Most private equity funds that are subject to the U.S. securities laws rely on Rule 506(b) of Regulation D, a safe harbor under Section 4(a)(2) of the Securities Act of 1933 (Securities Act), in forming funds and soliciting investors. In particular, Section 4(a)(2) exempts transactions by an issuer “not involving any public offering” from the registration requirements of Section 5 of the Securities Act. The SEC has amended¹ Rule 506 of Regulation D to disqualify securities offerings involving certain “felons” and other “bad actors” from relying on Rule 506 of Regulation D (Bad Actor Rules).² The Bad Actor Rules became effective on September 23, 2013.

Background: Dodd-Frank Act Requirement to Adopt “Bad Actor” Provisions

Acting on the mandate in Section 926(1) of the Dodd-Frank Act, the SEC adopted disqualification rules “substantially similar” to those in Rule 262 of Regulation A under the Securities Act.³ The amendments to Rule 506 disqualify securities offerings involving certain “felons” and other “bad actors” from relying on Rule 506 of Regulation D where an issuer or certain “covered persons” have had a “disqualifying event.”

“Covered Persons”

The disqualification provisions in the Bad Actor Rules generally apply to the following categories of persons:

• Investment managers of private fund issuers;
• The directors, executive officers, other officers participating in the offering, and general partners and managing members of such investment managers;
• The directors and executive officers of such general partners and managing members and their other officers participating in the offering;
• The issuer and any predecessor of the issuer or affiliated issuer;
• The directors, executive officers, other officers participating in the offering, and general partners or managing members of the issuer;
• Any 20% beneficial owner of an issuer’s outstanding voting equity securities⁴, calculated on the basis of voting power;
• Certain promoters; and
• Persons compensated for soliciting investors as well as the general partners, directors, executive officers, other officers participating in the offering and managing members of any compensated solicitor.

On December 4, 2013, the Division of Corporation Finance of the SEC issued new Compliance and Disclosure Interpretations (the Interpretations) regarding the Bad Actor Rules.⁵ In particular, the Interpretations stated that for purposes of Rule 506(d), 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, not every affiliate of the issuer that has issued securities.⁶ In the private equity fund context, an affiliated issuer generally will mean a parallel investment vehicle of the issuer, but not other affiliates under common control with the issuer or controlled portfolio companies of the issuer. 

“Disqualifying Events”

Some of the “bad acts” in the Bad Actor Rules, which disqualify covered persons from relying on a Rule 506 exemption for a sale of securities, are those that result in any of the following:⁷

• SEC cease-and-desist orders barring or limiting such persons from engaging in certain enumerated activities under the federal securities laws;
• SEC cease-and-desist orders, entered into within the last five years, in connection with violations of anti-fraud provisions of the federal securities laws;
• Criminal convictions, entered within ten years before such sale (or five years in the case of issuers, their predecessors and affiliated issuers), in connection with the purchase or sale of any security, making any false filing with the SEC, or arising out of the conduct of certain types of financial intermediaries such as underwriters and broker-dealers;
• Court restraining orders and injunctions, entered within five years before such sale, in connection with the purchase or sale of any security, making any false filing with the SEC, or arising out of the conduct of certain types of financial intermediaries such as underwriters and broker-dealers;
• Suspension or expulsion from membership in, or restrictions on a covered person’s ability to associate with members of, a securities self-regulatory organization; and
• Final orders of certain enumerated state and federal regulators (including the CFTC, federal banking agencies, state securities regulators and insurance, banking and savings associations) that (1) bar the covered person from associating with the above-referenced regulated entities, or (2) find a violation of any law or regulation prohibiting fraudulent, manipulative or deceptive conduct⁸ and that were entered into within ten years before such sale.

Pre-Existing Event Disclosure

As proposed, the Bad Actor Rules would have applied to all Rule 506 offerings occurring after the effective date of the new provisions, even where the disqualifying event occurred before the effective date of such new provisions. In response to concerns that such retroactive applicability would result in unfair outcomes, the Bad Actor Release provides that only triggering events occurring on or following the effective date will trigger disqualification. However, triggering events occurring before the effective date must be disclosed to investors.⁹

Due Diligence Requirement

The Bad Actor Rules provide an exception from disqualification where the issuer can demonstrate that it did not know and, using reasonable care, could not have known that a covered person with a disqualifying event participated in the offering. The Bad Actor Release states that the steps an issuer should take in exercising reasonable care will “vary according to the particular facts and circumstances.”¹⁰ The SEC suggests that fund sponsors may wish to distribute “questionnaires or certifications” to certain management personnel and placement agents. 

Waivers

The Bad Actor Rules provide that the SEC may grant a waiver of disqualification where an issuer has shown good cause that it is not necessary, under the circumstances, that the registration exemption be denied.¹¹ In addition, disqualification of a covered person subject to a disqualifying event will not occur if, before the relevant sale is made pursuant to Rule 506, the court or regulatory authority that entered the relevant order, judgment or decree advises the SEC, in writing, that disqualification is inappropriate.

Practical Considerations

For private funds engaging in a Rule 506 offering, it will be important for sponsors of such funds to establish appropriate policies and procedures. Initially, such policies and procedures should be designed to ascertain whether any covered person has been subject to a disqualifying event occurring prior to September 23, 2013. In the event there is any such instance, this fact should be disclosed to the investors of the relevant private fund issuer, and the Rule 506 offering will not be subject to disqualification as a result of such prior event. On a going-forward basis, such policies and procedures should be designed (i) to prevent the presence or participation of a covered person with a disqualifying event in an offering and (ii) in the event such presence or participation nonetheless occurs, to demonstrate that the disqualification exception should apply to the offering based on the fund’s exercise of reasonable care.

In particular, these policies and procedures might include requirements, among others, to:

• Circulate written questionnaires to current fund investors that are 20% beneficial owners thereof, fund directors, executive officers of the investment manager and other “participating” officers of the investment manager, inquiring whether they have been subject to a disqualifying event. Investment managers might consider instructing recipients to promptly inform them upon becoming subject to a disqualification event in the future;
• Review distribution and placement agent agreements in order to ascertain the identity of all compensated solicitors. Once identified, investment managers might consider circulating written questionnaires to all such solicitors, inquiring whether they have been subject to a disqualifying event; and
• Require prospective employees (or at least officer candidates), fund directors and solicitors to complete a written questionnaire inquiring whether they have been subject to a disqualifying event. Investment managers might consider not hiring or appointing any such persons that have been subject to a disqualifying event.

Amendment to Form D

Form D has been amended to require issuers claiming a Rule 506 exemption to certify that the offering is not disqualified by one of the disqualification provisions set forth in Rule 506(d).