Rule 506 FAQs: Some Answers, Some New Questions

On December 4, 2013, the SEC released a new batch of FAQs regarding new Rules 506(d) and 506(e). Before diving in to the clarifications provided and the new uncertainties raised by the SEC in the new FAQs, you might want to take a quick look back at our prior post explaining the rules.  Broadly speaking, Rule 506(d) disqualifies an issuer from relying on Rule 506 in a private offering if a person subject to the rule (a “covered person”) has committed any of a number of enumerated prohibited acts (“bad acts”) with various look-back periods.  Rule 506(e) requires issuers to disclose to purchasers past bad acts by covered persons that do not lead to disqualification, but would have led to disqualification at the time of the offering if Rule 506(d) had been applicable to the offering.

Some of the answers provided by the SEC in the new FAQs are straightforward.  For example:

  • Bad acts under the laws of non-U.S. jurisdictions (and orders, judgments, etc. of authorities in non-U.S. jurisdictions) don’t count for purposes of Rule 506(d)
  • If the body that enters the relevant order, judgment, or decree advises in writing that the order, judgment, or decree should not result in a violation of Rule 506(d)(1) (as described in Rule 506(d)(2)(iii)), then a separate waiver from the SEC is not necessary (in other words, Rule 506(d)(2)(iii) is self-executing)
  • Compensated solicitors (discussed below) are not limited to registered brokers and their associated persons
  • The term “affiliated issuer” means only an affiliate (per Rule 501(b)) that is issuing securities in the same offering, including offerings subject to integration
  • There are no waivers for the requirement to disclose bad acts that would have led to disqualification at the time of the offering if Rule 506(d) had then been applicable
  • If a past bad act was outside of the applicable look back period at the time of the offering, then disclosure under Rule 506(e) is not required
  • In an offering with multiple placement agents, disclosure of the bad acts of the covered persons of all placement agents then involved in the offering to all purchasers is required – the disclosure obligation to a particular purchaser is not limited to the placement agent that actually solicits such purchaser
  • In a continuous offering, Rule 506(e) disclosures need not be made for all covered persons who have ever been involved in the offering; rather, disclosure must be made a reasonable time prior to a particular sale with respect to covered persons then involved in the offering

A few of the FAQs, however, are less clear and in some cases raise additional questions:

When must an issuer bring down or freshen its bad actor inquiry?

The bad actor determination must be made any time an issuer is offering or selling securities.  The SEC’s position is that an issuer “may reasonably rely” on a covered person’s undertaking to provide notice of a disqualifying event pursuant to contractual or bylaw requirements or an undertaking in a questionnaire.  However, a covered person’s current certification and undertaking to provide notice of any future bad acts goes stale at some point and requires freshening via a bring-down certification or other means.  The SEC is not clear on when a bring down would be necessary, stating only that “if an offering is continuous, delayed, or long-lived, the issuer must update its factual inquiry periodically.”  What is a “long-lived” offering?  What does “periodically” mean?  Would an issuer that uses an annual questionnaire with an undertaking to provide notice of any subsequent bad acts need to obtain bring-downs of the bad actor reps for an offering conducted nine months after the date of the last questionnaire?  How about six months?  These are just a few of the questions raised by this attempted clarification by the SEC.

When does the “I couldn’t have known” exception apply?

Rule 506(d)(2)(iv) provides an exception to the disqualification provisions in Rule 506(d)(1) if the issuer establishes that it did not, and in the exercise of reasonable care could not, know about the bad act.  Reasonable care requires that the issuer at least make inquiry of the covered persons, but the specific steps that constitute reasonable care in a given instance will depend on the facts and circumstances.  This exception applies not only to bad acts (i.e., the issuer has correctly identified the covered persons but fails to discover a bad act), but also to matters of the identity of covered persons (i.e., the issuer fails to identify all covered persons or mistakenly excludes from inquiry a covered person).

When can an issuer avoid disqualification by terminating the covered person status of a bad actor?

If a placement agent becomes subject to a disqualification while an offering is ongoing, the issuer can continue to rely on Rule 506 as long as it terminates the engagement with the placement agent and pays no compensation to the agent for future sales.  A similar concept applies when only one or a subset of covered persons associated with the placement agent are affected by a disqualification event (i.e., the offering can continue as long as the persons subject to the disqualifying event are terminated by the placement agent or reduced to roles that do not make them “covered persons” for purposes of Rule 506(d)).   It’s unclear when the termination of covered person status must occur in order to allow the issuer to continue to rely on Rule 506.  It makes sense that if the disqualifying event occurs after sale A in the offering, but the bad actor is cut off before Sale B, then the Rule 506 exemption remains available.  But what if there are intervening sales that occur after the disqualifying event occurs but before the bad actor is cut off?  What if a disqualifying event has occurred, but the issuer doesn’t immediately learn about the disqualifying event?  Would the Rule 506(d)(2)(iv) exception be available?  If so, at what point in time would the analysis of the issuer’s factual inquiry focus on?

What constitutes “participating in” an offering?

Covered persons, for purposes of the rule, include “any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers” (a “compensated solicitor” for short) in the offering as well as “any director, executive officer, or other officer participating in the offering” of the compensated solicitor. One of the FAQs relates to when an officer of a compensated solicitor is deemed to be “participating in the offering” and therefore is a covered person.  The SEC describes a spectrum of activities a person could engage in with respect to the offering.  On one end of the spectrum, a person who merely sits on the deal committee of a compensated solicitor and approves the involvement of the compensated solicitor in the offering, or who performs only administrative duties like bookkeeping, is not “participating” in the offering.  On the other end of the spectrum are persons who actively solicit investors on behalf of the compensated solicitor, and who clearly are “participating” in the offering.  In the mushy middle are persons who do more than just administration, but less than actual solicitation.  If a person engages in activities such as performing due diligence, preparing offering documents, or communicating with the issuer or prospective investors about the offering, and if those activities are not “transitory or incidental,” then the person will be deemed to be “participating” in the offering.  How will the SEC analyze whether actions are transitory or incidental?  Will the SEC examine a particular person’s role in other offerings?   

How does one recognize a scienter-based anti-fraud provision of the federal securities laws?

One of the bad acts that can lead to disqualification is a covered person being subject to any order of the SEC entered within the last five years that 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.”  There is some ambiguity here as it relates to securities regulations that are promulgated pursuant to provisions of securities laws, where the laws contain scienter elements but the rules do not.  For example, since Section 10(b) of the Exchange Act contains a scienter element, would a cease and desist order relating to violations of any rule promulgated pursuant to Section 10(b) of the Exchange Act qualify as bad acts for purposes of the rule?  The SEC answers no and provides the example of Exchange Act Rule 105, which is promulgated pursuant to Exchange Act Section 10(b) but does not contain a scienter element.  A cease and desist order relating to Rule 105 would not qualify as a bad act for purposes of the rule.