- SEC Bars “Bad Actors” From Relying on Key Private Placement Exemption
- July 22, 2013 | Authors: Thomas John Holton; Ruoke Liu
- Law Firm: Bingham McCutchen LLP - Boston Office
On July 10, 2013 the U.S. Securities and Exchange Commission (“SEC”) adopted amendments to Rule 506 under SEC Regulation D that are designed to prevent “bad actors” from relying upon the exemption provided by the Rule (the “Rule 506 Exemption”).1 The Rule 506 Exemption is the most commonly used “private placement” exemption from the requirement to register offerings of securities under the U.S. Securities Act of 1933 (the “Securities Act”). In particular, many privately offered funds, including hedge funds and private equity funds, rely on the Rule 506 Exemption.
The SEC proposed these amendments in May 2011. The final amendments adopted by the SEC on July 10 are largely the same as the amendments proposed in 2011, but the SEC made some important changes designed to simplify the way in which the amendments apply. In particular, the SEC adopted a transitional rule under which legal problems that occur prior to the effective date of the amendments do not disqualify an issuer from relying on the Rule 506 Exemption. Instead such legal problems must be disclosed to prospective investors a reasonable time before they invest.
Summary — What You Need to Do Now
The amendments will take effect in September 2013, 60 days after their publication in the Federal Register. Essentially, the amendments prohibit an issuer of securities from relying on the Rule 506 Exemption if the issuer or specified persons who are affiliated with the issuer, such as directors and executive officers (the “Covered Persons”), have had certain types of legal problems with U.S. federal, state or regulatory authorities or U.S. national securities exchanges (the “Disqualifying Events”). More information regarding who are Covered Persons and what are Disqualifying Events appears below.
Issuers that rely on the Rule 506 Exemption to distribute their securities must determine whether any of their Covered Persons have any Disqualifying Events. For privately offered funds, such as hedge funds and private equity funds, the investment manager must also determine whether it or any of its Covered Persons have any Disqualifying Events. These determinations must be made within the sixty day period before the amendments take effect.
Once the amendments take effect, if any Covered Person has a Disqualifying Event that occurred prior to the effective date of the amendments, the Disqualifying Event must be disclosed to prospective investors a reasonable time before they invest. This disclosure must be reasonably prominent. Presumably, this disclosure could be included in a private placement memorandum or other offering document, or in a separate disclosure document that is provided to prospective investors a reasonable time before their investment.
If any Covered Person of an issuer has a Disqualifying Event that occurs after the amendments take effect, the issuer will for a period of time be prohibited from relying on the Rule 506 Exemption, absent a waiver from the SEC or in some cases another authority. The length of this time period will vary depending upon the nature of the Disqualifying Event.
In the future, issuers that rely on the Rule 506 Exemption should implement a program to determine whether any of their Covered Persons have Disqualifying Events. Such a program could require, for example, that new hires certify that they have no Disqualifying Events, that existing personnel certify annually that they have no Disqualifying Events, and that the issuer perform periodic due diligence to identify any unreported Disqualifying Events.
Background on Regulation D
The Securities Act generally requires that offers and sales of securities in the United States be registered with the SEC. This registration requirement is subject to several exemptions, including an exemption for private placements, which are typically limited to high net worth or institutional investors.
In 1982 the SEC promulgated Regulation D under the Securities Act in order to clarify the conditions that must be met in order for an offering of securities to qualify for the private placement exemption. Regulation D is a “safe harbor,” which means that, if an offering is made in accordance with Regulation D, the offering is exempt from the registration requirements of the Securities Act. Regulation D consists of three separate “safe harbor” exemptions, which are set forth respectively in Rules 504, 505 and 506 of Regulation D. An offering, however, may be a private placement that is exempt from the registration requirements of the Securities Act even if it does not fall within one of the Regulation D exemptions.
At the same time that the SEC adopted the amendments covered by this Alert, the SEC ended the condition that offerings made under Regulation D must not involve any public advertising or marketing. For more information on this, see our Alert titled SEC Adopts Amendments to Rule 506 and Rule 144A to Permit General Solicitation and General Advertising, and Proposes Additional Related Requirements.
The SEC adopted the amendments covered by this alert pursuant to Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), which directed the SEC to amend Regulation D to disqualify persons who have been found to have violated securities and other laws or engaged in wrongful conduct from relying on the Rule 506 Exemption.
Who are Covered Persons?
Under the amendments the Covered Persons of an issuer of securities are as follows:
1. The issuer of securities itself, together with any predecessor of the issuer or affiliated issuer. For example, if a corporation subject to a Disqualifying Event was converted into a limited liability company, the limited liability company would be subject to the same Disqualifying Event. The Disqualifying Event would continue to apply even if the conversion also involved a change of control, e.g., if as part of the conversion a new controlling equityholder assumed control over the limited liability company. An issuer, however, is not prohibited from relying upon the Rule 506 Exemption if one of its affiliated issuers has a Disqualifying Event that arose before the affiliate relationship.
2. A general partner or managing member of the issuer of securities if the issuer is organized as a partnership or limited liability company.
3. A director, executive officer, or other officer participating in the securities offering. Originally the SEC had proposed that all officers of an issuer should constitute its Covered Persons. The SEC, however, agreed with comments on the proposed amendments that treating all officers of an issuer as Covered Persons would be overly broad and might prevent an issuer with many officers from relying on the Rule 506 Exemption merely by virtue of misconduct of one junior officer with no role in offering securities. Accordingly, under the final amendments an officer of an issuer is a Covered Person of the issuer only if he or she is an executive officer or participates in the securities offering.
The SEC explained that in order for a non-executive officer to be a Covered Person he or she would need to have more than transitory or incidental involvement in a securities offering. For example, an officer would be considered a participant in a securities offering if he or she participated in (a) preparation of the private placement memorandum or other offering document, (b) due diligence activities, and (c) negotiations or other communications with prospective investors or other participants in the offering, such as placement agents or intermediaries representing prospective investors.
4. Holders of at least 20% of the Issuer’s Voting Securities. The SEC proposed that any holder of 10% or more of any class of the issuer’s equity securities should be a Covered Person. Comments on the proposed amendments persuaded the SEC that this part of the proposal would be overinclusive and would include as Covered Persons equity holders who do not control the issuer and whose prior bad acts do not reflect upon the issuer. Under the amendments as adopted a holder of 20% or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power, will be a Covered Person.
The SEC did not adopt a definition of “voting securities” for purposes of this provision. Rather the SEC commented that the term should be applied:
based 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 exercise of a voting right.
As one would expect, voting securities would include common or ordinary shares having the right under normal circumstances to elect the board of directors or other governing body of the issuer. The SEC, however, indicated that the definition of “voting securities” could apply broadly to many types of equity securities that are not, in ordinary parlance, generally considered voting securities. The SEC commented that securities that confer the right to approve significant transactions, such as acquisitions, dispositions, or financings, would be considered voting securities. Thus, for example, limited partners in a limited partnership that generally lack authority to manage the partnership but have the right to approve key decisions might hold voting securities for purposes of this provision. In addition, preferred shareholders that have the right to elect a corporation’s directors only if a specified contingency occurs, such as non-payment of dividends on the preferred shares, may likewise hold voting securities for purposes of this provision.
The 20% threshold is calculated as a percentage of total outstanding voting securities, calculated on the basis of voting power, and not as a percentage of any particular class of voting securities. The SEC explained that, if a class of equity securities has a relatively small share of total voting power, even a large holder of securities of that class may not have sufficient control or influence over the issuer to be a Covered Person. On the other hand, a holder of even a modest share of “supervoting or high vote securities” may be considered a Covered Person. While it is fairly easy to state this principle in general terms, applying it in the real world may be difficult. For example, how would you weigh the total voting power in a corporation with outstanding preferred shares that assume control of the board only if their dividends are unpaid for three consecutive years and common shares that in all other cases hold all voting rights? Would you need to consider the financial position of the corporation and the likelihood that it will fail to pay preferred share dividends for three consecutive years?
Helpfully, the SEC indicated that securities of a class that has only “defensive” voting rights limited to approving changes to the rights and preferences of the class would not be considered voting securities.
5. Investment Managers of Funds. The amendments provide that, if an issuer of securities is an investment fund, the issuer’s Covered Persons include (a) its investment manager, (b) any general partner or managing member of its investment manager, (c) the directors and executive officers of its investment manager and its general partner or managing member, and (d) any other officers participating in the securities offering (as outlined in paragraph 3 above) of its investment manager and its general partner or managing member. This reflects the fact that investment funds generally have few, if any, employees of their own and instead operate through personnel provided by their investment managers.
6. Promoters connected with the Issuer in any Capacity at the Time of the Sale of Securities. The SEC adopted without change its proposal that promoters of an issuer are Covered Persons of the issuer. The definition of “promoter” in Rule 405 under the Securities Act applies. Rule 405 defines a promoter to include (a) any person that, alone or together with others, directly or indirectly, takes initiative in founding the business or enterprise of the issuer, or (b) any person that, in connection with founding or organizing the business or enterprise of an issuer, directly or indirectly receives in return for services or property (or both services and property) 10% or more of any class of securities of the issuer or 10% or more of the proceeds from the sale of any class of securities of the issuer, provided that a person who receives those securities or proceeds solely as underwriting commissions or solely in return for property is not a “promoter” if that person does not otherwise participate in founding and organizing the issuer.
Laden with phrases such as “directly or indirectly”, the Rule 405 definition of "promoter" applies very broadly and may include, for example, officers, directors, and direct or indirect control persons of entities involved in the launch of an enterprise.
7. Placement Agents and Other Solicitors. The amendments provide that any person that has been or will be paid (directly or indirectly) compensation for soliciting purchasers in connection with sale of securities in an offering, together with any director, officer, general partner, or managing member of such person, is a Covered Person for purposes of determining whether the offering may rely on the Rule 506 Exemption. This provision is not limited to executive officers or officers who participate in an offering. Thus, an issuer may be unable to rely on the Rule 506 Exemption if it engages a placement agent and a single junior officer of the placement agent has a Disqualifying Event. Prior to engaging a placement agent for an offering, an issuer that seeks to rely on the Rule 506 Exemption should obtain assurances from the placement agent that neither the placement agent, nor any of its directors, officers, general partners, or managing members, has a Disqualifying Event.
What are Disqualifying Events?
The following Disqualifying Events may prevent an issuer from relying on the Rule 506 Exemption for private offering of securities:
1. Criminal convictions within 10 years before the sale of securities (or five years, in the case of the issuer and its predecessors and affiliated issuers) of any felony or misdemeanor (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. The SEC adopted this provision as it was proposed.
2. Court orders, judgments or decrees entered within five years before the sale of securities in the offering, that, at the time of the sale, restrain or enjoin a Covered Person from engaging or continuing to engage in any conduct or practice (a) in connection with the purchase or sale of any security; (b) involving the making of a 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. The SEC adopted this provision as it was proposed.
3. Final orders from specified state or federal regulators, such as a state securities, banking, savings association, credit union, and insurance regulators; federal banking agencies; the U.S. Commodity Futures Trading Commission (the “CFTC”); or the National Credit Union Administration that either:
(a) bar the Covered Person at the time of the sale from:
(i) associating with an entity regulated by these federal or state authorities;
(ii) engaging in the business of securities, insurance or banking; or
(iii) engaging in savings association or credit union activities; or
(b) are based on a violation of any law or regulation that prohibits fraudulent, manipulative or deceptive conduct entered within 10 years prior to the sale of securities.
The SEC added the CFTC to the list of federal and state agencies in this provision on the basis that the type of conduct that typically triggers CFTC sanctions is similar to the types of conduct that would result in a Disqualifying Event if it were the subject of an order by one of the other federal and state agencies covered by this provision. Moreover, the CFTC has regulatory authority over the investment managers of hedge funds and other collective investment vehicles that invest in commodity futures contracts and various other types of derivatives.
As part of the amendments, the SEC added a definition of “final order” to Regulation D so as to better clarify the scope of this Disqualifying Event. This definition provides that a “final order” is a written directive or declaratory statement by one of the federal or state agencies referred to above that (a) is issued under applicable statutory authority that provides for notice and an opportunity for a hearing and (b) constitutes a final disposition or action by that agency. Thus ex parte orders that are issued without an opportunity for a hearing would not be Disqualifying Events. For an order of a federal or state agency to constitute a “final order”, as defined, it is not necessary that a hearing actually occur before the order was issued. Nor is it necessary for the conduct that generated the order to have been undertaken by the Covered Person with any particular intention or state of mind (“scienter” in legalese).
4. SEC disciplinary orders that, at the time of the sale of securities, either (a) suspend or revoke a Covered Person’s registration as a broker, dealer, municipal securities dealer, or investment adviser; (b) place limits on the activities, functions, or operations of the Covered Person; or (c) bar the Covered Person from being associated with any entity or from participating in the offering of any penny stock. The SEC adopted this provision in the same form that it had proposed.
5. SEC cease and desist orders entered within five years before the sale of securities that, at the time of the sale, order a Covered Person to cease and desist from committing or causing a violation or future violation of (a) any anti-fraud provision of the federal securities laws, such as Rule 10b-5 under the U.S. Securities Exchange Act of 1934, that requires a particular intention, state of mind, or scienter, or (b) the requirement to register offerings of securities with the SEC under Section 5 of the Securities Act.
Unlike SEC disciplinary orders referred to in paragraph 4 above, SEC cease and desist orders can be brought against any person and not just against persons regulated by the SEC. The Dodd-Frank Act did not require the SEC to include its own cease and desist orders among the Disqualifying Events. The SEC, however, observed that an SEC cease and desist order often reflects the same level of “bad conduct” that may be the basis for a federal court injunction. Accordingly, the SEC concluded that the cease and desist orders described in the prior paragraph should have the same disqualifying effect as federal court orders of the types described in paragraph 2 above.
6. Suspension or expulsion of a Covered Person from membership in a securities “self-regulatory organization” or from association with a member of a securities self-regulatory organization, such as a U.S. registered national securities exchange or national securities association, for any act or omission constituting conduct inconsistent with just and equitable principles of trade. This Disqualifying Event was adopted as proposed.
7. Either (a) SEC refusal or stop orders issued within five years before the sale of securities applicable to a registration statement under the Securities Act (and orders suspending a Regulation A exemption for an offering statement) that either a Covered Person filed (as a registrant or issuer) or in which a Covered Person was or was named as an underwriter, or (b) investigations or proceedings to determine whether any such order should be issued to which a Covered Person is subject that are pending at the time of the proposed sale of securities. This Disqualifying Event was adopted as proposed.
8. Either (a) U.S. Postal Service false representation orders to which a Covered Person is subject entered within five years before the sale of securities, or (b) temporary restraining orders or preliminary injunctions pending at the time of the sale of securities concerning conduct alleged by the U.S. Postal Service to constitute a scheme for obtaining money or property through the mail by false representations.
Exception from Disqualification
The amendments contain an exception from the disqualification from relying on the Rule 506 Exemption if the issuer establishes that it did not know and, in the exercise of reasonable care, could not have known that a disqualifying event existed because of the presence or participation of another Covered Person. The SEC declined to provide guidance on the specific steps that should be taken in order to demonstrate reasonable care, noting that these would vary depending upon the facts of each case. Nevertheless, the SEC advised that reasonable care necessarily includes some inquiry by the issuer into the relevant facts, and that in general issuers should ask Covered Persons whether they have Disqualifying Events. In some circumstances, it may be sufficient to ask an entity whether any of its directors or officers have Disqualifying Events. For example, it may be sufficient when an issuer engages a registered broker-dealer as its placement agent to obtain from the placement agent a representation that neither the placement agent nor any of its officers, directors, or controlling persons has a Disqualifying Event.
The SEC indicated that when an offering continues indefinitely or for a long period of time reasonable care includes updating prior factual inquiries. Again the SEC declined to specify the frequency and extent of the required updates, commenting that these will depend upon the circumstances of the issuer, the offering, and the participants involved in the offering. At the same time, the SEC noted that periodic updates could be sufficient in the absence of circumstances, such as pending judicial or regulatory proceedings or known weaknesses in screening procedures, that suggest closer monitoring is required.
The SEC delegated to the Director of its Division of Corporation Finance authority, on behalf of the SEC, to grant waivers of the disqualification from relying upon the Rule 506 Exemption. In addition, this disqualification will not apply if, before a sale is made under the Rule 506 Exemption, the court or regulator that issued an order or judgment advises in writing, whether in such order or judgment or in a separate communication to the SEC, that disqualification from relying on the Rule 506 Exemption should not arise as a consequence of such order or judgment.
Bingham has assisted many clients with successful applications for waivers of disqualifications under existing “bad actor” provisions of the federal securities laws. We expect that our experience obtaining waivers of comparable disqualifications will enable us to provide effective representation to clients seeking waivers of the new disqualifications under these amendments.
These amendments impose a significant new condition on issuers that seek to offer securities on a private placement basis under the Rule 506 Exemption. Prior to launching the offering they should (a) identify their Covered Persons, and (b) ask those Covered Persons or their representatives whether they have any Disqualifying Events or make other factual inquiries reasonably designed to confirm that the Covered Persons do not have Disqualifying Events. The burdens associated with this process will vary enormously from issuer to issuer depending upon the circumstances. For example, a pre-IPO operating company that has privately issued several series of preferred stock might need to consider the rights of each series of preferred stock and the holders of the same in order to determine whether any of those holders is a Covered Person. On the other hand, a newly formed company with just one class of common shares outstanding and a small management team would probably have less difficulty determining which, if any, of its shareholders is a Covered Person.
Given the risk that an issuer may through no fault of its own be unaware that one of its Covered Persons has a Disqualifying Event, it is prudent for any issuer that seeks to rely on the Rule 506 Exemption to conduct the factual inquiries necessary to demonstrate that it has exercised reasonable care to determine that none of its Covered Persons has a Disqualifying Event so that it is eligible for the exception from disqualification discussed above under “Exception from Disqualification”. It is also prudent for an issuer to prepare and maintain records detailing the factual inquiries that it has undertaken, so that it is ready, if called upon to do so, to demonstrate that it exercised reasonable care in these inquiries.
The amendments will pose particular challenges for many investment funds, including hedge funds, private equity funds, real estate funds, and funds registered under the U.S. Investment Company Act of 1940 that offer their shares on a private placement basis under the Rule 506 Exemption. Funds often offer their shares on a continuous basis or for lengthy offering periods. These funds would need to consider taking steps to properly update their inquiries as to whether any of their Covered Persons has a Disqualifying Event. In addition, the investment manager of a fund, together with the investment manager’s general partners, managing members, and at least some of their personnel, will be Covered Persons of the fund. In order to rely on the Rule 506 Exemption the fund would need to make factual inquiries as to these Covered Persons. If the investment manager is a large organization or is part of a group of companies, this may be a significant undertaking.
1See Securities Act Release No. 9414 (July 10, 2013).