On December 4, 2013, the SEC’s the Division of Corporation Finance issued additional Compliance and Disclosure Interpretations (the Guidance) on certain aspects of the “bad actor” rules under the Securities Act of 1933 that became effective on September 23, 2013.  As described in our previous client alert on this topic, the new rules disqualify certain persons (known as “Covered Persons”) who have been the subject of specific disqualifying events from being involved in Reg D private offerings relying on Rule 506.  That alert can be accessed by clicking here. The new Guidance clarifies the following aspects of Rules 506(d) and 506(e):

Reasonable Care.  Issuers must determine with reasonable care if they are subject to bad actor disqualification any time they are offering or selling securities in reliance on the Rule 506 exemption from Securities Act registration.  The Guidance clarifies that if an issuer is not offering securities, such as a fund that is winding down and is closed to investment, it need not determine whether Rule 506(d) applies unless and until it commences a Rule 506 offering. Instead, the issuer may rely on a Covered Person’s agreement to provide notice of a potential or actual bad actor triggering event.  If, however, an offering is ongoing, the issuer must periodically update its inquiry by, for example, bring-down representations, questionnaires, certifications, negative consents, checking public databases and other steps depending on the circumstances.

Rule 506(d) provides that if an issuer can establish that it did not know, and in the exercise of reasonable care, could not have known that a bad actor disqualification existed, the issuer will not be subject to disqualification.  The Guidance makes clear that this exception applies when, despite the exercise of reasonable care, the issuer (a) was unable to determine the existence of a disqualifying event, or that a particular person was a Covered Person, or (b) initially reasonably determined that the person was not a Covered Person but subsequently learned that determination was incorrect.  The Guidance notes that issuers will still need to consider what steps are appropriate upon discovery of a disqualifying event or Covered Persons during the course of an ongoing offering.  The Guidance states that an issuer may need to seek waivers of disqualification, terminate the relationship with Covered Persons, provide Rule 506(e) bad actor disclosure or take other remedial steps that address the disqualification.   

Bad Actors: Affiliated Issuers, Placement Agents and Solicitors.  The Guidance addresses the bad actor status of affiliated issuers, placement agents and solicitors.  

The Guidance clarifies that an “affiliated issuer” of an issuer for purposes of bad actor disqualification and due diligence includes only affiliates of the issuer that are issuing securities in the same offering, including offerings subject to integration pursuant to Rule 502(a).  

With respect to placement agents, an issuer can continue to rely on the Rule 506 exemption from Securities Act registration for future sales in an offering even though a placement agent experiences a disqualifying event while the offering is still ongoing if: (a) the engagement with the placement agent was terminated and the placement agent did not receive compensation for the future sales; or (b) if the disqualifying event affected only the covered control persons of the placement agent and such persons were terminated or no longer performed roles that would cause them to be considered Covered Persons for purposes of Rule 506(d).

The Guidance also provides that paid solicitors covered by Rule 506(d) are not limited to registered broker-dealers, but include all persons who have been or will be paid directly or indirectly, for solicitation of purchasers.  However, a solicitor’s directors and officers who participate in an offering are included in the list of Covered Persons if their participation includes involvement in due diligence activities, preparation of offering materials, providing structuring or other advice to the issuer in connection with the offering and communicating with the issuer, prospective investors or other offering participants about the offering.  The Guidance clarifies that these activities must be more than transitory or incidental and do not include any persons whose sole involvement in the offering is as a member of a paid solicitor’s deal or transaction committee that is responsible for approving such solicitor’s participation in the offering, administrative functions, such as opening brokerage accounts, wiring funds and bookkeeping activities. 

Disclosure.  The Guidance makes clear that issuers may not waive the obligation to disclose past disqualifying events that occurred prior to the September 23, 2013 effective date of Rule 506(d).  However, issuers are required to disclose only events that would have triggered disqualification at the time of the offering.  With respect to solicitors, the Guidance clarifies that issuers are required to provide disclosure of past disqualifying events of all paid solicitors and their covered control persons who are involved with the offering to all investors, and not only to the investors that were solicited by such persons.  However, issuers are not required to provide disclosure with respect to paid solicitors who are no longer involved in the offering.

Disqualification Triggers.  The Guidance clarifies that disqualification is not triggered by actions taken in jurisdictions outside the U.S., such as convictions, court orders, or injunctions in a foreign court or regulatory orders issued by foreign regulatory authorities.  The Guidance also provides that disqualification is triggered only by cease and desist orders from violations of scienter-based provisions of the federal securities laws and rules.  Further, if an order issued by a court or regulator provides that Rule 506 disqualification should not arise as a result of the order, it is not necessary to seek a waiver from the SEC or to take any other action to confirm that a bad actor disqualification will also not apply as a result of the order.