Compliance: Rule 506 “bad actor” disqualifications

The SEC adopted amendments disqualifying private securities offerings involving bad actors from relying on the Rule 506 safe harbor exemption.

Rule 506 of Regulation D under the Securities Act of 1933 is the most widely used of three Regulation D private offering safe harbor exemptions from registration under the Act, accounting for an estimated 90 percent to 95 percent of all Regulation D offerings. In 2012 alone, it is estimated that amount of capital raised in Rule 506 private offerings (debt and equity combined) was $898 billion, compared to $1.2 trillion in registered offerings.

Effective Sept. 23, 2013, the Securities and Exchange Commission (SEC) adopted amendments to Rule 506 disqualifying private securities offerings involving certain felons and other bad actors from relying on the Rule 506 safe harbor exemption. Although inside counsel may have a good understanding of its own officers and directors, the breadth of the people covered by this rule is broad and the look-back period of five years in many, ten years in some, cases is long. Inside counsel may want to consider how to deal with large investors, brokers and even potential targets and acquirers in this new environment.

The rule

Under Rule 506(d)(1), no exemption is available under Section 506 for a sale of securities if the issuer; any predecessors of the issue, or any affiliated issuer; any director, executive officer, other officer participating in the offering, general partner or managing member of the issuer; any beneficial owner of 20 percent or more of the issuer’s outstanding voting securities, calculated on the basis of voting power; any promoter connected to the issuer in any capacity at the time of such sale; any investment manager of an issuer that is a pooled investment fund; any person that has been or will be paid (directly or indirectly) remuneration for soliciting purchasers in connection with such sale of securities; any general partner or managing member of any such investment manager or solicitor; or any director, executive officer or other officer participating in the offering of any such investment manager or solicitor (or general partner or managing member of such investment manager or solicitor) is subject to one of the following:

  1. Conviction of any felony or misdemeanor involving the purchase or sale of any security, the making of any false filing with the SEC, or conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment advisor or paid solicitor of purchasers of securities;
  2. Court order restraining or enjoining such person from conduct in connection with the purchase or sale of securities; involving any false filing with the SEC; or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment advisor or paid solicitor of purchasers of securities;
  3. Final order of a State securities banking or insurance authorities or commission or a federal banking agency or the U.S. Commodity Futures Trading Commission or the National Credit Union Administration either barring the person from association with a regulated entity or from engaging in the business of banking, insurance or securities; or based on a violation of law or regulation prohibiting fraudulent, manipulative or deceptive conduct;
  4. Suspension or expulsion as a broker, dealer, municipal securities dealer or investment advisor or subject to practice limitations in connection thereto;
  5. Cease and desist orders from violating any scienter-based anti-fraud provisions of the federal securities laws or from violating Section 5 of the Act;
  6. Suspension or expulsion from a registered national securities exchange or registered national or affiliated securities association;
  7. SEC stop orders or orders suspending Regulation A exemptions; or
  8. U.S. Postal Service false representations.

Under Section 506(e), if the disqualification occurred before Sept. 23, 2013, the issuer may still rely on Rule 506, provided the issuer discloses the disqualification to each purchaser in writing a reasonable time prior to the sale.

Inside counsel considerations

The “reasonable care” exception to the bad actor disqualifications under Section 506(d)(2) sets the agenda in connection with what needs to be done by inside counsel of companies planning to use the Rule 506 safe harbor exemption in the future. Under Section 506(d)(2), an issuer will not lose the Rule 506 safe harbor, despite the existence of a disqualifying event, if the issuer can show that it did not know and could not have known of the disqualification with the exercise of “reasonable care.” An issuer will not be able to establish “reasonable care” unless it has made a factual inquiry into whether a disqualification exists, and the factual inquiry will depend on the facts and circumstances concerning the issuer and the other offering participants.

So, inside counsel of companies will need to make factual inquiries in the form of questionnaires and certifications and other factual investigations into covered persons related to the company, including the revision of questionnaires and certifications for officers and directors in light of the new Rule 506(d) disqualifications and the gathering of relevant information from existing investors holding more than 20 percent of the outstanding voting securities of the company. Counsel will also need to consider including representations and warranties in agreements with brokers, dealers and placement agents, and to conduct due diligence and include representations and warranties in stock purchase agreement with large prospective investors, to ensure that the inclusion of such covered persons will not result in a disqualification.

Inside counsel need to structure due diligence in connection with mergers and acquisitions with the Rule 506(d) disqualifications in mind as well, including representations and warranties in acquisition agreements that shed light on potential disqualifications. Although Rule 506(d)(3) provides an exception for disqualifications relating to an affiliated issuer before the affiliation arose, it is limited to affiliated entities that are not in control of the issuer or under common control with the issuer by a third party that was in control of the affiliated entity at the time of the merger or acquisition. So, many acquisitions or change of control transactions may not be covered by this exception.

Contributing Author

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Robert J. Gavigan

Robert J. Gavigan is a partner in the Corporate group of Cohen & Gresser LLP.

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Contributing Author

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Andrew M. Por

Andrew M. Por is an associate in the Corporate group of Cohen & Gresser LLP.

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