August 20, 2013

Jaqueline M. Hummel, Managing Director

On July 10, 2013, the Securities and Exchange Commission (“SEC”) adopted amendments to Rule 506 of Regulation D under the Securities Act of 1933, as amended (the “Securities Act”) which adds new Rule 506(d). Rule 506(d) will disqualify securities offerings involving certain “felons and other ‘bad actors” from reliance on the Rule 506 offering exemption as mandated by Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

It is important to note that the new disqualification provisions apply to all Rule 506 offerings. This includes both offerings involving general solicitation and advertising as permitted under the SEC’s newly adopted Rule 506(c) and those involving no general solicitation or advertising as specified under the existing Rule 506(b) which will remain available.

Disqualification Provisions

 Under the “bad actor” disqualification provisions, an issuer may not rely on the Rule 506 offering exemption if the issuer or certain other persons involved with the offering (“Covered Persons”) has a disqualifying event (a “Disqualifying Event”) after September 23, 2013 (the “Effective Date”), unless the disqualification is waived or otherwise remedied.

Events occurring prior to September 23, 2013 that would be Disqualifying Events had they occurred after the Effective Date will not disqualify an issuer from relying on Rule 506, but must be disclosed in writing to offerees a reasonable time prior to sale.

An issuer that is disqualified from relying on Rule 506 may, under certain circumstances, privately offer securities, but will be required to rely on more limited and burdensome exemptions from registration.

The Regulation D limited exemptions include Rule 504 and Rule 505. Rule 504 and Rule 505 limit the amount of securities that may be offered to $1 million and $5 million respectively. Seeking these alternative exemptions on a state-by-state basis can be burdensome in terms of time and expense. These alternative offerings will also involve making significant additional filings on a state-by-state basis.

Depending on the terms of the offering, some issuers may not be able to comply with certain states’ rules and would therefore not be able to offer or sell their securities in that state.

Any issuer that made sales at a time when there were unknown Disqualifying Events may still rely on Rule 506 for those prior sales, if the issuer can establish that it did not know and, in the exercise of reasonable care could not have known, that such Disqualifying Events existed.

Issuers that are subject to disqualification may apply for a waiver, which may be granted upon a showing of good cause if the SEC determines that disqualification is not necessary, or, in the case of a final order (as discussed below), based on a determination of the issuing authority that disqualification is not necessary. Circumstances that may be relevant to a waiver request may include, but are not limited to, 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 re-associate with a regulated entity. 

Covered Persons and Disqualifying Events

 The following persons are Covered Persons:

• the issuer and any predecessor of the issuer 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;
• any investment manager to an issuer that is a pooled investment fund and any director, executive officer, other officer participating in the offering, general partner or managing member of any such investment manager, as well as any director, executive officer or officer participating in the offering of any such general partner or managing member;
• 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 sales of securities in the offering (each such person, a “Compensated Solicitor”); and
• any director, executive officer, other officer participating in the offering, general partner, or managing member of any Compensated Solicitor.

Covered Persons Analysis

 The Adopting Release provides further clarification with respect to the following categories of Covered Persons:

Officers

Only directors, executive officers or other officers who participate in the offering are Covered Persons. Whether an “other officer” participates in an offering will be a factual determination.

In making such a determination, the SEC has indicated that participation in an offering is “more than transitory or incidental involvement” and may include involvement in due diligence activities, involvement in the preparation of disclosure documents and communication with the issuer, prospective investors or other offering participants (as applicable). The SEC uses the definition of “officers” under Rule 405 under the Securities Act, which defines the term “officer” as “a president, vice president, secretary, treasurer or principal financial officer, controller or principal accounting officer, and any person routinely performing corresponding functions with respect to any organization.

20% or Greater Beneficial Owners of Issuer Equity Securities

Beneficial owners of 20% or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power, are Covered Persons. The SEC has not adopted a definition of “voting securities” but indicated in the Adopting Release that the term should be applied based on factors such as whether security holders 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. The SEC explained in the Adopting Release, that it would consider securities that confer to security holders 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, to be voting securities for purposes of the rule. Conversely, the SEC stated that it would not consider securities that confer voting rights limited solely to approval of changes to the rights and preferences of a class voting securities for purposes of the rule. The 20% threshold is calculated on the basis of overall voting power as opposed to a share-based approach (i.e., the number of votes rather than the number of shares is relevant for the purposes of determining whether a beneficial owner meets this threshold).

Investment Managers

The term “investment manager” encompasses both investment advisers (i.e., advisers with respect to securities) and other investment managers (advisers with respect to other assets such as commodities, real estate and certain derivatives).  Sub-advisers are included in the term “investment manager”.

Promoters

Promoters that are connected with the issuer in any capacity at the time of a sale of securities offered pursuant to Rule 506 are Covered Persons. The category of promoter is broad and captures all individuals and entities that have the relationships with the issuer or to the offering specified in Rule 405 under the Securities Act. Rule 405 provides, in pertinent part, that a promoter is any person who, either alone or with others:

• directly or indirectly takes initiative in founding or organizing the business or enterprise of an issuer; or
• in connection with the founding or organization of the business or enterprise of an issuer, directly or indirectly receives 10% or more of any class of issuer securities or 10% or more of the proceeds from the sale of any class of issuer

Issuers should note that seed investors may be considered promoters under this broad definition.

Disqualifying Events

 The following events are Disqualifying Events:

• criminal convictions;
• court injunctions and restraining orders;
• final orders of certain regulators;
• commission disciplinary orders;
• certain SEC cease-and-desist orders;
• suspension or expulsion from self-regulatory organization (“SRO”) membership or association with an SRO member;
• stop orders and orders suspending exemptions under Regulation A of the Securities Act; and
• U.S. Postal Service false representation orders.

Detailed Description of Disqualifying Events

 No exemption under Rule 506 will be available for a sale of securities if a Covered Person:

Criminal Convictions 

 Has been convicted, within ten years before such sale (or five years, in the case of issuers), of any felony or misdemeanor:

• in connection with the purchase or sale of any security;
• involving the making of any false filing with the SEC; 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

Court Injunctions and Restraining Orders

 Is subject to any order, judgment or decree of any court of competent jurisdiction entered within five years before such sale that, at the time of such sale, restrains or enjoins such person from engaging or continuing to engage in any conduct or practice:

• in connection with the purchase or sale of any security;
• involving the making of any false filing with the SEC; 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.

For the purposes of this category, there are no specific due process requirements, requirements that all appeals have been exhausted or the time for appeal has expired as a condition for disqualification under the amendments. Persons “subject to” an order are only those persons specifically named in the order; persons who come within the scope of an order but who are not named will not be treated as “subject to” the order for purposes of disqualification under the amendments.

Final Orders of Certain Regulators

Is subject to a final order of a state securities commission (or an agency or officer of a state performing like functions); a state authority that supervises or examines banks, savings associations, or credit unions; a state insurance commission (or an agency or officer of a state performing like functions); an appropriate federal banking agency; the U.S. Commodity Futures Exchange Commission (“CFTC”); or the National Credit Union Administration that:

• at the time of such sale, bars the person from:
  1. association with an entity regulated by such commission, authority, agency, or officer;
  2. engaging in the business of securities, insurance or banking; or
  3. engaging in savings association or credit union activities;

• constitutes a final order based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct entered within ten years before such sale.

SEC Disciplinary Orders

Is subject to an order of the SEC entered pursuant to Section 15(b) or 15B(c) of the Exchange Act or Section 203(e) or (f) of the Advisers Act that, at the time of such sale:

• suspends or revokes such person’s registration as a broker, dealer, municipal securities dealer or investment adviser;
• places limitations on the activities, functions or operations of such person; or
• bars such person from being associated with any entity or from participating in the offering of any penny

Certain SEC Cease-and-Desist Orders

Is subject to any order of the SEC entered within 5 years before such sale that, at the time of such sale, orders the person to cease and desist from committing or causing a violation or future violation of:

• any scienter-based anti-fraud provision of the federal securities laws; or
• Section 5 of the Securities

Suspension or Expulsion from SRO Membership or Association with an SRO Member

Is suspended or expelled from membership in, or suspended or barred 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 constituting conduct inconsistent with just and equitable principles of trade.

Stop Orders and Orders Suspending the Regulation A Exemption

 Has:

• filed, or was or was named as an underwriter in, any registration statement or Regulation A offering statement filed with the Commission that, within five years before such sale, was the subject of a refusal order, stop order, or order suspending the Regulation A exemption; or
• is, at the time of such sale, the subject of an investigation or proceeding to determine whether a stop order or suspension should be issues. 

Postal Service False Representation Orders

Is:

• subject to a U.S. Postal Service false representation order entered within five years before such sale; or
• at the time of such sale, subject to a temporary restraining order or preliminary injunction with respect to conduct alleged by the U.S. Postal Service to constitute a scheme or device for obtaining money or property through the mail by means of false

Transition Issues and Mandatory Disclosure

Issuers do not have a disclosure obligation under Rule 506(d) to purchasers with respect to sales made to such purchasers prior to the Effective Date (even if such sales were part of a continuing offering that began before the Effective Date). An issuer subject to mandatory disclosure must furnish to each purchaser, at a reasonable time prior to sale, a description in writing of any matters that would have triggered disqualification under the disqualification provisions if such matter had occurred after the Effective Date. The SEC has indicated that a failure to disclose or a failure to adequately disclose under this rule would be more than an “insignificant deviation” from the requirements of Regulation D, such that the issuer would lose its exemption under Rule 506.

Action items

Immediate Steps

Issuers seeking to rely on Rule 506 on or after September 23, 2013 should take the following steps as soon as possible:

• identify all potential Covered Persons; and
• determine whether any Covered Person has a Disqualifying Event (see the following questionnaire);
• determine what contingent action to pursue based upon the existence of Disqualifying Events.

Suggested Additional Steps

 In addition, issuers should consider taking the following steps:

• amend subscription agreements to require applicable investors to provide information about potential Disqualifying Events relating to such persons;
• amend any agreements or contracts with potential Covered Persons (g., placement agent agreements, employment agreements and agreements with investors) to include appropriate representations, disclosure requirements and other relevant provisions;
• implement compliance policies or procedures addressing the determination of whether a Covered Person has had a Disqualifying Event; and
• amend limited partnership agreements or comparable documents to provide the authority for prompt mandatory redemption or withdrawal in the event a beneficial owner could subject the issuer to disqualification.