Legislative Priorities

Ropes & Gray LLP: Disqualification of “Bad Actors” from Regulation D Offerings

By Jason Brown

Ropes & Gray LLP

Effective September 23, 2013, the SEC adopted amendments to Regulation D to disqualify securities offerings involving “bad actors” from reliance on the exemption from registration pursuant to Rule 506. The disqualification applies to Rule 506 generally and not just the newly adopted Rule 506(c) (which permits general solicitation).

The covered persons (i.e., persons who could be considered “bad actors” under the rule) most likely to be involved with private equity funds include:

  • Investment managers of funds;
  • The directors, executive officers, other officers participating in the offering, general partners and managing members of such investment managers;
  • The fund itself and affiliate issuers (“affiliate issuer” could arguably include a wide array of related entities);
  • Directors, executive officers, other officers participating in the offering, general partners or managing members of the fund (e.g., the fund’s general partner or Cayman directors);
  • 20% beneficial owners of the fund measured by voting power (fund sponsors will need to consider whether investors in the funds hold “voting securities” for purposes of Rule 506); and
  • Persons compensated for soliciting investors (e.g., placement agents) as well as the general partners, directors, executive officers, other officers participating in the offering, and managing members of any compensated solicitor.

There is a wide array of disqualifying events. However, the disqualifying events most likely to apply to covered persons of private equity funds are as follows (each of which has certain time periods after which the event is no longer a disqualifying event):

  • 1. Certain SEC orders in connection with violations of anti-fraud provisions of the federal securities laws;
  • 2. Criminal convictions, court injunctions and restraining orders in connection with the purchase or sale of a security, involving the making of a false filing with the SEC, or arising out of the conduct of certain financial intermediaries; and
  • 3. Final orders from certain state and federal regulators (i) that bar a person from associating with a regulated entity in the business of securities, insurance or banking or (ii) that find a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct.

A fund will be disqualified only for disqualifying events that occur after September 23, 2013. If an event that would otherwise be a disqualifying event occurred before September 23, the fund is required to provide investors with written disclosure of the event.

The bad actor amendment includes a waiver provision, under which the SEC may grant a waiver of disqualification if it determines that an issuer has shown good cause that it is not necessary under the circumstances that the registration exemption be denied. The adopting release identifies a number of circumstances that could, depending on the specific facts, be relevant to the evaluation of a waiver request.

The final rule provides an exception from disqualification when the issuer can show it did not know and, in the exercise of reasonable care, could not have known that a covered person with a disqualifying event participated in the offering. Therefore, the SEC suggests that fund sponsors consider distribution of “questionnaires or certifications, perhaps accompanied by contractual representations, covenants and undertakings,” to, among others, investment manager personnel and placement agents. Fund sponsors may also wish to add appropriate provisions to placement agent contracts to address a situation in which a placement agent becomes a bad actor during an offering.

In light of the seriousness of the bad actor rules, a “bad actor” finding applicable to an investment manager could constitute a form of commercial “death penalty” for the firm and/or its personnel. Therefore, to the extent enforcement actions are brought against a fund manager or its personnel, the bad actor rules should be taken into account in settlement negotiations. Additionally, investment managers should take care when hiring new employees to ensure any such employees constituting covered persons are not subject to any “bad actor” disqualifications under Rule 506.

For an issuer that is disqualified from using Rule 506, a separate question is whether the nature of the offering permits reliance on Section 4(a)(2) to conduct the offering, notwithstanding the non-availability of the safe harbor that would otherwise be provided by Rule 506.

In conclusion, prior to September 23, 2013 (or as soon as possible thereafter), firms should determine the universe of applicable covered persons, determine the due diligence to be performed on those covered persons and the deadline for performing such diligence. Fund sponsors currently fundraising will need to conduct this due diligence prior to the effective date of the rule (i.e., September 23, 2013) so that they can determine if disclosure is required for pre-September 23 disqualifying events. For funds not currently fundraising, their deadline may be several years in the future (although it may be a concern for new hires in the interim).