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Rule 506 “Bad Actor” Disqualification: SEC Issues Small Entity Compliance Guide

Securities Alert | September 23, 2013
By: Neil P. Casey, Lori S. Smith, Merritt A. Cole

On September 19, 2013, the SEC issued a small entity compliance guide (the Compliance Guide) concerning its recently adopted Rule 506(d) (the Bad Actor Rule).1 The Bad Actor Rule generally prohibits an issuer from conducting a securities offering in reliance on Rule 506 under the Securities Act of 1933 (the Securities Act) if certain persons connected with the offering (Covered Persons) are subject to “disqualifying events”, which include various criminal convictions, regulatory actions and orders, SRO disciplinary actions, and court orders, among other things (Disqualifying Events). The Compliance Guide provides a summary and explanation of the Bad Actor Rule that issuers may find helpful in assessing the rule’s impact on their fundraising activities, as well as developing appropriate compliance procedures. A few selected highlights and issues from the Compliance Guide, which are likely to be of significant practical concern to issuers, are noted below.

Disclosure of Pre-Effective Date Disqualifying Events

The Bad Actor Rule takes effect today, September 23, 2013 (the Effective Date). However, the rule provides that a Disqualifying Event that has occurred before the Effective Date will not disqualify an issuer from relying on Rule 506 so long as the issuer discloses the event in writing to investors a reasonable time prior to sale of the securities. In that case, the Compliance Guide notes that the disclosure must be “appropriately presented in the total mix of information available to investors.” It is important to note that conduct occurring prior to the Effective Date can trigger disqualification because the Disqualifying Event is deemed to occur as of the date of the relevant conviction, order or regulatory action, not the date of the underlying conduct.

Promoters as Covered Persons

Covered Persons under the Bad Actor Rule include the issuer, its predecessors and affiliated issuers, as well as directors and certain officers, general partners, and managing members of the issuer, 20 percent beneficial owners of the issuer, promoters, investment managers and principals of pooled investment funds, and persons compensated for soliciting investors, as well as the general partners, directors, certain officers, and managing members of an investment manager or compensated solicitor. As noted in the Compliance Guide, the “promoter” category of Covered Persons, as defined in the Securities Act rules, is very broad. A promoter is anyone who, “either alone or with others, directly or indirectly takes initiative in founding the business or enterprise of the issuer”, who in connection therewith becomes a 10% shareholder of the issuer or receives 10% of any class of the issuer’s securities (other than as underwriting commissions or in exchange for property).  Because of this expansive definition, the Compliance Guide cautions that the existence of intervening entities (which may themselves be promoters) between the issuer and a person will not necessarily mean that person is not a promoter.

“Look Back” Period for Certain Disqualifying Events

Many categories of Disqualifying Events include a look-back period, meaning that a Disqualifying Event that occurred in the past will continue to have a disqualifying effect for a specific time period thereafter. The Compliance Guide notes that the relevant look-back period will commence on the date the Disqualifying Event itself occurred (e.g., the date on which the particular order or injunction is entered), not the date of the underlying conduct that triggered the Disqualifying Event.

The Compliance Guide contains several helpful clarifications as to when various Disqualifying Events cease to have a disqualifying effect under the rule. For example, a court injunction or restraining order is subject to a five-year look back period, but will have a disqualifying effect only if it remains in effect at the time of the sale of securities.  Similarly, a final order that bars a person from associating with a regulated entity, from engaging in the business of securities, insurance or banking or from engaging in savings association or credit union activities will be disqualifying only for so long as it has effect.  The Compliance Guide notes, for example, that an indefinite bar that granted the person the right to reassociate after three years would only have a disqualifying effect until the person was permitted to reassociate, assuming the bar had no continuing effect after reassociation.

Reasonable Care Exception

The Bad Actor Rule includes an exception from disqualification if the issuer establishes that it did not know, and in the exercise of reasonable care could not have known, that a Disqualifying Event was in effect. In order to rely on this exception, an issuer will be required to establish that it has made a factual inquiry into whether a Disqualifying Event exists, the nature and scope of which may vary based on the facts and circumstances concerning the issuer and other offering participants. Unfortunately, the Compliance Guide does not provide any further guidance on what might constitute a sufficient factual inquiry. However, at a minimum, issuers should send written inquiries to Covered Persons (e.g., questionnaires) which would enable them to demonstrate the actions they took to determine whether Covered Persons were subject to Disqualifying Events.  Issuers should also consider searching publicly available data bases, as appropriate.

Waivers for Good Cause

Disqualification under the Bad Actor Rule may be waived for good cause by the SEC. A number of factors could be relevant to the SEC’s evaluation of a waiver request and the Compliance Guide suggests that issuers should refer to past applications and waivers granted under Regulation A for additional guidance. Staff in the SEC’s Office of Small Business Policy will also be available to discuss potential waiver issues. A court or issuing authority (other than the SEC) may also waive disqualification if, before the relevant sale of securities, it advises the SEC in writing (either separately or in its order, judgment or decree) that disqualification under the Bad Actor Rule should not be triggered by its order, judgment or decree.

Transition Issues

The Compliance Guide also addresses a few transition issues, confirming that sales made prior to the Effective Date of the Bad Actor Rule will not be subject to mandatory disclosure requirements or disqualification under the rule, even if such sales are part of an offering that continues after the Effective Date. However, sales made after the Effective Date in connection with any offering commenced before the Effective Date will be subject to the Bad Actor Rule. Accordingly, issuers will need to update their written offering materials for these continuous offerings to disclose any pre-Effective Date Disqualifying Events.

Sales made prior to the occurrence of a Disqualifying Event will be unaffected by such event, but the issuer will not be able to rely on Rule 506 for any sales made on or after the date of that event unless the disqualification is waived by the SEC or other relevant court or authority, or the issuer is unaware of the event and is able to qualify for the “reasonable care” exception described above.

Conclusion

The Compliance Guide provides a clear summary of the Bad Actor Rule, along with a few helpful examples to explain its application to various situations. The most immediate concern for issuers will be to identify their Covered Persons and to conduct a factual inquiry to determine whether any of those Covered Persons is subject to a Disqualifying Event. Because the failure to discover a Disqualifying Event could be catastrophic unless the issuer qualifies for the“reasonable care” exception described above (particularly in a purported Rule 506(c) offering with general solicitation, where there may be no alternative registration exemption available), it will be imperative for issuers to develop best practices for conducting factual inquiries into each of their Covered Persons, and to document and record the steps taken in each case.

For more information regarding this News Alert, please contact Neil P. Casey (212.631.4414; caseyn@whiteandwilliams.com) or Lori S. Smith (212.714.3075smithl@whiteandwilliams.com) in the New York office or Merritt A. Cole (215.864.7018; colem@whiteandwilliams.com) in the Philadelphia office.


1 The Compliance Guide is available at  http://www.sec.gov/info/smallbus/secg/bad-actor-small-entity-compliance-guide.htm#part3. The SEC’s adopting release with respect to the Bad Actor Rule is available at http://www.sec.gov/rules/final/2013/33-9414.pdf.

This correspondence should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult a lawyer concerning your own situation and legal questions.
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