Do your due diligence when it comes to individuals connected with your private placement – otherwise, it could cost you your exemption and ruin your offering.

Last month, the SEC adopted new Rules 506(d) and (e) to Regulation D of the Securities Act of 1933, which will disqualify the exemptions provided under Rules 506(b) and (c) of Regulation D if the issuer is connected with anyone with a relevant criminal conviction, regulatory or court order, or other “disqualifying event” occurring prior to September 23, 2013.

It is essential for issuers to understand the present rules and comply with them, as compliance is necessary in order to preserve your private placement exemptions. We advise you to consult with counsel immediately if you are planning to engage, or have already engaged, in a private placement transaction in which there is a possibility that one of the individuals associated with the offering has a questionable prior history.  This article summarizes the issues you need to watch for and the actions you must take in order to preserve your exemption.

Only sales of securities made on or after September 23, 2013 are subject to these disqualifications and disclosure requirements, even if the offering continues to September 23, 2013 and beyond.  Moreover, sales made before the occurrence of a “disqualifying event” will not be affected.

“Covered Persons” and “Disqualifying Events” – When Disqualification is Triggered

Rules 506(d) and (e) provide that “covered persons” involved with “disqualifying events” will disqualify an issuer from its exemption under Rule 506.  “Covered Persons” are defined by the SEC as including:

1. the issuer, including its predecessors and affiliated issuers;
2. directors, general partners, and managing members of the issuer;
3. executive officers of the issuer, and other officers of the issuers that participate in the offering;
4. 20 percent beneficial owners of the issuer, calculated on the basis of total voting power;
5. promoters connected to the issuer;
6. for pooled investment fund issuers, the fund’s investment manager and its principals; and
7. persons compensated for soliciting investors, including their directors, general partners and managing members.

Terms such as “officer” and “promoter” have been given broad meanings by the SEC; therefore, we recommend that you contact counsel immediately if you believe that anyone associated with your offering has been involved with a “disqualifying event.”

“Disqualifying Events” are defined by the SEC as including:

1. Certain criminal convictions;
2. Certain court injunctions and restraining orders;
3. final orders of certain state and federal regulators;
4. Certain SEC disciplinary orders;
5. Certain SEC cease-and-desist orders;
6. SEC stop orders and orders suspending the Regulation A exemption;
7. Suspension or expulsion from membership in a self-regulatory organization (SRO), such as FINRA, or from association with an SRO member; and
8. U.S. Postal Service false representation orders.

Much like the definition of “covered persons,” many of these “disqualifying events” are subject to broad interpretation by the SEC, and many are subject to lengthy look-back periods in which the disqualification can last for several years following the occurrence of the “disqualifying event.” Issuers should watch for individuals who have been involved with any dispute or disciplinary action in connection with fraud, the sale of securities, or the financial industry generally.

Your Duties as an Issuer

Issuers should conduct adequate due diligence in connection with their “covered persons.”  An exemption from Rule 506 disqualification exists if the issuer can demonstrate that it did not know and, in the exercise of reasonable care, could not have known, that a “covered person” with a “disqualifying event” participated in the issuer’s offering.  Unfortunately, there is no bright-line test for establishing “reasonable care” – it is subject to a facts and circumstances determination by the SEC.  At a minimum, an issuer must make a factual inquiry to covered persons into whether they have been involved with any “disqualifying event.”

Importantly, a “covered person” will not be subject to disqualification if (i) the “disqualifying event” occurred before September 23, 2013, and (ii) the “disqualifying event” is disclosed in writing to investors reasonably in advance of the Rule 506 sale.  Absent such disclosure, the issuer will lose its Rule 506 exemption unless it can prove to the SEC that it did not know and, in the exercise of reasonable care, could not have known, that a “disqualifying event” existed and was required to be disclosed.  The SEC has stated that it expects issuers to give reasonable prominence to such written disclosures to investors.

An issuer may also apply to the SEC for a waiver of the disqualification requirement.  This will require the issuer to demonstrate good cause.  The SEC is maintaining a public database of waiver applications and rulings which counsel may consult in order to assess the possible outcome of such a waiver application.

How to Protect Against Disqualification

Protecting your exemptions for your offerings will require two approaches – (1) developing adequate procedural safeguards, and (2) promptly handling issues which you discover or which are brought to your attention.  We recommend that you consult with counsel if you are planning a Rule 506 offering, or are presently engaged in such an offering, to develop your procedural safeguards to protect your exemption from disqualification.  Furthermore, we recommend that you immediately consult with counsel upon learning of any potential “disqualifying event.”

All issuers relying on a Rule 506 exemption should make inquiry to the individuals connected with their offering regarding “disqualifying events.”  This can include questionnaires for partners, managers, officers, directors, and employees of the issuer, as well as disclosure requirements and indemnity provisions in agreements with promoters, broker/dealers, and the like.  This may also include third-party verification services.

If the disqualifying event occurred prior to September 23, 2013, the issuer should make prominent, written disclosure to investors.  An example of such a disclosure would be a clearly-labeled section in a private placement memorandum which states, in capital letters, that a “covered person” is subject to a “disqualifying event,” as well as the relationship of such covered person with the issuer and brief descriptions of their involvement with the issuer and of the “disqualifying event.”

Presently, this new rule has not been subject to much SEC enforcement or rule interpretation.  As time goes on, more precedent will be developed by the SEC that will enable issuers to have a clearer picture of the actions they must take in order to preserve their Rule 506 exemptions.  We recommend that you routinely check with counsel regarding anticipated and on-going offerings relying on Rule 506 exemptions in order to understand the regulatory landscape and ensure your compliance with Rules 506 (d) and (e).