied. The SEC identified a number of circumstances that could, depending on the specific facts, be relevant to the evaluation of a waiver request, including 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.

    Disclosure of Disqualifying Events and Transition Matters

    All sales made under Rule 506 after the effective date of the amendments would be subject to the disqualification provisions. Under new Rule 506(e), disqualifying events that occurred before the effective date of the rule amendments will not result in disqualification provided that disclosure to investors regarding such events is provided. Issuers must 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, and must provide such information a reasonable time prior to sale.

    The final release indicates that if the disclosure is required and not adequately provided to an investor, relief will not be available under Rule 508, under which “insignificant deviations” from Regulation D requirements do not necessarily result in loss of the exemption with regard to an offer or sale of securities to a particular individual or entity. However, the failure to furnish the required disclosure on a timely basis will not prevent an 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 disqualifying events.

    Sales of securities made before the effective date will not be affected by any disqualification or disclosure requirement, even if such sales are part of an offering that continues after the effective date. Disqualifying events that occur while an offering is underway will be treated in a similar fashion. Sales made before the occurrence of the disqualifying event will not be affected by the disqualifying event, 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 disqualifying event, the issuer can rely on the reasonable care exception.

    Amendment to Form D

    Under the rule amendments, the signature block of Form D will now contain a certification confirming that the offering is not disqualified from reliance on Rule 506 for one of the reasons stated in Rule 506(d).

    Recommendations for Compliance with New Rule Amendments

    We recommend that issuers and broker-dealers take the following steps to ensure compliance with the new rule amendments and to establish a basis for the application of the reasonable care exception:

    1. An issuer should conduct a disqualifying event analysis with respect to the issuer and its predecessor companies and affiliated companies. For an issuer that has had a long operating history, and that has a number of predecessor companies or affiliated companies, this inquiry may prove challenging.

    2. An issuer should circulate a questionnaire to its existing and new directors, officers and promoters (and, if possible, to any beneficial owner of 20% or more of its outstanding voting equity securities) to confirm whether or not a disqualifying event occurred prior to the effectiveness of Rule 506(d). If so, disclosure must be included in the offering documents for an offering that will be made in reliance on the accredited investor exemption in Rule 506.

    3. A broker-dealer should conduct an analysis with respect to the broker-dealer, and circulate a questionnaire to its existing and new directors and officers (and any other person that may be paid compensation directly or indirectly in connection with an offering) to confirm whether or not a disqualifying event occurred prior to the effectiveness of Rule 506(d). If so, disclosure must be included in the offering documents for an offering that will be made in reliance on the accredited investor exemption in Rule 506 and for which that broker-dealer will receive, directly or indirectly, remuneration for soliciting purchasers.

    4. The questionnaires circulated by issuers and broker-dealers should contain a positive obligation on the part of any respondent to update the issuer or broker-dealer if any disqualifying event occurs after the date of completion of the initial questionnaire. In addition, such inquiries could be made annually as part of any questionnaire used in the preparation of an entity’s periodic reporting documents.

    5. An agency agreement or underwriting agreement should contain reciprocal representations and warranties from the issuer and the agent/underwriter with respect to the application of Rule 506(d). This is necessary for a law firm to be able to render a legal opinion with respect to the Rule 506 offering. This is also necessary in order for an issuer to establish a basis for the application of the reasonable care exception with respect to the involvement of the broker-dealer and in order to deliver the required certification in the Form D post-closing filing with the SEC. To be in a position to give these representations and warranties in the agency/underwriting agreement in an informed manner, the issuer and the agent or underwriter must make the foregoing inquiries.