In late May 2011, the U.S. Securities and Exchange Commission proposed rules that would disqualify certain “bad actors” from using one of the most common “private placement” exemptions from the registration requirements of the Securities Act of 1933 (the “Securities Act”).
The proposed rules are intended to implement Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The proposed rules seek to “protect investors who fall victim to sellers who repeatedly engage in securities fraud”1 by preventing persons who have been found to have violated certain laws or engaged in other wrongful conduct from relying on the Rule 506 exemption from the registration requirements of the Securities Act.
In broad terms, the Securities Act 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 better clarify which securities offerings qualify as private placements that are exempt from the registration requirements of the Securities Act. Regulation D is a “safe harbor,” which means that, if an offering is made in accordance with a Regulation D exemption, 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. However, an offering may be exempt from the registration requirements of the Securities Act even if it does not fall within one of the Regulation D exemptions.
Under Rule 506 of Regulation D, in particular, an issuer may sell an unlimited amount of unregistered securities to unlimited numbers of “accredited investors” (as defined under Regulation D) and up to 35 non-accredited investors, as long as specified conditions are met. In particular, there may be no public advertising or solicitation if an offering is to qualify for an exemption under Rule 506.
In view of the securities frauds that have been discovered in recent years and, in particular, “a growing number of private placements being used to defraud accredited investors,”2 Congress determined that “bad actors” who have violated securities laws or engaged in some other types of wrongful conduct in the past should not be able to rely on Rule 506 to offer securities without registering the offering under the Securities Act.
The rules proposed by the SEC would disqualify an issuer from relying on the Rule 506 exemption if the issuer or any of its “covered persons” has had one or more “disqualifying events,” which include:
Not included as disqualifying events are many types of criminal activity, including activity that may involve theft or other dishonesty and non-securities-related fraud. In the proposing release, the SEC noted that the North American Securities Administrators Association has requested that, in the interest of investor protection and uniformity with state laws, the list of disqualifying events be expanded to include, among other things, any criminal conviction involving fraud or deceit. As noted below, the SEC has requested comments on whether to expand the range of disqualifying events under the proposed rules.
The proposed rules would take account of all disqualifying events, regardless of whether they occurred before or after the new rules come into effect. However, the disqualification provisions would apply to sales of securities made in reliance on Rule 506 only after the new rules come into effect. With respect to a disqualifying event that occurs while an offering is underway, only sales made after the occurrence of the disqualification would be disqualified. This retroactive aspect of the proposal, which could bar use of the Rule 506 exemption as a result of orders agreed to years before the Dodd-Frank Act, is controversial, prompting two of the five SEC commissioners to vote against the proposed rules.
The proposed rules would apply to a broad range of “covered persons,” including:
Consequently, if an issuer or any of the persons listed above relating to the issuer has had one of the disqualifying events, the issuer would not be able to rely on the Rule 506 exemption.3
In the proposing release, the SEC stated that the proposed rules would not cover the investment advisers of any issuers or the directors, officers, general partners or managing members of such investment advisers. The SEC questioned, however, whether it would be appropriate to include as covered persons under the final rules investment advisers (and their directors, officers, general partners or managing members) of certain types of pooled investment vehicles, including (i) mutual funds and other investment companies registered under the Investment Company Act of 1940 (the “1940 Act”); and (ii) hedge funds, private equity funds, and other privately offered funds that rely on either the Section 3(c)(1) (under 100 investors) or Section 3(c)(7) (qualified purchaser funds) exemptions from the 1940 Act registration requirements.
Exemptions and Waivers
The proposed rules would provide an exception from disqualification where an issuer can show that it did not know and, in the exercise of reasonable care, could not have known that a disqualifying event existed. In order to demonstrate reasonable care, an issuer would be expected to undertake an inquiry to determine whether any disqualifications exist. The sufficiency of an inquiry would depend upon circumstances presented, such as the identity of the covered persons, the nature of the offering, the nature of the offering participants, the presence of other screening and compliance mechanisms, and the cost and burden of the inquiry.
In addition, the SEC has proposed to grant itself authority to waive the disqualification in particular cases where the issuer has shown good cause that it is not necessary under the circumstances that the exemption be denied.
The Practical Implications
The rules, as proposed, may present substantial challenges to many issuers that wish to rely on the Rule 506 exemption. Affected issuers could include public and private corporate issuers; hedge funds, private equity funds, real estate funds and other alternative investment funds; mutual funds and other investment companies that are registered under the 1940 Act but may issue securities without registration under the Securities Act; and non-U.S. funds whose securities are privately offered in the United States. The burden of complying with the proposed rules would grow as the number of persons involved in an offering increases. Issuers would need to exercise reasonable care to confirm that none of their officers, directors, general partners, managing members, promoters or 10% beneficial owners is subject to one of the disqualifying events. Issuers that might be contemplating a Rule 506 offering would also need to obtain information on the disciplinary history of their prospective officers, directors, general partners and managing members. Similarly, it may be advisable for such issuers to revise their subscription documentation in order to better ascertain the disciplinary history of their prospective beneficial owners, which may, one day, hold 10% or more of any class of the issuer’s equity securities and thus, become “covered persons.” An issuer that engaged a placement agent or other person to solicit investors would also need to exercise reasonable care to confirm that none of the solicitation agent or its officers, directors, general partners or managing members is subject to a disqualifying event. Given the recent legal difficulties of many of the larger and mid-sized brokerage firms, the proposed rules may make it more difficult for them to participate in Rule 506 offerings without obtaining waivers from the SEC.
Offerings that may not, under the proposed rules be made pursuant to Rule 506, might still be made in reliance upon another exemption from the registration requirements of the Securities Act, including for example, (i) a private placement under Section 4(2) of the Securities Act that does not rely on Regulation D, (ii) an offering under Section 4(5) of the Securities Act solely to one or more accredited investors where the aggregate offering price does not exceed $5 million, (iii) an institutional placement under Rule 144A, or (iv) an offshore placement under Regulation S. These other exemptions, however, are often, for a variety of reasons, not available to an issuer. Furthermore, issuers that would be disqualified from relying on Rule 506 under the proposed rules, but that are still able to effect private placements under, for instance, Section 4(2) of the Securities Act would not have the benefit of preemption from certain state securities or “blue sky” law requirements afforded by Section 18 of the Securities Act.
Issuers that are not themselves subject to a disqualification may regain eligibility to rely on Rule 506 if they are able to cure the disqualification by terminating their relationship with the “bad actor” whose involvement in the offering triggers disqualification.
General and Specific Comments Requested
The SEC is seeking comments on the proposed rules by July 14, 2011. The SEC has specifically requested comments on, among other topics, whether:
In light of the range and nature of topics expressly presented for public comment and concerns raised by the SEC in the proposing release, it is possible the final rules may differ significantly from the SEC proposal.
Thomas John Holton, Partner, Investment Management
This article was originally published by Bingham McCutchen LLP.