Alert July 23, 2013

SEC Adopts New Condition for Rule 506 Safe Harbor That Disqualifies Offerings Involving Felons and Other “Bad Actors”

On July 10, 2013, the SEC voted to adopt final amendments to rules and forms under the Securities Act of 1933 (the “Securities Act”) that implement Section 926 of the Dodd-Frank Act.  Section 926 requires the SEC to adopt rules that disqualify securities offerings involving certain “felons and other ‘bad actors’” from reliance on the safe harbor from Securities Act registration provided by Rule 506 of Regulation D under the Securities Act.  Section 926 directs the SEC to adopt disqualification provisions for Rule 506 offerings that (a) are substantially similar to Rule 262 under the Securities Act, which contains the disqualification provisions of Regulation A under the Securities Act, and (b) incorporate specific disqualifying events enumerated in Section 926, which include certain state regulatory orders and bars.

The final amendments add to Rule 506 new paragraph (d) under a which a sale of securities is disqualified from the Rule 506 exemption if a “covered person” is subject to a “disqualifying event” that occurs after the effective date of the final amendments.  Disqualifying events that occur prior to the effective date must be disclosed to investors.  The occurrence of a disqualifying event will not affect prior sales, but subsequent sales may not rely on Rule 506 unless, as discussed below, the disqualification is waived or removed, or, if the issuer is unaware of a triggering event, Rule 506(d)’s reasonable care exception applies.

This article provides a high level summary of the final amendments, which include significant detail, particularly regarding the precise character of disqualifying events.  Goodwin Procter has also issued a client alert that addresses the impact on operating company issuers of the final amendments and related SEC rulemaking action regarding private offerings, including the modification of Regulation D to permit offerings involving general solicitation.

Covered Persons

A disqualifying event with respect to any of the following covered persons for an issuer that occurs after the effective date of the final amendments will trigger disqualification under Rule 506(d):

  • the issuer and any predecessor or affiliated issuer;
  • any director, executive officer, other officer participating in the offering, general partner, or managing member of the issuer;
  • any beneficial owner of 20% or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power (a “20% Holder”);
  • any promoter connected with the issuer in any capacity at the time of the sale;
  • each investment manager of an issuer that is a pooled investment fund, as well as (a) each director and executive officer of the investment manager, (b) any other officer of the investment manager participating in the offering, (c) each general partner or managing member of the investment manager, (d) each director and executive officer of such general partner or manager, or (e) any other officer of such general partner or manager participating in the offering; and
  • any person that has been or will be paid (directly or indirectly) remuneration for soliciting purchasers in the offering (a “compensated solicitor”), as well as (i) each director and executive officer of a compensated solicitor, (ii) any other officer of a compensated solicitor participating in the offering, (iii) any general partner or managing member of a compensated solicitor, (iv) each director and executive officer of such general partner or managing member, and (v) any other officer of the such general partner or managing member participating in the offering.

Officers “Participating in an Offering.”  The adopting release notes that “[p]articipation in an offering would have to be more than transitory or incidental involvement, and could include activities such as participation or involvement in due diligence activities, involvement in the preparation of disclosure documents, and communication with the issuer, prospective investors or other offering participants.  We anticipate that issuers should be able to determine which of their own officers are participating in an offering without undue difficulty, and can exercise control over which officers participate.  We also believe that it is reasonable to expect that compensated solicitors should be prepared to confirm which of their officers are participating in an offering as part of any engagement.”

20% Holders.  Rule 506(d) does not define what will constitute “voting securities” for purposes of determining an issuer’s 20% Holders.  The adopting release states that the SEC intends that “the term should be applied based on whether securityholders have or share the ability, either currently or on a contingent basis, to control or significantly influence the management and policies of the issuer through the exercise of a voting right. [footnote omitted]  For example, we would consider that securities that confer to securityholders the right to elect or remove the directors or equivalent controlling persons of the issuer, or to approve significant transactions such as acquisitions, dispositions or financings, would be considered voting securities for purposes of the rule. Conversely, securities that confer voting rights limited solely to approval of changes to the rights and preferences of the class would not be considered voting securities for purposes of the rule.”

Disqualifying Events

In general terms, disqualifying events with respect to covered persons consist of serious violations of financial industry rules and regulations; these include: criminal convictions, court injunctions or restraining orders related to the purchase or sale of securities, false SEC filings or the conduct of specified securities industry businesses (e.g., acting as a broker-dealer); certain SEC disciplinary orders involving a suspension of SEC registration, limitations on activities or an industry bar; certain final orders of certain state regulators (such as state securities, banking and insurance regulators), the CFTC, and certain federal bank regulators; suspension or expulsion from membership in, or suspension or bar from associating with a member of, a securities industry self‑regulatory organization; SEC stop orders and orders suspending a Regulation A exemption; and U.S. Postal Service false representation orders.  Some of these events are subject to look-back periods of five, and in some cases, ten years.

Reasonable Care Exception.  Rule 506(d) includes a “reasonable care” exception that allows an issuer to rely on Rule 506 despite the existence of a disqualifying event, if the issuer can show that it did not know and, in the exercise of reasonable care, could not have known of the disqualification.  The instruction to this exception states that “[a]n issuer will not be able to establish that it has exercised reasonable care unless it has made, in light of the circumstances, factual inquiry into whether any disqualifications exist.  The nature and scope of the factual inquiry will vary based on the facts and circumstances concerning, among other things, the issuer and the other offering participants.”

Neither Rule 506(d) nor the adopting release describe how to satisfy this reasonable care standard.  The adopting release does, however, observe “that issuers will have an in-depth knowledge of their own executive officers and other officers participating in securities offerings gained through the hiring process and in the course of the employment relationship, and in such circumstances, further steps may not be required in connection with a particular offering.  Factual inquiry by means of questionnaires or certifications, perhaps accompanied by contractual representations, covenants and undertakings, may be sufficient in some circumstances, particularly if there is no information or other indicators suggesting bad actor involvement. . . . [I]n the case of a registered broker-dealer acting as placement agent—it may be sufficient to make inquiry of an entity concerning the relevant set of covered officers and controlling persons, and to consult publicly available databases concerning the past disciplinary history of the relevant persons.”

With respect to continuous, delayed or long-lived offerings, the adopting release states that “reasonable care includes updating the factual inquiry on a reasonable basis.  Again, the frequency and degree of updating will depend on the circumstances of the issuer, the offering and the participants involved, but in the absence of facts indicating that closer monitoring would be required (for example, notice that a covered person is the subject of a judicial or regulatory proceeding or knowledge of weaknesses in an organization’s screening procedures), we would expect that periodic updating could be sufficient.  We expect that issuers will manage this through contractual covenants from covered persons to provide bring-down of representations, questionnaires and certifications, negative consent letters, periodic re-checking of public databases, and other steps, depending on the circumstances.”

Conditional Exclusion of Certain Affiliated Issuers.  Rule 506(d) disregards a potentially disqualifying event with respect to an affiliated issuer that arose prior to the affiliate relationship if the affiliated issuer is not (i) in control of the issuer or (ii) together with the issuer, under common control of a third party that controlled the affiliated issuer at the time of that event.

Waiver of Disqualification by SEC.  Rule 506(d) allows the SEC to waive disqualification “upon a showing of good cause and without prejudice to any other SEC action” if it determines “that it is not necessary under the circumstances that an exemption be denied.”  In discussing the various disqualifying events, the adopting release identifies a number of examples of circumstances (such as a change of control, change of supervisory personnel, absence of notice and opportunity for hearing, and relief from a permanent bar for a person who does not intend to apply to reassociate with a regulated entity) that could, depending on the specific facts, be relevant to the SEC’s evaluation of a waiver request.

Waiver of Disqualifying Event By Issuing Authority.  An otherwise disqualifying event will not trigger disqualification under Rule 506(d) if, prior to a sale in reliance on Rule 506, the court or regulatory authority responsible for the relevant order, judgment or decree advises in writing, whether in the relevant judgment, order or decree, or separately to the SEC or its staff, that the order, judgment or decree should not result in  disqualification under Rule 506.

Disclosure of Disqualifying Events that Pre-Date Rule 506(d)’s  Effective Date

A disqualifying event that pre-dates the effectiveness of the final amendments will not trigger disqualification under Rule 506(d).  However, under new Rule 506(e) an issuer will be required to provide each purchaser with written disclosure of “pre-effective disqualifying events” a reasonable time prior to sale.  SEC expects this disclosure to be given “reasonable prominence” and to be “appropriately presented in the total mix of information available to investors.”  The adopting release cautions that in the SEC’s view, an issuer that does not fulfill the disclosure requirements of Rule 506(e) cannot avail itself of Rule 508, under which insignificant deviations from Rule 506’s conditions do not necessarily result in the loss of the Rule 506 exemption.

Rule 506(e) includes a “reasonable care” exception mirroring that under Rule 506(d).


The effective date of the final amendments is 60 days after their publication in the Federal Register.