Securities Regulation and Corporate Governance

On December 4, 2013, the Staff of the SEC’s Division of Corporation Finance issued new Compliance and Disclosure Interpretations (C&DIs) providing guidance on rules recently adopted by the SEC that prohibit certain felons and other “bad actors” from participating in private securities offerings that rely on Rule 506 of Regulation D under the Securities Act of 1933 (Securities Act).  The rule generally applies to the issuer, certain third parties that participate in the offering, and certain controlling persons, officers and affiliates of the issuer and such third parties (covered persons).

The C&DIs can be found here.  A summary description of the C&DIs is below.

• An issuer is required to determine whether it is subject to bad actor disqualification during any time when it is offering or selling securities in reliance on Rule 506, but not at times when it is not offering securities, such as when a fund is winding down and is closed to investment.  (Securities Act Rules Question 260.14)
• An issuer may reasonably rely on a covered person’s agreement to provide it with notice of any potential or actual bad actor disqualifying event (such as pursuant to an undertaking in a questionnaire or certification). If, however, an offering is continuous, delayed or long-lived, the issuer must take steps, depending on the circumstances, to update its factual inquiry periodically. (Securities Act Rules Question 260.14)
• If a placement agent or one of its covered control persons becomes subject to a disqualifying event while an offering is ongoing, the issuer may rely on Rule 506 for future sales in that offering if the engagement with the placement agent is terminated and the placement agent does not receive compensation for the future sales or, if the disqualifying event only affects a covered control person, if that person is terminated or ceases to perform a role that would cause it to be a covered person. (Securities Act Rules Question 260.15)
• An “affiliated issuer” is an affiliate (as defined in Rule 501(b) of Regulation D) of the issuer that is issuing securities in the same offering.  The Staff noted that offerings subject to integration pursuant to Rule 502(a) of Regulation D are considered to be issued in the same offering. (Securities Act Rules Question 260.16)
• “Compensated solicitors” include all persons who have been or will be paid, directly or indirectly, remuneration for soliciting purchasers, regardless of whether they are, or are required to be, registered as brokers under Exchange Act Section 15(a)(1) or are associated persons of registered brokers. (Securities Act Rules Question 260.17)
• A person whose sole involvement with a Rule 506 offering is as a member of a compensated solicitor’s deal or transaction committee that is responsible for approving such compensated solicitor’s participation in the offering does not “participate” in the offering, and thus is not a covered person. (Securities Act Rules Question 260.18)
• “Participation” of officers of a compensated solicitor in an offering is not limited to soliciting investors.  Such officers will be deemed to be “participating” in a Rule 506 offering if, for example, they participate or are involved in due diligence activities or the preparation of offering materials (including analyst reports used to solicit investors), provide structuring or other advice to the issuer in connection with the offering, or communicate with the issuer, prospective investors or other offering participants about the offering, so long as these activities are more than transitory or incidental. (Securities Act Rules Question 260.19)
• Disqualification will not be triggered by actions taken in jurisdictions other than the United States, such as convictions, court orders, or injunctions in a foreign court, or regulatory orders issued by foreign regulatory authorities. (Securities Act Rules Question 260.20)
• Disqualification for SEC cease and desist orders relating to the violation of scienter-based anti-fraud provisions of the federal securities laws will not be triggered by orders to cease and desist from violations of non-scienter based rules.  The Staff noted, for example, that an order to cease and desist from violations of Exchange Act Rule 105 would not trigger disqualification, even though that rule is promulgated under Exchange Act Section 10(b). (Securities Act Rules Question 260.21)
• If an order that would ordinarily result in disqualification from Rule 506 provides that disqualification should not arise as a result of the order, it is not necessary for the issuer to seek a waiver from the Commission or to take any other action to confirm that disqualification will not apply as a result of the order. (Securities Act Rules Question 260.22)
• The reasonable care exception applies whenever the issuer can establish that it did not know and, despite the exercise of reasonable care, could not have known that a disqualification existed under Rule 506(d)(1).  Thus, the exception includes circumstances in which the issuer:
  • identified all covered persons but, despite the exercise of reasonable care, was unable to determine the existence of a disqualifying event;
  • was unable to determine that a particular person was a covered person; or
  • initially reasonably determined that the person was not a covered person, but subsequently learned that determination was incorrect.

The Staff cautioned, however, that the issuer will need to consider what steps are appropriate upon discovery of a disqualifying event, which may include seeking a waiver of disqualification, terminating the relationship with the covered person, providing disclosure of the disqualifying event pursuant to Rule 506(e) or taking other remedial steps to address the disqualification.  (Securities Act Rules Question 260.23)

• The obligation under Rule 506(e) to disclose past events that would have been disqualifying, except that they occurred before the effective date of Rule 506(d), is not subject to waiver. (Securities Act Rules Question 260.24)
• Rule 506(e) requires only disclosure of events that would trigger disqualification if Rule 506(d) were applicable. Because events outside the applicable look-back period and orders that do not have continuing effect would not trigger disqualification, there is no obligation under Rule 506(e) to disclose these events. (Securities Act Rules Question 260.25)
• Issuers are required to provide all investors with the Rule 506(e) disclosure for all compensated solicitors (and their covered control persons) who are involved with the offering at the time of sale.  The issuer may not limit disclosure of such events to the investors that are solicited by that particular solicitor. (Securities Act Rules Question 260.26)

• In a continuous offering, the issuer is not required to provide disclosure under Rule 506(e) for all solicitors that were ever involved during the course of the offering.  Instead, the issuer must provide the required disclosure, at a reasonable time prior to the sale of securities, only with respect to the compensated solicitors that are involved in the offering at the time of sale. (Securities Act Rules Question 260.27)

Our Client Alert regarding the SEC’s July 10, 2013 adopting release  promulgating the “bad actor” disqualification rules can be found here.  The amendments became effective on September 23.