SEC Division of Corporation Finance Issues Five Additional C&DIs Relating to “Bad Actor” Rule

by Katten Muchin Rosenman LLP

On January 3, the Securities and Exchange Commission’s Division of Corporation Finance issued five new Compliance and Disclosure Interpretations (C&DIs) with respect to Rule 506 under the Securities Act of 1933 (Securities Act). These C&DIs relate to the rule (Rule 506(d)) recently adopted by the SEC (Bad Actor Rule) that disqualifies issuers from relying on Rule 506 of Regulation D for securities offerings involving certain felons and other so-called “bad actors” (the persons subject to the Bad Actor Rule being referred to as covered persons). These are in addition to the C&DIs relating to the Bad Actor Rule released on December 4, 2013, as discussed in the Corporate and Financial Weekly Digest edition of December 6, 2013. The new C&DIs include the following interpretative guidance: 

C&DI 260.28 provides that a shareholder that becomes a 20% beneficial owner by purchasing securities in an offering is not a “covered person” subject to the Bad Actor Rule with respect to such offering (as that shareholder was not a covered person at the time of the sale). It would, however, be a covered person with respect to any sales of securities in the same offering made after it became a 20% beneficial owner. 

C&DI 260.29 and C&DI 260.30 clarify that that the term “beneficial owner” under Rule 506(d) is interpreted the same way as under Securities Exchange Act of 1934 (Exchange Act) Rule 13d-3 (i.e., any person who, directly or indirectly (which includes “looking through” entities to their controlling persons), has or shares: (1) the power to vote and/or (2) the power to dispose of, a security). 

C&DI 260.31 clarifies that the analysis for determining beneficial ownership under Rule 506(d) (and, consequently, whether a party or group of parties constitutes a 20% beneficial owner of the issuer and is therefore a “covered person”) is conducted the same as it is for purposes of Exchange Act Rules 13d-3 and 13d-5(b). By way of example, C&DI 260.31 provides that shareholders that have entered into a voting agreement under which each shareholder agrees to vote its shares in favor of director candidates designated by another party have formed a group, and the group beneficially owns the shares beneficially owned by its members. Shareholders party to a voting agreement that have the power to vote shares beneficially owned by others party to the voting agreement (e.g., through an irrevocable proxy or the right to designate director nominees) are deemed to beneficially own such shares. Shareholders that do not have the power to vote other parties’ shares would not be deemed beneficial owners of such shares solely as a result of entering into the voting agreement.  

C&DI 260.31 provides that if a group, such as the group formed by entering into the voting agreement, is a 20% beneficial owner, then disqualification under Rule 506(d) would arise from triggering events involving the group itself. If a party to the voting agreement becomes a 20% beneficial owner (i.e., a covered person) as a result of shares of other parties being added to such covered person’s beneficial ownership, disqualification would arise from triggering events involving that covered person. 

C&DI 260.32 provides that an order issued by a court or a regulatory authority pursuant to Rule 506(d)(2)(iii), advising the SEC that Rule 506 disqualification should not occur as a consequence of such order, does not waive the disclosure obligations set forth in Rule 506(e), which requires investors to disclose events that would have triggered disqualification under the Bad Actor Rule but for the fact they occurred before September 23, 2013. Rule 506(d)(2)(iii) permits issuers to rely on the self-executing statement of a regulatory authority to avoid Rule 506 disqualification when that regulatory authority advises the SEC in a writing that Rule 506 disqualification should not arise as a consequence of a disqualifying event occurring on or after September 23, 2013. C&DI 260.32 further clarifies that a regulatory authority may, however, determine that an order entered before September 23, 2013 would not have triggered disqualification under Rule 506(d)(1) because the violation was not a final order based on a violation of any law or regulation prohibiting fraudulent, manipulative or deceptive conduct entered within 10 years before such sale.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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