Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank") requires the Securities and Exchange Commission ("SEC") to adopt rules that would make the exemption from registration under the Securities Act of 1933 ("Securities Act") provided by Rule 506 of Regulation D thereof unavailable for any securities offering in which certain "felons" or other "bad actors" are involved. Effective September 23, 2013, the SEC adopted bad actor disqualifications provisions codified under section (d) of Rule 506.1
The disqualification provisions in Rule 506(d) prohibit issuers or other "covered persons" from participating in Rule 506 offerings, if they have been convicted of, or are subject to court or administrative sanctions for, securities fraud or other violations of specified laws.
Similar disqualification provisions are found in Rule 504(b)(3) of Regulation D, Rule 262 of Regulation A and Rule 503 of Regulation Crowdfunding ("Regulation CF") of the Securities Act, each of which regulations provides a transactional exemption from the registration requirements of the Securities Act.
Under Regulation D, Regulation A or Regulation CF, a disqualification from the use of the applicable exemption occurs if (1) a covered person is involved in the offering, (2) that covered person is subject to one or more of the relevant disqualifying events and (3) the disqualifying event occurs within the lookback period provided by the regulation.
Since 2013, the staff of the SEC Division of Corporation Finance has issued several sets of Securities Act Rules Compliance and Disclosure Interpretations ("C&DI") relating to the bad actor disqualifications.2 There has been a noticeable trend of companies steering away from using the Rule 506 exemption in order to avoid the burden of compliance, and instead relying on Section 4(a)(2) of the Securities Act to raise capital.
In early 2020, the SEC, in a proposed rule, noted that while the existing framework governing "bad actor" disqualifications in Regulation D, Regulation A, and Regulation CF was substantially similar in substance across the different exempt offerings, there was inconsistency in the periods of time for determining whether a covered person had engaged in disqualifying acts, the so-called "lookback."3 Regulation D measured the lookback from the time of sale, while Regulation A and Regulation CF measured lookback from the time the issuer filed the offering statement. On November 2, 2020, SEC amended4 the lookback periods in Regulation A and Regulation CF to align with that of Regulation D, to make consistent all their lookback periods to refer to the time of sale. This amendment became effective on March 15, 2021.5
The Rule 506(d) disqualification provisions are substantially the same as those found in Regulation A and Regulation CF.6 We note below any material differences. The disqualification provisions apply to the following "covered persons":
- the issuer and any predecessor of the issuer;
- any affiliated issuer;
- any director, executive officer, other officer participating in the offering, general partner or managing member of the issuer;7
- any beneficial owner of 20% or more of the issuer's outstanding voting equity securities, calculated on the basis of voting power (based on the Securities Exchange Act of 1934 (the "Exchange Act") Rule 13d-3);
- any promoter (as defined in Rule 405 under the Securities Act) connected with the issuer in any capacity at the time of such sale;8
- any investment manager of an issuer that is a pooled investment fund;9
- any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with such sale of securities (a "compensated solicitor");
- any general partner or managing member of any such investment manager or solicitor;10 or
- 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.11
A discussion of some of the terms included in the covered person categories follows.
An "affiliated issuer" is an affiliate (as defined in Rule 501(b) of Regulation D) of the issuer that is issuing securities in the same offering, including offerings that are subject to integration under Rule 502(a) of Regulation D.12 The term "affiliated issuer" would generally not include an affiliate of a fund, such as a portfolio company, unless that affiliate was issuing securities in the same offering.
Officer participating in the offering
Participation in an offering means more than transitory or incidental involvement. Participation in an offering is not limited to solicitation of investors. The term could include activities such as participation or involvement in due diligence activities, involvement in the preparation of disclosure documents, the offer of structuring or other advice, and communication with the issuer, prospective investors or other offering participants. Administrative functions, such as opening brokerage accounts, wiring funds, and bookkeeping activities, are generally not deemed to constitute participating in the offering. The SEC staff has also indicated that persons whose sole involvement with an offering are as members of a compensated solicitor's deal or transaction committee that is responsible for approving the entity's participation in the offering are not "participating" in the offering.13
1 Release No. 33-9414 (July 10, 2013) (the "Adopting Release"). The Adopting Release is available at: https://bit.ly/3uPOeuI.
2 C&DI 260.14 – 260.38 of the SEC's Securities Act Rules C&DIs can be found at: https://bit.ly/3ppjVKh.
3 See SEC Release 33-10763 (Mar. 4. 2020) at II.G, available at: https://bit.ly/3pe5g4b.
4 Release Nos. 33-10884; 34-90300 (November 2, 2020). The releases are available at: https://bit.ly/3pcE4D3.
6 The disqualification provisions of Rule 504(b)(3) of Regulation D cite Rule 506(d), so they are not separately discussed in this article except where there are material differences.
7 The phrase "other officer participating in the offering" is not in the covered person definition in Rule 503(a) of Regulation CF.
8 Rule 262(a) of Regulation A also looks for promoters at the time of filing and at the time of any offer after qualification.
9 Investment managers are not covered persons for the purposes of Regulation A or Regulation CF.
10 Regulation A and Regulation CF do not include "investment manager" here.
11 Rule 262(a) of Regulation A does not refer to an "investment manager" here. Rule 503(a) of Regulation CF includes only "any general partner, director, officer or managing member of any such solicitor."
12 See C&DI 260.16.
13 See C&DIs 260.18 and 260.19.
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