Tag: Rule 506(d)

What is a “Voting Equity Security” under the Bad Actor Rule?

When the Securities and Exchange Commission adopted Rule 506(d), it did not define “voting equity securities.” That left many fund managers having to take an aggressive approach on compliance with the “bad actor rule.” The SEC has provided some additional clarity.

Vote

I have to admit that I did not pay much attention to the recent rule release for Regulation A. I’m skeptical that it’s a particularly useful fundraising tool for funds. Also, Regulation recently came under siege from state securities regulators.

It turns out that the SEC buried some clarification about Rule 506(d) in the release for the updated Regulation A. If you don’t want to read all 450+ pages of the rule release, just turn to page 203 for the discussion of the change.

The SEC has reconsidered its initial interpretation as it applies to the bad actor rule in 506(d) and created a bright-line test. (As a compliance professional, I like bright-line tests.)

Previously the SEC consider securities as voting equity securities if:

“securityholders have or share the ability, either currently or on a contingent basis, to control or significantly influence the management and policies of the issuer through the exercise of a voting right.”

I think most people looked at this and said if you have or could possibly have 20% of anything in the company, you fall within the bad actor rule. The SEC decided this interpretation was too broad and wanted a definition that would “facilitate compliance.”

The new definition:

In this regard, we believe that such a term should include only those voting equity securities which, by their terms, currently entitle the holder to vote for the election of directors. In other words, we believe the term should be read to denote securities having a right to vote that are presently exercisable. Additionally, while the ability to control or significantly influence the management or policies of the issuer may be derived in part from the power to vote for the election of directors, in order to dispel any uncertainty as to the scope of our interpretation, we believe the term “voting equity securities” should be interpreted based on the present right to vote for the election of directors, irrespective of the existence of control or significant influence.

That is a great change, making the definition more narrow. A great change that is limited to investment vehicles formed as corporations.

Of course, the SEC flubbed and used the term “directors” in this definition. That leaves fund compliance professionals scratching their heads as to how this interpretation applies to a private fund, which is typically organized as a limited partnership.

I think you have to ignore it. You can argue that a right of limited partners to remove the general partner without fault is the equivalent to the right to elect a director of a corporation. I’m just not sure you win that argument. It certainly make the bright line test much more blurry.

Sources:

Vote by Theresa Thompson
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Bad Actors on Form ADV and Under Rule 506(d)

venn diagram and compliance

The Securities and Exchange Commission has layered two tests for bad actors on to private fund managers. On Form ADV, the fund manager will need to disclose bad actor events. Then the second test comes under the new Rule 506(d) that also requires disclosure for bad actors in private placements and a bar for recent bad actors. From a compliance perspective, the question comes down to how do you deal with certifications.

Unfortunately, the employees for Form ADV disclosure are potentially different than the employees than the 506(d) disclosure and bans. For 506(d) its limited to “officers participating in the offering.”

Participation in an offering would have to be more than transitory or incidental involvement, and could include activities such as participation or involvement in due diligence activities, involvement in the preparation of disclosure documents, and communication with the issuer, prospective investors or other offering participants.

I’m not sure that helps much for fund managers. It does mean that you can exclude administrative assistants.

For Form ADV, the disclosure pertains to

Your advisory affiliates are: (1) all of your current employees (other than employees performing only clerical, administrative, support or similar functions); (2) all of your officers, partners, or directors (or any person performing similar functions); and (3) all persons directly or indirectly controlling you or controlled by you.

The Form ADV disclosure is potentially for a broader group of employees. Your organization may have employees who are not clerical, but are also not officers participating in the offering.

I think it’s probably just easier to require every employee to fill out the questionnaires. Then you can get into the weeds of the analysis if there is a disclosure event.

That leads to the next item which is the questionnaires. The main concept between the two are the same. If your employees have been involved in financial crimes, you need to disclose that information. However, the time frames, laws covered, and conviction status vary between each regulatory requirement.

I tried to sit down and create a unified questionnaire that would address disclosures for both Form ADV and Rule 506(d). In ended up being a huge pain in the neck and I gave up. I have two separate questionnaires that I require all employees to deliver.  Let me know if you have come up with a unified questionnaire.

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Participating Bad Actors and Private Funds

bad actor

The SEC staff issued new Compliance & Disclosure Interpretations relating to Rule 506(d), the new bad actor rule. Under the rule, an issuer may not rely on the Rule 506 exemption if the issuer or any other person covered by rule has a relevant disqualifying event that occurred on or after September 23, 2013 (the effective date of the rule 506).

It’s a tricky rule, mandated by Dodd-Frank. Conceptually, I agree that the law should not permit bad guys to participate in private offerings of securities. The devil is in the details.

One murky item was what it meant to “participate” in the offering. For a big placement agent or brokerage, it’s easy to wall someone off. But how does that work from the perspective of the issuer? The SEC offered two new answers to questions about “participation.”

Question 260.18

Question: Does the term “participating” include persons whose sole involvement with a Rule 506 offering is as members of a compensated solicitor’s deal or transaction committee that is responsible for approving such compensated solicitor’s participation in the offering?

Answer: No.

Question 260.19

Participation in an offering is not limited to solicitation of investors. Examples of participation in an offering include participation or involvement in due diligence activities or the preparation of offering materials (including analyst reports used to solicit investors), providing structuring or other advice to the issuer in connection with the offering, and communicating with the issuer, prospective investors or other offering participants about the offering. To constitute participation for purposes of the rule, such activities must be more than transitory or incidental. Administrative functions, such as opening brokerage accounts, wiring funds, and bookkeeping activities, would generally not be deemed to be participating in the offering.

Those question are clearly addressed to placement agents and brokers, not to issuers.

So who is “participating” in the offering at a fund manager?

The rule explicitly covers the fund manager. But the fund manager is rarely an individual.

The rule explicitly covers “any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with such sale of securities.” That would cover the marketing group, if any of them are getting paid a commission. Of course that raises the other issuer of whether the marketing group is subject to broker-dealer registration.

The rule also includes any “general partner or managing member of any such investment manager.” Those are legal terms and could be avoided by the organizational structure and titles granted to the manager’s principals. But I would include the principal owners of the fund manager.

Then the rule moves down the next rung and includes “any director, executive officer or other officer participating in the offering of any such investment manager”.  The SEC release clearly said that merely being an officer, does not bring you into the scope of the rule’s disqualification. An “officer” test based solely on job title would be unduly burdensome and overly restrictive.

Participation in an offering would have to be more than transitory or incidental involvement, and could include activities such as participation or involvement in due diligence activities, involvement in the preparation of disclosure documents, and communication with the issuer, prospective investors or other offering participants.

That brings the marketing group clearly back into the rule because is communicates with prospective investors.

I have trouble with “preparation of disclosure documents.” Lots of people in the organization help to prepare the disclosure documents and are involved in due diligence activities.

I was hoping the SEC’s new interpretations would help narrow the scope of those covered by the rule at the fund manager. But they do not.

References:

Ignoring Changes to Regulation D

compliance and ignore this sign
While many embraced lifting the ban on general solicitation and advertising, most despised the additional mess that the SEC added in. Fortunately, you can probably ignore much of that mess. At least for a few months.

We knew that the SEC was going to require that firms selling public private-placements were going to have to take some reasonable steps to confirm that the purchasers were actually accredited investors. Congress wrote that into the JOBS Act. (Although I suspect they would have written it differently if they knew the end result.)

Based on the July 10 SEC meeting, 506(c) and 506(d) go into effect on September 23. The dreaded changes to Form D and Rule 156 do not. Those are only proposed rules.

SEC Chairman Mary Jo White made this obvious in a recent letter response to Congressman McHenry.

It’s clear that funds can use the public private-placement regime under Rule 506(c) on September 23, 2013. The current rules on filing the Form D are in place. There will be no requirement to file the advertisements with the SEC. There will be no required legends on the advertisements.

For now.

The changes to Form D and the advertising legends are merely in a proposed rule. The SEC may abandon its concerns and not issue a final rule. (unlikely) The SEC may make significant changes to the rule. (possibly)

Chairman White makes it clear that there will need to be some transitional guidance for offerings that commence before the effective date of the final rule. So you can ignore the proposals.

But the proposed rule is clearly a signal that the SEC wants to do something more for private placements. I would guess that some form of the rule will be adopted before the end of the year. The mutual fund industry will be furious that their product advertisements are weighed down with disclaimers, while cowboy hedge funds are all over the place and grabbing bigger fees.

There are signs ahead. But we can ignore them for now.

References:

Ignore This Sign, 2004
Marietta, Georgia, USA
Hacking the City, by Brad Downey

Employee Criminal History and 506(d)

baD BOYSThe bad actor rule in the new Rule 506(d) makes private placements a bit harder and will require private funds and companies to do more homework in connection with the fundraising. That’s because an issuer cannot rely on the Rule 506 exemption if the issuer or any other person covered by the rule had a “bad actor disqualification.”

An issue arises when you ask about criminal history. It’s been decades since I had to fill out a job application, but I remember the question asking if you are a convicted felon. That allows employer to quickly discard job applications filed by convicted criminals. A few states have felt that this is discriminatory and have enacted limitations on asking whether a job applicant has a criminal history.

This conflicts with the Rule 506(d) requirement that you exercise reasonable care in determining whether a covered employee is a bad actor. Some states limit your ability to run a criminal background inquiry and some limit your ability to even ask whether a prospective employee has a criminal background.

A shotgun approach will not work.

Most of these state laws allow you to eventually ask the criminal background question. If you are subject to 506(d) you need to ask the question, it can’t be one of the first questions.

References:

The New Rule 506(d) and Bad Actors

baD BOYS

At its latest meeting, the Securities and Exchange Commission approve the rule that lifted the ban on general solicitation and advertising for certain private placements. The SEC also adopted the new rule that disqualifies felons and other bad actors from participating in certain securities offerings. The first rule was mandated by the JOBS Act. The “bad actor” rule was mandated by Dodd-Frank.

The bad actor rule makes private placements a bit harder and will require private funds and companies to do more homework in connection with the fundraising. That’s because an issuer cannot rely on the Rule 506 exemption if the issuer or any other person covered by the rule had a “bad actor disqualification.”

I think the starting point is who is covered by the rule. The rule applies to

  • The issuer, including its predecessors and affiliates
  • Directors, executive officers, general partners, and managing members of the issuer
  • Any other officer participating in the offering
  • Anyone who holds 20% or more of the outstanding voting equity securities
  • Investment managers and principals of pooled investment funds
  • Any general partner or managing member, director, executive officer or other officer participating in the offering of a fund sponsor
  • Solicitors paid to sell the securities investors as well as the general partners, directors, officers, managing members or other officer participating in the offering

For fund managers registered with the SEC the employees affected are a narrower group than those in Item 11 on Form ADV. That part of the Form ADV disclosure applies to all employees, other than employees performing only clerical, administrative, support or similar functions. Plus the Form ADV includes all of the officers, partners, directors, and certain affiliates.

The big difference is the 20% threshold for ownership in the company. For startups, that would likely pull some angel investors into the “actor” category.

It’s not clear what to do if the 20% investor is an entity. The rule does not seem to cover that circumstance. I suppose that if Bernie Madoff set up Scumbag Bernie Investor LLC to invest in the fund that would be a mere facade to hide his ownership. If the entity has multiple owners and officers it seems that a single “bad actor” inside the investor should not taint the whole entity.

The other fuzzy item is “officers participating in the offering.” The SEC had declined to merely use job title as the defining line. That would have included everyone who had the title of vice president.

Participation in an offering would have to be more than transitory or incidental involvement, and could include activities such as participation or involvement in due diligence activities, involvement in the preparation of disclosure documents, and communication with the issuer, prospective investors or other offering participants.

I’m not sure how I feel about that guidance. A lot of people end up reviewing the Private Placement Memorandum.

Of those relevant actors to determine if they were bad, they need to have been involved in a “disqualifying event” which includes:

  • Criminal convictions in connection with financial fraud.
  • Subject to an order of judgement that limits involvement in the securities industry.
  • Subject to an order of judgement that limits involvement in the banking industry
  • Subject to an order of judgement from the CFTC.
  • Subject to a US Postal Service false representation order.

The actual list is much more convoluted, long, and unwieldy. That means putting together a questionnaire will be difficult. For private fund adviser, it does not match up squarely with the Form ADV disclosures and is not as clearly written as the Form ADV disclosures.

The default would be to put together a questionnaire and just use the text of Rule 505(d). I’m not sure it’s comprehensible by a non-lawyer. Actually, I’m not sure it’s easily comprehensible by a lawyer. I just added it to my questionnaire for Form ADV, making it extend to four pages.

The next question is how much diligence you need to conduct to determine if one of your “actors” is a “bad actor”? The rule requires the issuer to exercise “reasonable care.” Which in “light of the circumstances, the issuer made a factual inquiry into whether a disqualification exists.”

That’s the kind of fuzziness that keeps a compliance officer up at night.

Fortunately, the SEC offers some color to the “reasonable care” in the release.

For example, we anticipate that issuers will have an in-depth knowledge of their own executive officers and other officers participating in securities offerings gained through the hiring process and in the course of the employment relationship, and in such circumstances, further steps may not be required in connection with a particular offering.

So the questionnaire approach should work for employees, unless you have some suspicion that an employee has been up to no good.

What about for investors?

Factual inquiry by means of questionnaires or certifications, perhaps accompanied by contractual representations, covenants and undertakings, may be sufficient in some circumstances, particularly if there is no information or other indicators suggesting bad actor involvement.

That’s enough to let me fall asleep at night. Maybe I’ll need just a little bourbon to take the edge off.

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