SEC Issues New Guidance on Bad Actor Rules

Simon Riveles 506 Disqualification, Bad Actor

By Simon Riveles and Simon Cooke

On July 10, 2013, the U.S. Securities and Exchange Commission (“SEC”) adopted amendments to Rule 506 of the Securities Act of 1933 to disqualify securities’ offerings relying on the Rule 506 exemption that involve certain “bad actors”. These amendments came into effect on September 23, 2013. Please refer to our earlier blog for background on these amendments.

On December 4, 2013, the SEC responded to queries by private fund managers and others by posting additional Compliance and Disclosure Interpretations (“CDIs”) in order to clarify the application of the above amendments. These CDIs have provided some clarification but have also created new questions as well as leaving some original questions unanswered. The relevant CDIs range from 260.14 to 260.27. Several CDIs deserve particular focus and are outlined below:

Affiliated Issuer

CDI 260.16 has clarified that the definition of “affiliated issuer” is limited to any affiliate that is issuing securities in the same offering. This clarification has allayed concerns that the term “affiliated issuer” would capture every affiliate of the issuer that has issued securities. This was of particular concern to, for example, controlled portfolio companies of private equity funds or remote affiliates of large financial services’ firms where the number of affiliates requiring inquiry regarding the involvement of “bad actors” could be numerous.

Factual Inquiry Update

CDI 260.14 notes that “an issuer may reasonably rely on a covered person’s agreement to provide notice of a potential or actual bad actor triggering event”. However, if an offering is “continuous, delayed or long-lived”, the issuer must update its factual inquiry regarding “bad actor” triggering events, “periodically”. This CDI could be further clarified by defining “periodically” in order to outline precisely how often a factual inquiry is required. Examples of the methods of factual inquiry noted in the CDI include questionnaires and certifications as well as periodic re-checking of public databases.

Reasonable Care Exception

CDI 260.23 has provided clarification regarding the extent of the “reasonable care” exception, which “applies whenever the issuer can establish that it did not know and, despite the exercise of reasonable care, could not have known that a disqualification existed under Rule 506(d)(1)”. This CDI notes that the exception extends to circumstances where the issuer was unable to determine the existence of a disqualifying event or that a particular person was a covered person. It also applies where the issuer initially reasonably determined that a person was not a covered person but then realized this determination was incorrect. The SEC has not provided clarification on what steps would constitute “reasonable care” by an issuer, leaving untouched its original guidance that it would be determined on a case-by-case basis.

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