Many companies raise money through private placements under Regulation D, especially under Rules 505 and 506. Many investment bankers assist companies in raising Regulation D capital. While there are a number of other exemptions from registration under federal law (including Rule 504 for up to $1 million; Rule 147 for intrastate exemptions; Rule 701 for compensatory benefit plans; and Regulation S for offshore transactions), Rules 505 and 506, and especially Rule 506, are by far the most frequently used exemptions. Those exemptions are not available to the extent the bad-boy disqualification rules apply.
The Long History of SEC Disqualifications
Rule 505, and Rule 240 before Rule 505 was effective, have been subject to certain disqualifications as defined in Rule 262 of Regulation A (17 CFR § 230.262). Rule 262 was first adopted in 1936 in SEC Rel. No. 33-632 (Jan 21, 1936) and was recently amended with the Regulation A+ rules adopted by the Securities and Exchange Commission (the “SEC”) on March 25, 2015 (SEC Rel. 33-9741). These disqualification provisions make the exemptions from registration under Regulation A and Rule 505 of Regulation D unavailable for an offering if, among other things, an issuer, any of its predecessors, or any affiliated issuer is subject to certain administrative orders, industry bars, an injunction involving certain securities law violations or specified criminal convictions.
Disqualification also occurs if any of the issuer’s directors, officers, general partners, ten percent beneficial owners of any class of the issuer’s equity securities, or promoters, underwriters, persons compensated for soliciting purchasers, or any of the underwriters’ or paid solicitors’ partners, directors, or officers, is subject to administrative orders, injunctions, associational bars or specified convictions. SEC Regulation C, Rule 405 provides that a well-known seasoned issuer (WKSI) can be disqualified from accessing the public capital markets on an accelerated and streamlined basis if it becomes an “ineligible issuer” as a result of administrative or civil sanctions, among other things. The definition of “ineligible issuer” was adopted with the WKSI rules in SEC Release 33-8591 (Aug. 3, 2005).
Disqualifications Brought to Rule 506
Historically, even with a disqualification under Rule 505, an issuer could use Rule 506. That has no longer been the case since September 23, 2013, when Rule 506(d) became effective due to the mandate set forth in the Dodd Frank Wall Street Reform and Consumer Protection Act of 2010. Rule 506(d) (the “Bad Actor Provisions”) is a disqualification from the ability to use Rule 506 by bad actors. While the Bad Actor Provisions are similar to the provisions under Regulation A (before the 2015 amendments), they were not the same. For example,
In Rule 506(d) one of the categories of covered persons includes beneficial owners of 20 percent or more of an issuer’s voting equity securities, whereas in Rule 262 of Regulation A and Rule 505 of Regulation D, the category includes beneficial owners of 10 percent or more of any class of the issuer’s equity securities.
Another category of covered persons in Rule 506(d), but not in Rule 262 and Rule 505, includes any investment manager of an issuer that is a pooled investment fund and any director, executive officer, or other officer participating in the offering, of any such investment manager or general partner or managing member of such investment manager.
Although the disqualifying events in Rule 506(d) are also similar to disqualifying events in Rule 262, they are broader in certain respects. In addition to certain administrative orders, industry bars, injunctions involving securities law violations and specified criminal convictions covered under Regulation A and Rule 505, the disqualifying events in Rule 506(d) also include:
Commission cease and desist orders involving scienter-based antifraud provisions of the federal securities laws and violations of Section 5 of the Securities Act; and
Final orders of certain state and federal regulatory authorities that impose a bar from association with a regulated entity, engaging in the business of securities, insurance or banking, or engaging in savings association or credit union activities, or a final order based on a violation of any law or regulation that prohibits fraudulent, manipulative or deceptive conduct and is issued within ten years of the proposed sale of securities.
As amended, the Rule 262 Bad Actor disqualification is substantially the same as the Rule 506(d) Bad Actor disqualification. In neither rule is there a requirement that the actions from which the disqualification derives be scienter-based, although some actions (such as a criminal conviction, (Rule 262(a)(1) and Rule 506(d)(1)(i)) or a “scienter-based anti-fraud provision of the federal securities laws” (Rule 262(a)(5)(i) and Rule 506(d)(1)(v)(A)) do require some level of intent. Notably, the Bad Actor rules do not include final orders of Canadian provincial regulators in the list of disqualifying events.
The effective date for new Rule 262 is June 19, 2015, although there are complex transition rules in Rule 262(b). For the Bad Actor Provisions of Rule 506(d) to be applicable, the disqualifying events must have occurred on or after September 23, 2013. Where the events occurred before the effective dates of the rules (September 23, 2013 for Rule 506; June 19, 2015 for Regulation A), the issuers must still comply with the disclosure requirements of Rule 262(d) or Rule 506(e) (as applicable). (Note that the “disqualifying event” is not the action that led to the criminal conviction or final order of the applicable federal or state regulator, but the conviction or order.)
Much of this is explained in the SEC’s “A Small Entity Compliance Guide” (September 19, 2013).
Federal and State Ability to Create and then Waive a Disqualification
The SEC has the authority to bring enforcement actions that might result in a bar under the Bad Boy Provisions or the Bad Actor Provisions; so do the states. In Colorado specifically, the Colorado Division of Securities has the statutory authority to conduct investigations and issue subpoenas (C.R.S. § 11-51-601), enforce the securities laws by injunction (C.R.S. § 11-51-602), seek criminal penalties through the state attorney general’s office or through a district attorney (C.R.S. §§ 11-51-603, 603.5), seek civil enforcement (C.R.S. § 11-51-604(14)), and conduct administrative proceedings, including a very prompt-acting cease and desist proceeding (C.R.S. § 11-51-606(1.5)).
Depending on the findings in such proceedings, the respondent’s or defendant’s ability to use Rule 506 (or Rule 505) may be impacted. This clearly should be a consideration for any person negotiating a settlement of any SEC or state enforcement action because the result may be more than bargained for—not only the sanctions included in the order, but an incidental treatment as a Bad Boy, Bad Actor, or both. While the sanctions may be painful, the resultant inability to raise capital may be devastating.
As the New York Times reported on March 13, 2015 (at page B6), in a speech the previous day SEC Chair Mary Jo White discussed the fact that during 2013 and 2014, the SEC rejected 14 requests for waivers from the Bad Actor Provisions while granting 13 waiver requests. One of the more controversial waivers granted was to Oppenheimer & Company which settled a case that fell within the Bad Actor Provisions. Despite more than 30 regulatory actions over the previous decade, the SEC granted Oppenheimer a waiver. In her speech, Chair White attempted to distinguish enforcement actions from the resultant waivers that may be applicable.
SEC Chair White was responding to a speech a month earlier by Commissioner Daniel Gallagher. Commissioner Gallagher conflated the enforcement actions taken by the SEC with waivers. He described the SEC’s authority to impose sanctions as being “both remedial and punitive in nature.” He went on to say “that until such time as the Commission officially decides whether disqualifications will continue to be treated as sanctions or whether we will revert to the historical practice of treating them apart from the enforcement process, I will condition my vote on enforcement recommendations matters on an understanding of the planned disposition of requested waivers. A settlement should involve a meeting of the minds on all aspects of the resolution. A settlement should bring finality.” In the opinion of Commissioner Gallagher, where waivers are an important consideration, they should be considered with the other sanctions.
Seeking a Waiver From the SEC
Notwithstanding Commissioner Gallagher’s comments to the contrary, on March 13, 2015, the SEC Division of Corporation Finance issued updated guidance for persons seeking “Waivers of Disqualification under Regulation A and Rules 505 and 506 of Regulation D.” The guidance makes it clear that waivers will be treated separately from any enforcement proceeding that results in the disqualification and will be considered by the Division of Corporation Finance’s Office of Small Business Policy rather than by enforcement. When considering a waiver request, the guidance advises that the Division will consider the following factors, with the understanding that no single factor will be dispositive:
Who was responsible for the misconduct and what role the bad actor or actors have or had with respect to the party seeking the waiver. Depending on the circumstances and the conduct at issue, if misconduct committed by one or more individuals resulted in the waiver applicant’s disqualification, and the applicant removes or terminates its association with those individuals, the Division would generally view such actions taken as favorable to the waiver request.
Whether the misconduct occurred over an extended period or whether it was an isolated instance.
What remedial measures the party seeking the waiver has taken to address the misconduct, when those remedial measures began, and whether those measures are likely to prevent a recurrence of the misconduct and mitigate the possibility of future violations.
The severity of the impact on the issuer or third parties, such as investors, clients or customers, if the waiver request is not granted, and weigh any such impact against the facts and circumstances relating to the misconduct to assess whether disqualification would be a disproportionate hardship in the light of the parties involved in, and the nature of, the misconduct.
Like securities regulators in many states, the Colorado Securities Commissioner has the authority to issue cease and desist orders under C.R.S. §11-51-606(1.5), seek injunction under § 11-51-602, refer actions for criminal enforcement under § 11-51-603, or seek civil enforcement under § 11-51-604(14). Depending on how they are worded, orders issued by the Securities Commissioner or by a court in a state enforcement action may, or may not, fit within the Bad Actor Provisions of Rule 506(d).
It is important for Colorado lawyers when working with clients before the SEC and the Colorado Division of Securities (or the securities agency of any other state) to understand that waivers may be separate from the enforcement discussion. Many, if not most, enforcement actions are resolved by consent, without a hearing or a trial. If defense counsel in a securities enforcement proceeding in a federal or state forum is not familiar with the Bad Boy and Bad Actor Provisions, the sanctions against a respondent can be much more severe than the language of the eventual order. Disqualification from capital raising Rules 505 or 506, or from the Colorado Crowdfunding Act (when available), can be an unexpected consequence of a consensual settlement.
Furthermore, where Colorado has specific Bad Actor Provisions (such as those included in proposed H.B. 15-1246, the Colorado Crowdfunding Act), a federal waiver may not be sufficient to avoid disqualification under state law.
Where the discussions with the SEC or with the State Division of Securities are likely to result in sanctions which may result in disqualification from various capital raising alternatives under federal or state law, counsel and their clients should consider the ramifications before agreeing to any consensual order. That would be the time to discuss waivers and the concern that a federal waiver may not be sufficient under state law. Perhaps the concerns can be dealt with by limiting the language of the order; perhaps a waiver from the SEC and applicable state authorities will be required. The respondent should understand these issues before consenting to any sanction.
In a MarketWatch opinion published May 20, 2015, the columnist discussed the Deutsche Bank order issued by the SEC on May 1, 2015 (SEC Rel. 33-9764) granting Deutsche Bank a waiver from being an ineligible issuer under SEC Rule 405 notwithstanding Deustche Bank’s guilty plea to wire fraud in April 2015 related to the worldwide manipulation of LIBOR (the London Interbank Offered Rate). The guilty plea, together with other related actions, resulted in Deutsche Bank paying fines and penalties of $2.519 billion. According to the dissent filed by Commissioner Kara M. Stein:
Deutsche Bank’s illegal conduct involved nearly a decade of lying, cheating, and stealing. This criminal conduct was pervasive and widespread, involving dozens of employees from Deutsche Bank offices including New York, Frankfurt, Tokyo, and London. Deutsche Bank’s traders engaged in a brazen scheme to defraud Deutsche Bank’s counterparties and the worldwide financial marketplace by secretly manipulating LIBOR. The conduct is appalling. It was a complete criminal fraud upon the worldwide marketplace.
Commissioner Stein noted that this was Deutsche Bank’s third waiver request in eight years, and she did not see any evidence “that Deutsche Bank’s culture of compliance and the reliability and accuracy of its future disclosures establishes good cause for a waiver.”
In her dissent, Commissioner Stein also noted that 100% of the twelve WKSI waivers granted since August 2013 went to large financial institutions. One can question whether the SEC will show the same leniency to smaller issuers applying for waivers under Rule 506 or Regulation A, or even well-known seasoned issuer (WKSI) status.