On September 23, 2013, the SEC’s new rules become effective that disqualify certain persons from being involved in Reg D private offerings relying on Rule 506.  For clients who are currently conducting one or more of these private offerings, or are contemplating one, this alert summarizes your obligations under the new SEC rules. 

Essentially, under the new rules, certain persons who have been the subject of specific disqualifying events will be prohibited from having any involvement in a Rule 506 offering.  The persons who are potentially disqualified (known as “Covered Persons”) include:

• the issuer;

• any director, executive officer, or other officer of the issuer participating in the offering as well as the general partner or managing member of the issuer;

• any beneficial owner of 20 percent or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power;

• any promoter connected with the issuer in any capacity at the time of the sale;

• any investment manager of an issuer that is a pooled investment fund;

• any person who has been or will be paid (directly or indirectly) for soliciting purchasers;

• any general partner or managing member of any such investment manager or solicitor; and

• any director, executive officer or other officer participating in the offering of any such investment manager or solicitor or general partner or managing member of such investment manager or solicitor.

The new rules have a specific list of disqualifying events, such as felony convictions, SEC fraud actions, etc.  (See pages 142-145 of the final SEC release (link below) for a list of disqualifying events.)  The SEC expects “reasonable care” to be taken with respect to inquiring whether there are any disqualifying events involving the Covered Persons.  We suggest getting written confirmations from each promoter/broker/solicitor stating that no disqualifying events apply.

The term “promoter” is defined broadly and includes any person, individual or legal entity, that either alone or with others, directly or indirectly takes initiative in founding the business or enterprise of the issuer, or, in connection with such founding or organization, directly or indirectly receives 10 percent or more of any class of issuer securities or 10 percent or more of the proceeds from the sale of any class of issuer securities (other than securities received solely as underwriting commissions or solely in exchange for property).

The term “solicitor” includes third parties not affiliated with the issuer who are paid, directly or indirectly, for soliciting investors.

As noted above, a person who owns at least 20 percent of the voting securities of the issuer (the fund) is subject to disqualification. The SEC declined to adopt a specific definition of “voting securities” in light of the range of possible structures and control arrangements among issuers relying on Rule 506; however, it intends that the term be applied based on whether securityholders have the ability to control or significantly influence the management and policies of the issuer through the exercise of a voting right. The SEC takes the position that if investors have the right to replace the general partner, the LP interests are treated as having voting rights. Thus, certain conventional hedge fund terms, such as “kick out” rights, may have a bearing on whether a security may be considered a voting security. You should review each fund’s governing documents with your counsel to determine if investors have the right to remove the general partner and/or may otherwise hold voting securities and, if so, treat any investor owning at least 20 percent of any class of the fund as a Covered Person.

Covered Persons with disqualifying events that occurred prior to the effective date of the rule are not disqualified, but the issuer must disclose to its investors the relevant information regarding the event.  Since most offerings are ongoing, the SEC expects that the issuer would conduct periodic ongoing inquiry so that it would have reasonably current information with which to know whether a Covered Person is disqualified. 

The final SEC rule has additional details about the new rules and can be found here.