On May 25, 2011, the Securities and Exchange Commission
("SEC" or "Commission") issued proposed
amendments to Rule 506 of Regulation D implementing a "bad
actor" disqualification for issuers from participating in
exempt private placement securities offerings under Rule 506 (the
"Proposed Rule") as required by Section 926 of the
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010
(the "Dodd-Frank Act").1 Rule 506 is the most
widely used exemptive rule for limited and private offerings under
Regulation D, accounting for an estimated 90-95 percent of all
Regulation D offerings and the vast majority of capital raised in
transactions under Regulation D.2
In its current form, Rule 506 does not impose any bad actor
disqualification on issuers from participating in exempt securities
offerings and, indeed, preempts any disqualifications arising under
state law. Under the Proposed Rule, a disqualification under Rule
506 would arise upon specified disciplinary events involving an
issuer, its affiliated persons or entities, or certain service
providers such as promoters, underwriters, or other compensated
participants in the offering. Disqualifying events would include
significant disciplinary events such as criminal convictions, court
injunctions, and most types of suspensions and bars from securities
self-regulatory organizations ("SROs"). The Proposed
Rule's disqualification provisions would also be triggered by
less severe disciplinary events, such as certain SEC administrative
enforcement orders and certain types of orders issued by state and
federal securities and banking regulators.
Perhaps the most controversial aspect of the Proposed Rule is its
"retroactive" application to prior disciplinary events,
including settlements. Rule 506 offerings made after the effective
date would be subject to any disqualifying events that had occurred
within the relevant look-back periods,3 regardless of
whether the events occurred before enactment of the Dodd-Frank Act
or the effectiveness of the Proposed Rule. Absent relief, issuers
with relevant disciplinary history would be unable to raise capital
through Rule 506 offerings – even if those same issuers
(or their promoters, underwriters, executive officers, or
affiliates) had previously sought and received relief from
disqualifications that arose at the time.
This aspect of the Proposed Rule would present substantial
challenges for any party involved in a private placement under Rule
506 of Regulation D that had previously negotiated settlements with
the Commission or other regulators. Even those settlements that
were accompanied by customary orders granting relief from various
disqualifications under the federal securities laws –
including the similar disqualification arising under Rule 505 of
Regulation D – would not be "grandfathered"
from triggering the disqualification provisions of Rule 506 under
the terms of the Proposed Rule. This retroactive application is a
marked departure from the Commission's past treatment of
settlements falling within the look-back periods of other
disqualifications, such as the "ineligible issuer"
provision for well-known seasoned issuers ("WKSIs") under
Securities Act Rule 405.4 Unless mitigating guidance is
issued, those issuers involved in Rule 506 offerings –
and those performing specified functions related to Rule 506
offerings – will need to evaluate the need to seek relief
for long-settled or resolved disciplinary events.
The SEC has asked for comment on numerous issues, including whether
it should "extend the benefit of waivers previously granted in
respect of disqualification from Regulation A, Rule 505 of
Regulation D or Regulation E, so that such waivers would cover the
new disqualification provisions applicable to Rule 506."
Comments on the Proposed Rule are due by July 14, 2011.
Summary of the Proposed Rule
The Proposed Rule derives from Section 926 of the Dodd-Frank Act
and Rule 262 of Regulation A. Under the Proposed Rule, Rule 506
would be amended to eliminate the exemption for an offering of
securities that involves any of the following Covered Persons with
respect to whom a Disqualifying Event has occurred:
Covered Persons include: issuers, any
predecessor of the issuer, any affiliated issuer, and any director,
officer, general partner or managing member of the issuer; any
beneficial owner of 10 percent or more of any class of the
issuers' equity securities; any promoter connected with the
issuer in any capacity at the time of the sale; any person that has
been or will be paid (directly or indirectly) remuneration for
solicitation of purchasers in connection with the sale of
securities of the offering; or any director, officer, general
partner, or managing member of any such compensated
solicitor.5
Disqualifying Events include:
- Criminal Convictions: A conviction, within ten years before such sale (or five years, in the case of the issuer, the predecessor, and affiliated issuers), of any felony or misdemeanor, in connection with any purchase or sale of any security; involving the making of any false filing with the Commission; or arising out of conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities.6
- Court Injunctions and Restraining Orders: Any order, judgment or decree of any court of competent jurisdiction, that, entered within five years before the relevant sale, restrains or enjoins such person from engaging or continuing to engage in any conduct in connection with the purchase or sale of any security; involving the making of any false filing with the Commission; or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities.7
- Final Orders: A final order, judgment or decree of various regulators, such as state securities and insurance commissions and state and federal banking agencies, that at the time of such sale, bars a person from association with an entity regulated by such commission, authority, agency or officer; engaging in the business of securities, insurance or banking; or engaging in savings association or credit union activities. In addition, a final order based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct entered within ten years before the relevant sale.8 A bar under the Proposed Rule would have no limit to the look-back period, and is disqualifying so long as the bar has a continuing effect.
- Commission Disciplinary Orders: An order of the Commission entered pursuant to Section 15(b) or 15B(c) of the Securities Exchange Act of 1934 or Section 203(e) or (f) of the Investment Advisers Act of 1940, that, at the time of such sale, suspends or revokes registration as a broker, dealer, municipal securities dealer or investment adviser; places limitation on the activities, functions or operations of such person; or bars such person from association with any entity or from participating in the offering of any penny stock.9 The Commission has not proposed any look-back period for this disqualification event.10
- Suspension or Expulsion from SRO Membership: Suspension or expulsion from membership in, or suspension or bar from association with a member of, a registered national securities exchange or a registered national or affiliated securities association for any act or omission to act that is conduct inconsistent with just and equitable principles of trade.11 The Commission has not proposed any look-back period for this disqualification event.
- Stop Orders and Orders Suspending the Regulation A Exemption: Within five years before such sale, subject to a refusal order, stop order, or order suspending the Regulation A exemption (or is the subject of an investigation or proceeding to determine such event) after filing (as a registrant or issuer), or was or was named as an underwriter in, any registration statement or Regulation A offering statement filed with the Commission.12
- U.S. Postal Service False Representation Orders: A U.S. Postal Service false representation order entered within five years of the proposed sale of securities or a temporary restraining order or preliminary injunction with respect to conduct alleged to have violated the false representation statute that applies to U.S. mail.13
Reasonable Care Exception. Recognizing the
difficulty in determining whether disqualifications would apply to
Rule 506 sales, the Commission is proposing a reasonable care
exception that would apply if an issuer establishes that it did not
know and, in the exercise of reasonable care, could not have known
that a disqualification existed because of the presence or
participation of a Covered Person.14 The exercise of
reasonable care would entail a factual inquiry by the issuer that
would take into account such factors as the risk of presence of bad
actors, the presence of other compliance mechanisms, and the cost
and burden of the inquiry. With this exception, the Commission aims
to satisfy legislative intent and avoid placing an undue burden on
capital-raising activity.
Waiver. In keeping with the Congressional mandate
to adopt rules substantially similar to Regulation A, the
Commission proposes to carry over the waiver provisions of
Regulation A by permitting issuers to seek waivers from
disqualification upon a showing of good cause and without prejudice
to any other Commission action.15
Retroactive Application. As discussed above, past
disqualifying events that occurred within the relevant look-back
period (if one applies) would be subject to the proposed
disqualification rules. The proposed disqualification rules would
apply to all offerings made under Rule 506 after the effective date
of the new provisions, but would not apply to sales made before the
effective date, even if such sales were part of an offering that
continues after such date. Similarly, sales made prior to the
occurrence of a disqualification event would not be affected, but
subsequent sales would be denied the exemption absent a
waiver.
Implementation. The Commission has not proposed a
phase-in period, but seeks input on the timing of
implementation.
Other Considerations. In addition to the Proposed
Rule, the Commission is considering certain unifying changes that
go beyond the explicit scope of the Dodd-Frank Act, such as
imposing uniform disqualification standards for all exemptions
under Regulations A, D, and E without proposing rule text for the
specific regulations. Similarly, the Commission is also considering
a uniform ten-year look-back period for all disqualifying events
with stated look-back periods.
Footnotes
1 Pub. L. No. 111-203, Section 926, 124 Stat. 1376, 1851
(July 21, 2010) (to be codified at 15 U.S.C. 77d note). Section 926
of the Dodd-Frank Act instructs the Commission to adopt rules
disqualifying certain offerings from reliance on the safe harbor
provided from Rule 506 for exemption from registration under
Section 4(2) of the Securities Act of 1933. Section 926 mandates
the adoption of rules that are "substantially similar" to
Rule 262 of Regulation A.
2 See Disqualification of Felons and Other "Bad Actors"
from Rule 506 Offerings, Exchange Act Release No. 9211 (May 25,
2011) ("Proposing Release"). Rules 504, 505, and 506 of
Regulation D provide three distinct exemptions from the
registration provisions of the federal securities laws.
3 Certain disqualifying events are subject to ten-year look-back
periods (e.g., convictions), others to five-year look-back periods
(e.g., court injunctions, stop orders and orders suspending the
Regulation A exemption, USPS orders), and others are not subject to
any time limitation whatsoever (e.g., relevant state securities
commission orders, NCUA or federal banking orders, SEC
administrative enforcement orders, and SRO bar orders).
4 Securities Act Rule 405 excluded settlements occurring prior to
December 1, 2005 from the relevant disqualification trigger in the
definition of "ineligible issuer."
5 Proposed Rule 506(c)(1).
6 Proposed Rule 506(c)(1)(i).
7 Proposed Rule 506(c)(1)(ii).
8 Proposed Rule 506(c)(1)(iii).
9 Proposed Rule 506(c)(1)(iv).
10 The Proposing Release expressed the view that a
disqualification arises only for an order that prohibits or
requires a specific act to be performed. As such, an SEC order of
censures would not be a disqualifying event. The Commission also
noted that the Division of Corporation Finance has taken the
informal view that orders to pay civil money penalties would not be
disqualifying events.
11 Proposed Rule 506(c)(1)(v).
12 Proposed Rule 506(c)(1)(vi).
13 Proposed Rule 506(c)(1)(vii).
14 Proposed Rule 506(c)(2)(ii).
15 Proposed Rule 506(c)(2(i).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.