SEC Issues Guidance on Rule 506 “Bad Actor” Provisions

On December 4, 2013, the Division of Corporate Finance of the Securities and Exchange Commission (the “SEC”) issued Compliance and Disclosure Interpretations (“C&DIs”) regarding the “bad actor” rules adopted by the SEC, which generally disqualify securities offerings involving certain felons and other “bad actors” from reliance on Rule 506 of Regulation D. The rules are codified as Rules 506(d)–(e) under the Securities Act of 1933, as amended (the “Securities Act”), and became effective on September 23, 2013. Under Rule 506(d), if one of an enumerated list of covered persons in relation to an offering of securities is subject to a “disqualifying event” that occurred on or after September 23, 2013, then the issuer is generally disqualified from relying on Rule 506 of Regulation D. In addition, pursuant to Rule 506(e), if a covered person is subject to a matter that would have been a disqualifying event had it occurred on or after September 23, 2013, then the issuer must furnish to each purchaser, a reasonable time prior to selling securities in reliance on Rule 506, written disclosure of such matter.

The new C&DIs provide guidance and interpretations on certain key aspects of the bad actor rules that affect investment advisers and the funds they manage, including the following:

“Affiliated Issuer”.  The C&DIs clarified that the term “affiliated issuer,” as used in the bad actor rules, includes an offering made by an affiliate (as defined in Rule 501(d) of Regulation D) of the issuer “that is issuing securities in the same offering,” including an offering subject to integration pursuant to Rule 502(a) of Regulation D. In this regard, the C&DIs cite other guidance in which the SEC has provided examples of co-issuer or multiple issuer offerings, including a master fund offering conducted through feeder funds created for the sole purpose of investing their proceeds in the master fund, where all of the offers and sales of the funds are part of the same offering under Rule 502(a). Therefore, the term “affiliated issuer” would generally not include an affiliate of a fund, such as one of the fund’s portfolio companies, a portfolio company of an affiliated fund or an affiliate of the fund’s adviser, unless such affiliate were issuing securities in the same offering, including in the context of a master fund offering conducted through feeder funds as described above.

Compensated Solicitors.  The bad actor rules include as covered persons “compensated solicitors” (i.e., placement agents). The C&DIs clarified certain aspects of the bad actor rules that pertain to placement agents, including that:

• if a placement agent (or one of its employees or other personnel who are covered persons under the bad actor rules) becomes subject to a disqualifying event while an offering is ongoing, then the issuer may continue to rely on Rule 506 (1) if it terminates the engagement of the placement agent and the placement agent is not paid for any sales occurring after the disqualifying event or (2) if, in circumstances in which the disqualifying event applies to the placement agent’s employee or other personnel, such person is terminated (or such person no longer provides services that would cause it be a covered person);
• if an issuer has engaged multiple placement agents to solicit investors and, in accordance with Rule 506(e), the issuer is required to disclose the bad acts of placement agents being used for the offering, the issuer must provide the bad acts disclosure in respect of all placement agents to all investors (as opposed to providing to an investor the bad acts disclosure that pertains only to the placement agent responsible for soliciting that investor);
• if an offering made in reliance on Rule 506 is continuing or ongoing, Rule 506(e) does not require an issuer to provide to investors disclosure regarding the bad acts of placement agents that may have previously been involved in the offering but that are no longer involved in the offering;
• an officer of a placement agent could be considered to be “participating” in the offering if such officer is involved in due diligence activities, preparing offering materials or is involved in communications to investors or other participants in the offering (i.e., “participating” is not limited to the solicitation of investors), but “participating” does not include persons whose only involvement in an offering made in reliance on Rule 506 is as members of a placement agent’s deal or transaction committee responsible for approving the placement agent’s engagement in the offering or where the involvement is merely incidental or transitory in nature, such as opening brokerage accounts, wiring funds, and bookkeeping activities.

Reasonable Care Exception.  The C&DIs explained that the reasonable care exception can be satisfied by an issuer even in circumstances in which “despite the exercise of reasonable care, the issuer 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.”

Reliance on Covered Person Representations.  The C&DIs explained that an issuer offering securities in reliance on Rule 506 can reasonably rely on a contractual representation from a covered person that such covered person will notify the issuer if it is subject to a disqualifying event. However, for continuous offerings, issuers should periodically “bring-down” such representations and/or make updated factual inquiries into whether such covered person is subject to a disqualifying event.

Waivers of Mandatory Disclosure.  The C&DIs clarified that an issuer cannot seek a waiver from the requirement of Rule 506(e) to disclose matters that would have been disqualifying events had they occurred on or after September 23, 2013.

Mandatory Disclosure for Certain Past Events.  The C&DIs clarified that events that would not trigger disqualification under Rule 506(d) (e.g., a criminal conviction that occurred more than 10 years prior to an offering made in reliance on Rule 506) would not require mandatory disclosure under Rule 506(e).

Foreign Actions.  The C&DIs clarified that actions (such as convictions, orders or injunctions issued by a foreign court) occurring outside of the United States would not trigger a disqualifying event.

Court Order in Lieu of Waiver.  The C&DIs explained that an issuer is not required to obtain a waiver from the SEC if, in accordance with Rule 506(d)(2)(iii) of the bad actor rules, a court or regulator issues an order that disqualification from Rule 506 should not apply. In other words, this portion of Rule 506 is self-executing.

Timing of Determination.  The C&DIs explained that an issuer must determine whether it is disqualified by the bad actor rules at the “time they are offering or selling securities in reliance on Rule 506.”