New SEC regulations disqualify an issuer from selling unregistered securities under a Rule 506 exemption if a “covered person” related to the issuer (or involved in the offering) is considered a “bad actor.” See our companion article regarding general solicitations under Rule 506.
The bottom line: fund managers relying on Rule 506 to sell unregistered securities will need to work with their legal counsel and/or compliance consultants to identify covered persons, conduct initial diligence and ongoing monitoring to check for events that trigger disqualification. For many firms, diligence and monitoring will likely involve distributing questionnaires prior to offerings and subsequently on a periodic basis.
The “covered persons” whose behavior can trigger disqualification under the new regulations include the issuer, its predecessors and affiliates, as well as:
- The issuer’s directors and executive officers;
- Any of the issuer’s non-executive officers who are participating in the offering;
- The issuer’s general partners or managing members;
- Beneficial owners of 20% or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power;
- Promoters (as defined in Rule 405) connected with the issuer in any capacity at the time of the sale of securities;
- Any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with the sale of securities;
- Any general partner or managing member of such a solicitor, and any of the solicitor’s directors or executive officers; and
- Any of the solicitor’s non-executive officers who are participating in the offering.
If the issuer is a pooled investment fund, “covered persons” also include:
- Any investment manager of the issuer;
- The general partner or managing member of any such investment manager, as well as any of the investment manager’s directors or executive officers; and
- Any of the investment manager’s non-executive officers who are participating in the offering.
The following are disqualifying events under the new regulations:
- Criminal convictions in connection with the purchase or sale of a security, making of a false filing with the SEC, or arising out of the conduct of certain types of financial intermediaries (the criminal conviction must have occurred within 10 years of the proposed sale of securities or five years in the case of the issuer and its predecessors and affiliated issuers);
- Court injunctions and restraining orders in connection with the purchase or sale of a security, making of a false filing with the SEC, or arising out of the conduct of certain types of financial intermediaries (the injunction or restraining order must have occurred within five years of the proposed sale of securities);
- Final orders from the CFTC, federal banking agencies, the National Credit Union Administration, or state regulators of securities, insurance, banking, savings associations or credit unions that:
- Bar the issuer from associating with a regulated entity, engaging in the business of securities, insurance or banking, or engaging in savings association or credit union activities; or
- Are based on fraudulent, manipulative or deceptive conduct and are issued within 10 years of the proposed sale of securities.
- Certain SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment companies, and investment advisers and their associated persons;
- SEC cease-and-desist orders related to violations of certain anti-fraud provisions and registration requirements of the federal securities laws (the order must have been entered within five years of the proposed sale of securities), certain SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investments companies, and investment advisers and their associated persons;
- Suspension or expulsion from membership in a SRO or from association with an SRO member;
- SEC stop orders and orders suspending the Regulation A exemption issued within five years of the proposed sale of securities; and
- U.S. Postal Service false representation orders issued within five years before the proposed sale of securities.
It is important to note that the issuer will not be disqualified if the “disqualifying event” described above occurred prior to the effective date of the new rule: September 23, 2013; however, issuers must disclose a disqualifying event that occurred before the effective date to investors. The SEC requires that such disclosures be provided a reasonable time before the sale and be given reasonably prominent placement in the issuer’s offering materials.
Disqualification applies only for covered persons whose conduct is subject to a final order or conviction. An arrest or allegation is not enough to trigger disqualification. The SEC can also grant a waiver allowing the issuer to proceed under Rule 506, and the court or regulatory authority that ruled on the bad act can advise in writing that Rule 506 disqualification should not apply.
“Reasonable Care” Exception
If the issuer establishes that it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed at the time of the offering, the failure to disclose will not result in loss of exemption.
To establish that it has exercised “reasonable care,” an issuer must have made a factual inquiry into whether any disqualifications exist. The scope of the inquiry will vary based on the circumstances of the issuer and the other offering participants, taking into account such factors as the risk of having a bad actor, the impact of screening mechanisms already in place, and the cost of the inquiry.