Section 926(1) of the Dodd-Frank Act required the Securities and Exchange Commission (“SEC”) to adopt rules that disqualify securities offerings involving certain felons and other “bad actors” from reliance on Rule 506 under Regulation D of the Securities Act of 1933 (“Securities Act”). New paragraph (d) of Rule 506 was adopted pursuant to the mandate of Section 926(1) and became effective on September 24, 2013. Under such new paragraph (d) (“Bad Actor Provisions”) the involvement of bad actors in a private offering could have the effect of disqualifying the offering from the safe harbor exemption from registration provided under Rule 506. As such the Bad Actor Provisions require issuers that intend to rely on the Rule 506 exemption to undertake additional diligence.
A CLO’s capital stack often includes a portion of subordinated notes that are offered for purchase to institutional accredited investors (“IAI”) and/or accredited investors (“AI”). These IAI and AI purchasers typically meet the requirements to be considered covered purchasers under Rule 506. Due to the fact that IAI and AI purchasers meet the scriptures of Rule 506, CLO market participants have raised questions as to whether the Bad Actor Provisions will require participants in a CLO transaction to undertake additional diligence and whether such additional diligence could negatively impact the market for CLO subordinated notes.
However, it is our view that the Bad Actor Provisions should not impact CLO issuances. While IAI and AI purchasers in a CLO transaction may satisfy the Rule 506 qualified purchasers criteria, CLO issuances generally do not occur under Rule 506 and as a result the provisions of 506(d) generally will not apply to a CLO transaction.
In the United States CLOs commonly take the form of a private offering through the use of exemptions from registration available under the Securities Act. Sales and resales of CLO securities typically take place pursuant to the exemption under Section 4(a)(2) of the Securities Act (or, in the case of resales, the Section 4(a)(1½) interpretive exemption) and pursuant to Regulation S for sales to non-U.S. persons in offshore transactions, which in each case exempts from registration any transaction that does not involve a “public offering” or distribution.
The term “public offering” is not defined in the Securities Act. The SEC and the courts have analyzed various factors when considering whether an issuer has engaged in a “public offering.” These factors include: (i) the type of investor to whom the securities are offered (e.g., sophisticated investors able to obtain and understand information from the related issuer); (ii) the absence of general solicitation and general advertising in an offering; (iii) a limited number of investors; and (iv) transfer restrictions prohibiting the transfer of the covered securities except to similarly qualified investors.
CLO issuers (and their counsel) have paid careful attention to incorporate these restrictions (and other salient features intended to limit the universe of potential investors, including sufficiently high minimum denominations for such subordinated notes) into CLO transaction documentation. It is for this very reason (and not for Rule 506 compliance purposes) that CLO issuers often limit the issuance of subordinated securities to IAIs and AIs that are either “knowledgeable employees” or investors who are known by and who have a pre-existing relationship with the related issuer. In other words, the limitation of sales of subordinated CLO securities to IAIs and AIs is one of several mechanisms in a CLO intended to ensure that the issuance of CLO securities meets the requirements of Section 4(a)(2) or 4(a)(1½) and to preclude such issuance from being characterized as a “public offering.” The limitation has little, if anything, to do with Rule 506 as the CLO issuers generally do not rely on Rule 506.
For this reason, the application of the Bad Actor Provisions to the sale of CLO subordinated notes offered under exemptions other than Rule 506 is not required. It is unlikely that the CLO marketplace will adopt an approach that restricts (or prohibits) sales of subordinated securities to IAIs or AIs but the more likely result is that, given that such sales may be subject to more robust scrutiny, issuers will maintain high standard thresholds when marketing to IAIs and AIs including making sure minimum denominations stay sufficiently high (which typically means $250,000 or higher) for CLO subordinated notes.