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.

Conclusion

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.