Wednesday, July 22, 2015

Curing the “Bad Actor” Disqualification: Waivers and Due Diligence - Part II

In the previous blog post, I began discussing the “bad actor” concept as it relates to Rule 506 private placements. In that post, I focused specifically on who the potential “bad actors” are, and what sort of “bad acts” would lead to that designation. In this blog post I am going to discuss four exceptions to disqualification.

1. Timing of the Disqualification Events.

The “bad actor” disqualification rule became effective on September 23, 2013, and is a prospective rule. Therefore, only bad acts which occurred on or after that date are disqualifying events. It is important to note that it is the date of the conviction, suspension, or similar bad act (see my previous post here for the list of disqualifying “bad acts” which is important for timing purposes, rather than the date(s) of the conduct which resulted in the conviction, etc. Thus, any conviction, etc. occurring on or after September 23, 2013 is a disqualifying event, regardless of when the actual conduct took place.

However, Rule 506(e) requires disclosure, “to each purchaser, a reasonable time prior to sale” of a written description of any “bad acts” which would have been disqualifying but are not solely by virtue of the timing rule. Thus, if a broker participating in the sale had been suspended in January 2013, he would not be a “bad actor” and his participation would not destroy the Rule 506 exemption, but this fact would need to be disclosed to every purchaser of the securities (and, importantly to note, not only to those who would be purchasing securities through that particular broker).

2. Court or Agency Request

If the disqualifying event is due to, for example, a judge’s order or a regulatory agency’s finding, and the relevant judge or agency provides written notice to the SEC that the finding should not result in disqualification, then the disqualification will not arise. This notice may be provided either in the ruling itself, or may be separately provided to the SEC staff. In such cases, the issuer will not be required to also seek a waiver from the SEC; the judge or agency’s written notice is sufficient to “cure” the otherwise disqualifying “bad act.” Question 260.22 of the Securities Act Rules Compliance and Disclosure Interpretations ("C&DIs") addresses this point.

3. The “Due Diligence” Defense

If an issuer fails to discover a disqualifying event, it may in some instances rely on a “due diligence” defense. As with due diligence in other contexts, the standard is one of “reasonable care.” The burden is on the issuer to show that, after exercising reasonable care, it did not know, and could not have known, of the disqualifying event. To satisfy this burden, the issuer will need to show that it conducted a factual inquiry tailored to the facts and circumstances of the particular offering and its participants. Whether the issuer can rely on this defense is very fact-dependent. The better the internal monitoring controls, and the more care the issuer takes in investigating the “covered persons” it is working with, the better its chances of being able to make use of a due diligence defense.

If the issuer fails to disclose a prior “bad act” to purchasers of its securities, the consequences are the same as if the “bad act” was disqualifying—that is, loss of the ability to rely on Rule 506 registration exemption. That said, it does not mean that the offering cannot continue.  A disqualified Rule 506 offering can be conducted as a registered offering or under another registration exemption or safe harbor that is not subject to bad actor disqualification.

If an issuer newly discovers a Rule 506(d) disqualifying event or covered person during the course of an ongoing Rule 506 offering, it must then consider what steps would be appropriate. An issuer may need to seek waivers of disqualification, terminate the relationship with covered persons, provide Rule 506(e) disclosure to investors or take other remedial steps to address any Rule 506(d) disqualification. (Question 260.23 of C&DIs.)

4. Waivers of Otherwise Disqualifying “Bad Acts”

Rule 506(d)(2)(ii) provides that the SEC may waive an otherwise disqualifying bad act if “upon a showing of good cause...the Commission determines that it is not necessary under the circumstances that an exemption be denied.” More colloquially, this can be referred to simply as the “waiver rule.” The SEC provided a guide to submitting a waiver request, which is available here. It also maintains a list of waivers it has granted (through “no-action” letters) here (you should scroll down specifically to the subsection “Regulation D—Rule 506(d) Waivers of Disqualification.”) To get a sense of what kind of factors the SEC takes into account when deciding whether to grant these waivers, it may be helpful to read through some of these decisions. In addition, on March 13, 2015, the SEC provided its own separate guidance on what kinds of factors it will look at, which is available here. These factors include:
  • The nature of the violation or conviction and whether it involved the purchase or sale of securities
  • Whether the conduct involved a criminal conviction or scienter [intent]-based conviction (bad), as opposed to a civil or non-scienter based provision (less bad.) (Note that the SEC guidance specifically notes that the burden on the person seeking a waiver will be “significantly higher” in the case of the former category.)
  • Who was responsible for the misconduct? (For example, was it an executive officer at the company which is seeking the waiver? Or a participating officer of the placement agent working with the company? Generally speaking, a company will have a better chance of receiving a waiver in the former case as opposed to the latter.)
  • What was the duration of the misconduct? Here, of course, the longer the misconduct goes on, the less likely a waiver will be granted. Again, this goes to show the importance of putting in place a robust internal system to watch out for and correct wrongdoing. Here, because smaller companies often lack the resources to put in place the sophisticated internal controls that a larger, public company can, this may put them at a disadvantage when it comes to seeking a waiver.
  • What remedial steps have been taken? Once the misconduct is identified, what has the company done to fix the damage? For example, has it terminated its relationship with the persons involved? Has it instituted new policies to prevent a reoccurrence in the future? The more a company can show that it has taken steps to address the problem, the more likely it will be successful in its waiver application.
  • What is the impact if the waiver is denied? Here, the impact which the SEC is worried about is not merely about the impact on the party seeking the waiver itself, but also its customers, clients, and investors. This again can put smaller start-up companies at a significant disadvantage, because the aggregate impact of its not receiving a waiver will necessarily be less than that of, for example, a huge investment banking firm which is involved in hundreds of Rule 506 offerings a year. 
Going off of this last factor, there has in fact been significant criticism levied against the SEC for its willingness to grant Rule 506 waivers (among others) to large institutions (think of “too big to fail” or “systemically important” institutions.) Much of this criticism has come from members of the SEC themselves. On May 21, 2015, for example, Commissioner Stein penned a stinging dissent from the granting of a waiver to several large firms after they had received criminal convictions for manipulating currency exchange rates (the full text of her dissent is available here. In fact, the vast majority of waivers which are granted go to very large institutions. As Herrick Lidstone asks here: “One can question whether the SEC will show the same leniency to smaller issuers applying for waivers under Rule 506...”.  Indeed, given the backlash against the SEC for its leniency in granting waivers in the past, there may be a risk that any future crackdown will also disproportionately affect smaller issuers.


In conclusion, I would like to say that Rule 506(d) should not be taken lightly. It adds a layer of complexity to the Rule 506 private placements, which should be navigated with the assistance of experienced counsel. The main task for the company conducting a private placement in reliance on Rule 506(b) or (c) is to conduct adequate due diligence of its “covered persons” through the use of questionnaires, representations and covenants, as well as online research, to ensure that any involvement with a “bad actor” is terminated prior to the commencement of the offering.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate, securities, and intellectual property law.

Wednesday, July 15, 2015

Rule 506(d) “Bad Actor” Disqualifications: Who’s a Bad Actor and Why are They Bad? - Part I

Rule 506 is by far the most widely used Regulation D exemption for conducting private placements. According to the SEC, about 90-95% of all private placements are conducted pursuant to Rule 506. This Rule permits sales of an unlimited dollar amount of securities without Securities Act registration, provided certain requirements are satisfied. Traditionally, issuers relied on Rule 506(b) that allows unlimited amounts to be raised from accredited investors and up to 35 non-accredited investors, so long as there was no general solicitation and advertising and other conditions were met. In implementing Section 201(a) of the JOBS Act, the SEC added a new Rule 506(c) that allows general solicitation and advertising in Rule 506 offerings so long as all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verity their accredited investor status.

As of September 23, 2014, the SEC added a new section (d) to Rule 506. Rule 506(d) applies to all Rule 506 offerings, i.e., Rule 506(b) and Rule 506(c) offerings. It is important that all companies raising capital by means of Rule 506 know and understand the new addition to Rule 506 because failing to comply with Rule 506(d) will disqualify the entire offering.

Rule 506(d) identifies certain persons that may potentially become “bad actors.” It also lists certain events (“disqualifying events” or “bad acts”). An offering cannot be made using Rule 506 if it includes a “bad actor” that is engaging or has engaged in a “bad act.” This blog post focuses on (1) who may be a potential “bad actor” and (2) what constitutes a “disqualifying event” or “bad act.” The follow up blog will discuss certain exceptions from disqualification and how to obtain waivers.

Who are the potential bad actors?

Rule 506(d)(1) casts a wide net in terms of who can potentially be a bad actor (and can destroy the Rule 506 exemption). Possible "covered persons" include:
  • The issuer of the securities (as well as any predecessor of the issuer or any “affiliated issuer.” An affiliated issuer, as the name suggests, is an affiliate (a person who controls or is controlled by the issuer) who is also issuing securities in the same offering.
  • Any director, executive officer, or other officer participating in the offering. (Participation can include such activities as preparing due diligence and/or disclosure documents or communicating with other participants in the offering, including potential investors. In general, when trying to determine whether a particular officer is “participating” when it comes to performing a “bad actor” check, err on the side of caution and assume that the SEC is likely to answer “yes”, particularly when it comes to smaller start-up companies which may not yet have well-entrenched and explicit divisions of labor and responsibility.)
  • Any general partner or managing member of the issuer.
  • Any beneficial owner of 20% or more of the issuer’s outstanding voting equity securities.
  • Any “promoter” connected to the issuer in any capacity during the actual sale of securities. (The SEC defines “promoter” broadly: the term includes any natural person or legal entity that “directly or indirectly takes initiative” in founding the company, as well as any person who, in connection with the founding, receives (other than solely as underwriting compensation or in exchange for property) at least 10% of either the proceeds of any sale of securities by the issuer or at least 10% of any class of the securities themselves.)
  • Any investment manager of the issuer (if the issuer is a pooled investment fund), as well as its directors, executive officers, other participating officers, general partners, and managing members.
  • Any natural person or legal entity who has been or willed be paid to solicit purchasers of the offered securities (e.g. a placement agent), as well as their directors, executive officers, other participating officers, general partners, or managing members.
As you can see, the list of potential “bad actors” that an issuer will need to vet can potentially be a long one, especially, for example, if they will be working with several different placement agents. That being the case, a company seeking to raise money in a Rule 506 private placement should be proactive in determining if they are subject to bad action disqualification at time they are offering or selling securities in reliance of Rule 506. Some steps a company should take include adding bad actor disqualification representations and covenants in their placement agency agreements or securities distribution agreements and asking all participants covered by Rule 506(d) to complete a bad actor questionnaire and/or certification (and bring-downs of the same if the offering is long-lived). Also, the issuer may add a provision in its bylaws requiring each “covered person” to notify it of a potential or actual bad actor event. Further, the issuer should check and re-check public databases for any triggering events. We will talk more about the reasonable care exception in the next blog.

What constitutes a “disqualifying event” or a “bad act"?

Rule 501(d)(1)(i)-(viii) lists the bad acts.  A bad actor is any of the covered persons who:
  • Has been convicted within ten years of the sale (five years for issuers and their predecessors or affiliates) of any felony or misdemeanor in connection with the purchase or sale of any security; involving making any false filing with the SEC; or arising out of the business conduct of certain financial intermediaries;
  • Is subject to any final order, judgment or decree entered within five years of the sale that at the time of the sale restrains or enjoins such person from engaging or continuing to engage in any conduct or practice in connection with the purchase or sale of a security, involving the making of a false SEC filing, or arising out of the conduct of certain types of financial intermediaries;
  • Is subject to a final order from state securities regulators, insurance, banking, savings association or credit union regulators, federal banking agencies, the CFTC or the National Credit Union Administration that either (1) at the time of the current sale, bars the person from association with any entity regulated by such a commission, agency, etc.; engaging in the securities, banking, or insurance business; or engaging in savings association or credit union activities, or (2) constitutes a final order based on a violation of any law or regulation prohibiting fraudulent, manipulative, or deceptive conduct.
  • Is subject, at the time of the sale, to an SEC order entered under certain provisions relating to brokers, dealers, municipal securities dealers, investment companies and investment advisers and their associated persons;
  • Is subject to an SEC order (entered within five years of the current sale) that, at the time of the sale, orders the person to “cease and desist from committing or causing a violation or future violation” of 1) any scienter-based [i.e. intentional] antifraud provision of the federal securities laws (e.g. Section 10(b) and Rule 10b-5 of the Securities Exchange Act, Section 17(a) of the Securities Act); or 2) Section 5 of the Securities Act (dealing with selling unregistered securities (which have not received an exemption) in interstate commerce) (Cease and desist orders regarding violations which do not include a scienter (intent) element would not be included, and thus would not be disqualifying “bad acts.”)
  • Is suspended or expelled from membership in, or barred from associating with a member of, a registered national securities exchange (e.g. NYSE) or an affiliated securities association (e.g. FINRA) for actions found to be inconsistent with the just and equitable principles of trade;
  • Has filed either as a registrant or issuer, or who acted or was named as an underwriter for, any registration statement or Regulation A offering which, within the five years prior to the current securities offering, was the subject of an SEC stop order, refusal order, or an order suspending the Regulation A exemption, or who is currently the subject of an investigation or proceeding to determine whether such an order should be issued.
  • Is subject to a USPS false representation order entered within five years of the current sale of securities, or who has received a temporary restraining order or preliminary injunction regarding conduct alleged by the USPS to constitute a scheme to obtain money or property through the mail by means of false representations.
Only “bad acts” occurring on or after September 23, 2013 can destroy the exemption; those occurring prior to that date require disclosure, but do not themselves destroy the exemption. One important thing to note here is that this cut-off refers to the date of the conviction, order, etc. in question, not the underlying activities which eventually resulted in that action. For example, a broker who was suspended on October 1, 2014 for activity that occurred on June 3, 2014, would be a “bad actor” under the Rule, because the actual suspension occurred on or after September 23. Accordingly, the relevant look-back periods in the Rule are measured from the date of conviction or sanction, not from the date when the conduct occurred.

Final thing to note is that Rule 506(d) is not triggered by actions of foreign courts or regulations, such as convictions, court orders or injunctions.

Given the serious, even devastating potential consequences that can follow from failing to catch a “bad actor” disqualification, I strongly encourage companies considering raising capital through a Rule 506 private placement to devote the necessary time and resources to ensuring that the company and its covered persons are in full compliance with the “bad actor” disqualification provisions of Rule 506(d).

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate, securities, and intellectual property law.

Wednesday, July 8, 2015

NY DPC - New York Design Professional Services Corporation - What Is It and How To Form It?

New York has long been recognized as having some of the strictest laws on the books when it comes to what is known as the “professional service corporation” (a “PC” for short), a specialized kind of business entity that must be formed by individuals providing professional services, such as lawyers, doctors, or engineers.  You can recognize these corporations by the inclusion of PC at the end of their names (just like "Inc." for the traditional “C” corporation).

In particular, the NY law is very strict with regard to who may be shareholder,  officer or director of such a corporation.  In a traditional professional corporation, all of the directors and officers must be professionals licensed in New York to provide the kind of services the company is involved in (and the company can only provide one kind of service; it cannot, for instance, provide both legal and accounting services, even if it had both licensed attorneys and licensed accountants as employees.)  In addition, only licensed professionals with the company are allowed to own equity; non-licensed employees, even highly important ones, cannot. A common complaint has been that this restriction has made New York firms less competitive with out-of-state firms that do not have similarly strict restrictions when it comes to attracting and retaining key employees. Although the law includes a “grandfather” clause, it is highly restrictive and very difficult and expensive to make use of.

In January 2012, however, the NY state amended Section 1503 of its Business Corporation Law to allow for a new kind of professional services corporation, the Design Professional Services Corporation (DPC for short). In a DPC, as opposed to the traditional PC, a limited number of the company’s officers and directors (less than 25%) may be non-professionals; in addition, a limited amount of equity ownership (again, less than 25%) is permitted to be held by non-professional employees or within employee stock ownership plans (ESOPs). While any increased flexibility in the ability to choose the appropriate corporate form is welcome, the law’s changes are limited, and it will be important for anyone considering this new DPC form to be aware of those limitations. This blog post will give you a brief introduction to this relatively new kind of corporate form in New York and discuss the changes (and continuing limitations) it provides.

Although the law does provide greater flexibility than the traditional rules with regard to equity ownership and who may serve as an officer or director, it still requires that greater than 75% of both the equity ownership (i.e. outstanding shares) and officer/director positions remain in the hands of employees who are licensed professionals.  In addition, the company president, chief executive officer, and chairperson of the board of directors must be licensed professionals. With regard to the equity provisions, the “less than 25%” of equity which does not have to be held by licensed professional employees must, in the alternative, be held by non-professional employees and/or an ESOP. No other person (either a natural person or a legal entity such as a partnership or another corporation) is permitted to own any equity stake. In addition, the largest single shareholder must be either 1) a licensed professional; or 2) an ESOP where greater than 75% of the plan’s voting trustees and committee members are licensed professionals. Note, however, that even an ESOP eligible to be the largest shareholder must own less than 25% of the company’s shares, because the law explicitly says that “an ESOP... shall not constitute part of the greater than 75% owned by design professionals.”

Another important restriction to keep in mind is that the DPC form is available only to companies providing four specific kinds of professional services. These are:
  • Professional engineering
  • Architecture
  • Landscape Architecture
  • Land Surveying.
Unlike the traditional professional services corporation, however, a DPC is allowed to provide more than one kind of such service, as long as the company employs at least one professional in each service it will be providing.

Now that we’ve examined the requirements that must be met in order to form your company as a DPC, how do you go about it? Here are the steps:

  • Prepare and fully execute the Certificate of Incorporation.  The NY Division of Corporation provides a sample.  Note that there are special disclosure requirements that apply to the DPCs.
  • Prepare Moral Character Attestations for all unlicensed shareholders, officers and directors.  
  • Submit the Certificate of Incorporation, the Attestations and a filing fee to the NY State Education Department, which will then issue a Certificate of Authority (there is currently a wait of almost a month to get it).
  • Submit the Certificate of Incorporation and the Certificate of Authority to the NY State Department for filing. 
  • Finally, send a certified copy of the Certificate of Incorporation and a filing fee to the New York State Education Department.  
  • As a very final step, - all DPCs that provide engineering and/or land surveying services must also obtain a Certificate of Authorization to provide such services (and if both of these services are provided, then the DPC needs to obtain two certificates).  
  • Once every three years, DPCs must submit a statement and pay a filing fee to the NY State Education Department.

The new law also allows a currently existing PC to convert into a DPC if it meets the DPC requirements. This can be done by amending the existing PC’s certificate of incorporation to include all of the information indicated above (and the name should be changed to include the DPC signifier). The certificate of amendment must also include:
  • A tax clearance issued by the Department of Taxation and Finance certifying that the existing PC is current on all of its state tax liabilities; and
  • A certificate of good standing from the state Department of Education certifying that the existing PC is authorized to provide professional services without restriction
The state’s Office of Professions also provides a guide to converting a PC into a DPC on its website.

As you can see, the new DPC form does provide some greater flexibility for certain kinds of professional services corporations when it comes to stock ownership and officer/director positions. It will be interesting to see how popular this new form will be in the years to come and whether these initial, incremental reforms to New York’s professional services corporation law will herald additional reforms in future years.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate, securities, and intellectual property law.